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:||finančni trg, trg kapitala, obveznice, opcije, oblikovanje cene, obrestna mera, izvedeni finančni instrumenti, financial market, capital market, bonds, options, pricing, interest rate, derivatives|
|Work type:||Not categorized (r6)|
|Organization:||EF - Faculty of Economics|
|Publisher:||Bank for International Settlements|
|Number of pages:||38 str.|
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