Are Interest Rate Options Important for the Assessment of Interest Rate Risk?

Abstract

Fixed income options contain substantial information on the price of interest rate volatility risk. In this paper, we ask if those options will provide information related to other moments of the objective distribution of interest rates. Based on a dynamic term structure model, we find that interest rate options are useful for the identification of interest rate quantiles. A three-factor model with stochastic volatility is adopted and its adequacy to estimate Value at Risk of zero coupon bonds is tested. We find significant difference on the quantitative assessment of risk when options are (or not) included in the estimation process of the dynamic model. Statistical back tests indicate that bond estimated risk is clearly more adequate when options are adopted, although not yet completely satisfactory.