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 language | English (US) |
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Pages (from-to) | 652-661 |
Number of pages | 10 |
Journal | Journal of Banking and Finance |
Volume | 33 |
Issue number | 4 |
DOIs | |
State | Published - Apr 2009 |
Externally published | Yes |
All Science Journal Classification (ASJC) codes
- Finance
- Economics and Econometrics
Keywords
- Asian options
- Incomplete markets
- Risk premium
- Stochastic volatility