The Role of Options, Stochastic Volatility, and Jumps in the Interest Rate Risk Premia Dynamics

• Activity Number: 414
• Type: Topic Contributed
• Date/Time: Wednesday, August 5, 2009 : 8:30 AM to 10:20 AM
• Sponsor: Section on Bayesian Statistical Science
• Author(s): Bruno P. Lund*+ and Hedibert F. Lopes
• Companies: Chicago Booth School of Business and The University of Chicago
• Keywords: Term Structure ; Affine Jump Diffusion Model ; Particle Learning (PL) ; Jump Risk Premia ; Stochastic Volatility

Abstract

There is strong evidence that bond prices (and volatilities) jump, and supportive evidence that options bring information (beyond and above that contained in solely spot markets) about excess returns and/or risk premia. Putting these two features together allow us to gain a better understanding of the risk premia dynamics, since jumps can be directly linked to unexpected movements in macro variables, and the inclusion of options permits a better identification of the model. The contributions of this paper are threefold: (1) the estimation of an affine term structure jump diffusion model from options and bonds time series and cross sectional data, (2) to study model implied risk premia dynamics, and (3) to adapt and extend the Particle Learning (PL) algorithm proposed in Carvalho, Johannes, Lopes and Polson (2008) to sequentially learn about fixed parameters as well as state variables.