Treasury option returns and models with unspanned risks

Gurdip Bakshi; John Crosby; Xiaohui Gao; Jorge W. Hansen

doi:10.1016/j.jfineco.2023.103736

Treasury option returns and models with unspanned risks

Gurdip Bakshi^*, John Crosby, Xiaohui Gao, Jorge W. Hansen

^*Corresponding author for this work

Department of Economics and Business Economics

Research output: Contribution to journal/Conference contribution in journal/Contribution to newspaper › Journal article › Research › peer-review

5 Citations (Scopus)

Abstract

We document the phenomenon that average excess returns of out-of-the-money puts and calls on bond futures are negative, both unconditionally and conditionally on economic states. To explain these findings, we develop economically motivated restrictions in the context of a theory in which the pricing kernel is a general diffusion process with spanned and unspanned components. Our reconciliation is a framework that introduces market incompleteness and priced unspanned volatility risks, allowing for time-varying downside and upside futures risk premiums. The estimated model shows consistency with data on bond yields, yield volatilities, bond futures return volatilities, option prices, and option risk premiums.

Original language	English
Article number	103736
Journal	Journal of Financial Economics
Volume	150
Issue	3
Number of pages	30
ISSN	0304-405X
DOIs	https://doi.org/10.1016/j.jfineco.2023.103736
Publication status	Published - Dec 2023

Keywords

Interest-rate models
Option risk premiums
Options on futures on Treasury bonds
Unspanned risks in the pricing kernel

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10.1016/j.jfineco.2023.103736

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abstract = "We document the phenomenon that average excess returns of out-of-the-money puts and calls on bond futures are negative, both unconditionally and conditionally on economic states. To explain these findings, we develop economically motivated restrictions in the context of a theory in which the pricing kernel is a general diffusion process with spanned and unspanned components. Our reconciliation is a framework that introduces market incompleteness and priced unspanned volatility risks, allowing for time-varying downside and upside futures risk premiums. The estimated model shows consistency with data on bond yields, yield volatilities, bond futures return volatilities, option prices, and option risk premiums.",

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AU - Bakshi, Gurdip

AU - Crosby, John

AU - Gao, Xiaohui

AU - Hansen, Jorge W.

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Y1 - 2023/12

N2 - We document the phenomenon that average excess returns of out-of-the-money puts and calls on bond futures are negative, both unconditionally and conditionally on economic states. To explain these findings, we develop economically motivated restrictions in the context of a theory in which the pricing kernel is a general diffusion process with spanned and unspanned components. Our reconciliation is a framework that introduces market incompleteness and priced unspanned volatility risks, allowing for time-varying downside and upside futures risk premiums. The estimated model shows consistency with data on bond yields, yield volatilities, bond futures return volatilities, option prices, and option risk premiums.

AB - We document the phenomenon that average excess returns of out-of-the-money puts and calls on bond futures are negative, both unconditionally and conditionally on economic states. To explain these findings, we develop economically motivated restrictions in the context of a theory in which the pricing kernel is a general diffusion process with spanned and unspanned components. Our reconciliation is a framework that introduces market incompleteness and priced unspanned volatility risks, allowing for time-varying downside and upside futures risk premiums. The estimated model shows consistency with data on bond yields, yield volatilities, bond futures return volatilities, option prices, and option risk premiums.

KW - Interest-rate models

KW - Option risk premiums

KW - Options on futures on Treasury bonds

KW - Unspanned risks in the pricing kernel

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DO - 10.1016/j.jfineco.2023.103736

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VL - 150

JO - Journal of Financial Economics

JF - Journal of Financial Economics

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ER -

Treasury option returns and models with unspanned risks

Abstract

Keywords

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