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Interest rate volatility and risk management: Evidence from CBOE Treasury options

Raphael N. Markellos and Dimitris Psychoyios

The Quarterly Review of Economics and Finance, 2018, vol. 68, issue C, 190-202

Abstract: This paper investigates US Treasury market volatility and develops new ways of dealing with the underlying interest rate volatility risk. We adopt an innovative approach which is based on a class of model-free interest rate volatility (VXI) indices we derive from options traded on the CBOE. The empirical analysis indicates substantial interest rate volatility risk for medium-term instruments which declines to the levels of the equity market only as the tenor increases to 30 years. We show that this risk appears to be priced in the market and has a significant time-varying relationship with equity volatility risk. US Treasury market volatility is appealing from an investment diversification perspective since the VXI indices are negatively correlated with the levels of interest rates and of equity market implied volatility indices, respectively. Although VXI indices are affected by macroeconomic and monetary news, they are only partially spanned by information contained in the yield curve. Motivated by our results on the magnitude and the nature of interest rate volatility risk and by the phenomenal recent growth of the equity volatility derivative market, we propose the use of our VXI indices as benchmarks for monitoring, securitizing, managing and trading interest rate volatility risk. As a first step in this direction, we describe a framework of one-factor equilibrium models for pricing VXI futures and options on the basis of empirically favored mean-reverting jump-diffusions.

Keywords: Interest rate volatility; Volatility indices; Volatility risk premium; Level effect; Unspanned stochastic volatility; Macroeconomic news (search for similar items in EconPapers)
JEL-codes: C51 E44 G12 G13 G14 (search for similar items in EconPapers)
Date: 2018
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Handle: RePEc:eee:quaeco:v:68:y:2018:i:c:p:190-202