Spanned stochastic volatility in bond markets: a reexamination of the relative pricing between bonds and bond options

Don H Kim

No 239, BIS Working Papers from Bank for International Settlements

Abstract: This paper reexamines the issue of unspanned stochastic volatility (USV) in bond markets and the puzzle of poor relative pricing between bonds and bond options. I make a distinction between the "weak USV" and the "strong USV" scenarios, and analyze the evidence for each of them. I argue that the poor bonds/options relative pricing in the extant literature is not necessarily evidence for the strong USV scenario, and show that a maximally flexible 2-factor quadratic-Gaussian model (a non-USV model) estimated without bond options data can capture much of the movement in bond option prices. Dropping the positive-definiteness requirement for nominal interest rates and adopting "regularized" estimations turn out to be important for obtaining sensible results.

Keywords: term structure of interest rates; unspanned stochastic volatility; relative pricing; interest rate derivatives (search for similar items in EconPapers)
Pages: 40 pages
Date: 2007-12
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Citations: View citations in EconPapers (6)

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Persistent link: https://EconPapers.repec.org/RePEc:bis:biswps:239

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