Do interest rate options contain information about excess returns?

Caio Almeida, Jeremy J. Graveline, Scott Joslin

Research output: Contribution to journalArticle

17 Scopus citations

Abstract

There is strong empirical evidence that long-term interest rates contain a time-varying risk premium. Options may contain valuable information about this risk premium because their prices are sensitive to the underlying interest rates. We use the joint time series of swap rates and interest rate option prices to estimate dynamic term structure models. The risk premiums that we estimate using option prices are better able to predict excess returns for long-term swaps over short-term swaps. Moreover, in contrast to the previous literature, the most successful models for predicting excess returns have risk factors with stochastic volatility. We also show that the stochastic volatility models we estimate using option prices match the failure of the expectations hypothesis.

Original languageEnglish (US)
Pages (from-to)35-44
Number of pages10
JournalJournal of Econometrics
Volume164
Issue number1
DOIs
StatePublished - Sep 1 2011
Externally publishedYes

All Science Journal Classification (ASJC) codes

  • Economics and Econometrics

Keywords

  • Excess returns
  • Forecasting
  • Interest rates
  • Options
  • Risk premia

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