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Volatility and Risk Premia: Lessons from the Eurodollar Markets

By Ruslan Bikbov

Abstract

Lessons from the Eurodollar Markets We estimate affine models using the Eurodollar futures and options data. The rationale for this exercise comes from a combination of recent theoretical and empirical work, which documents a trade-off in models abilities to match the expectations hypothesis and generate conditional volatility, and suggests to break this tight connection by explicitly removing volatility from the term structure dynamics via the unspanned stochastic volatility (USV). However, the USV property is surprising in the light of the interest rate proxies studies, which find strong evidence for stochastic volatility. We believe that these results could be explained in part by estimation methodology typically used, and in part by a limited span of swaps data. We use a more general methodology in this paper, and Recent advances in affine dynamic term structure models show a trade-off between the abilities to match the first moments of the yield curve by means of flexible risk premia and to specify reasonable volatility dynamics (Dai and Singleton, 2002 (DS2 hereafter), Duffee, 2002). 1 Thes

Year: 2002
OAI identifier: oai:CiteSeerX.psu:10.1.1.194.6149
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