Identifying volatility risk premia from fixed income Asian options

Caio Almeida, José Vicente

Research output: Contribution to journalArticle

10 Scopus citations

Abstract

Fixed income options are frequently adopted by companies to hedge interest rate risk. Their payoff dependence on the cumulative short-term rate makes them particularly informative about interest rate volatility risk. Based on a joint dataset of bonds and Asian interest rate options, we study the interrelations between bond and volatility risk premia in a major emerging fixed income market. We propose a dynamic term structure model that generates an incomplete market compatible with a preliminary empirical analysis of the dataset. Approximation formulas for at-the-money Asian option prices avoid the use of computationally intensive Fourier transform methods, allowing for an efficient implementation of the model. The model generates a bond risk premium strongly correlated with a widely accepted emerging market benchmark index (EMBI-Global), and a negative volatility risk premium, consistent with the use of Asian options as insurance in this market.

Original languageEnglish (US)
Pages (from-to)652-661
Number of pages10
JournalJournal of Banking and Finance
Volume33
Issue number4
DOIs
StatePublished - Apr 2009

All Science Journal Classification (ASJC) codes

  • Finance
  • Economics and Econometrics

Keywords

  • Asian options
  • Incomplete markets
  • Risk premium
  • Stochastic volatility

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