Do Options Contain Information About Excess Bond Returns?

35 Pages Posted: 20 Mar 2006

See all articles by Caio Almeida

Caio Almeida

Getulio Vargas Foundation ; Princeton University

Jeremy J. Graveline

University of Minnesota - Carlson School of Management

Scott Joslin

University of Southern California

Date Written: March 15, 2006

Abstract

A bond or swap that is sold before it matures has an uncertain return. There is strong empirical evidence that long-term interest rates contain a time-varying risk premium. Interest rate options may contain information about this risk premium because their prices are sensitive to the volatility and market prices of the risk factors that drive interest rates. We ask whether risk premiums estimated using interest rate option prices are better able to predict changes in long-term interest rates. More specifically, we estimate 3-factor affine term structure models using the joint time series of interest rate cap prices and swap rates with different maturities. Our main finding is that the risk premiums estimated using interest rate option prices are better able to predict excess returns, both in- and out-of-sample. In contrast to previous literature, the arbitrage-free models with the most predictive power contain a stochastic volatility component.

Suggested Citation

Almeida, Caio and Graveline, Jeremy J. and Joslin, Scott, Do Options Contain Information About Excess Bond Returns? (March 15, 2006). AFA 2007 Chicago Meetings Paper. Available at SSRN: https://ssrn.com/abstract=891589 or http://dx.doi.org/10.2139/ssrn.891589

Caio Almeida

Getulio Vargas Foundation ( email )

Praia de Botafogo 190, 11o andar
Botafogo
Rio de Janeiro, Rio de Janeiro 22250-900
Brazil
5521-37995827 (Phone)
5521-2553-8821 (Fax)

HOME PAGE: http://www.fgv.br/professor/calmeida/

Princeton University ( email )

26 Prospect Avenue
Princeton, NJ 08540
United States

Jeremy J. Graveline (Contact Author)

University of Minnesota - Carlson School of Management ( email )

19th Avenue South
Minneapolis, MN 55455
United States
612-626-7817 (Phone)

HOME PAGE: http://www.tc.umn.edu/~jeremy/

Scott Joslin

University of Southern California ( email )

Marshall School of Business
Los Angeles, CA 90089
United States

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