Do Options Contain Information About Excess Bond Returns?

There is strong empirical evidence that risk premia in long-term interest rates are time-varying. These risk premia critically depend on interest rate volatility, yet existing research has not examined the impact of time-varying volatility on excess returns for long-term bonds. To address this issue, we incorporate interest rate option prices, which are very sensitive to interest rate volatility, into a dynamic model for the term structure of interest rates. We estimate three-factor affine term structure models using both swap rates and interest rate cap prices. When we incorporate option prices, the model better captures interest rate volatility and is better able to predict excess returns for long-term swaps over short-term swaps, both in- and out-of-sample. Our results indicate that interest rate options contain valuable information about risk premia and interest rate dynamics that cannot be extracted from interest rates alone.

On the asset market view of exchange rates

If the asset market is complete, then the difference between foreign and domestic agents’ log intertemporal marginal rates of substitution (IMRSs) equals the log change in the real exchange rate. This equation is frequently used to argue that changes in real exchange rates reflect differences between agents’ required compensation for exposure to asset return uncertainty. We show that the relative returns on frictionlessly traded assets are only reflected in the common component of agents’ IMRSs, not in differences. Instead, when this equation does offer insights, frictions in the goods market are the source of economic distinction between agents

The Scarcity Value of Treasury Collateral: Repo Market Effects of Security-Specific Supply and Demand Factors

In the repo market, forward agreements are security-specific (i.e., there are no deliverable substitutes), which makes it an ideal place to measure the value of fluctuations in a security's available supply. In this study, we quantify the scarcity value of Treasury collateral by estimating the impact of security-specific demand and supply factors on the repo rates of all the outstanding U.S. Treasury securities. Our results indicate the existence of an economically and statistically significant scarcity premium, especially for shorter-term securities. The estimated scarcity effect is quite persistent, seems to be reflected in the Treasury market prices, and could in part explain the flow-effects of the Fed's asset purchase programs. More generally, it provides additional evidence in favor of the scarcity channel of quantitative easing. These findings also suggest that, through the same mechanism, the Fed's reverse repo operations could help alleviate potential shortages of high-quality collateral

Who makes on-the-run Treasuries special?

The most recently issued, on-the-run, Treasuries are extremely liquid and frequently trade at a premium in both the cash and repo, or financing, markets. Previous research suggests that both the cash and repo premiums reflect demand from buy-and-hold investors who value the superior liquidity of these securities and are reluctant to lend them in the repo market. We find evidence that premiums in the repo market are also closely related to market participants' demand to hedge interest rate risk associated with their holdings of fixed income securities.On-the-run Treasuries Short-selling Liquidity Repo specials Repurchase agreements

Do interest rate options contain information about excess returns?

There is strong empirical evidence that long-term interest rates contain a time-varying risk premium. Options may contain valuable information about this risk premium because their prices are sensitive to the underlying interest rates. We use the joint time series of swap rates and interest rate option prices to estimate dynamic term structure models. The risk premiums that we estimate using option prices are better able to predict excess returns for long-term swaps over short-term swaps. Moreover, in contrast to the previous literature, the most successful models for predicting excess returns have risk factors with stochastic volatility. We also show that the stochastic volatility models we estimate using option prices match the failure of the expectations hypothesis.Interest rates Options Risk premia Excess returns Forecasting