Do interest rate options contain information about excess returns?

• Published in: Journal of econometrics Vol. 164; no. 1; pp. 35 - 44
• Main Authors: Almeida, Caio, Graveline, Jeremy J., Joslin, Scott
• Format: Journal Article Conference Proceeding
• Language: English
• Published: Amsterdam Elsevier B.V 01.09.2011; Elsevier; Elsevier Sequoia S.A
• Series: Journal of Econometrics
• Subjects: Abnormal returns; Applications; Asset pricing; Credit market; Econometrics; Exact sciences and technology; Excess returns; Financial engineering; Financial models; Forecasting; Forecasts; Inference from stochastic processes; time series analysis; Insurance, economics, finance; Interest rates; Interest rates Options Risk premia Excess returns Forecasting; Mathematical finance; Mathematics; Option pricing; Options; Probability and statistics; Risk premia; Risk premiums; Sciences and techniques of general use; Securities prices; Statistics; Stochastic models; Studies; C53; Options; Excess returns; E43; C58; E47; G12; Risk premia; Forecasting; Interest rates; Stochastic model; Interest rate; Prediction theory; Long term variation; Stochastic process; Forecasting theory; Stochastic volatility; Dynamic model; Time series; Statistical estimation; Statistical method; Price; Risk factor; Filtering theory; Autocorrelation; Econometrics
• ISSN: 0304-4076; 1872-6895
• DOI: 10.1016/j.jeconom.2011.02.007

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.