Discussion of:

“The Swaption Cube”

Anders B. Trolle and Eduardo S. Schwartz

Jakub W. Jurek

Princeton University – Bendheim Center for Finance

May 2011
Big Picture

Economic risk factors:

1. Real rate risk (e.g. TIPS)
2. Inflation risk (e.g. nominal bonds, interest rate swaps)
3. Market risk (e.g. equities)
4. Volatility / jump risk (e.g. options)
Big Picture

Economic risk factors:

1. Real rate risk (e.g. TIPS)
2. Inflation risk (e.g. nominal bonds, interest rate swaps)
3. Market risk (e.g. equities)
4. Volatility / jump risk (e.g. options)

The dynamics of real rates and inflation can interact in meaningful ways to determine
the “riskiness” of nominal securities: inflationary vs. deflationary recessions.
I Time-varying covariance of bond/stock returns (Viceira (2010)) → equilibrium
risk premia change sign.
I Important implications for pension plan liability management.
Big Picture
Time-varying bond beta
This Paper

The contribution of this paper is to study to the dynamics of nominal interest rates
using a comprehensive swaption dataset:
1. Model-free moments
2. Unspanned stochastic volatility + skewness
3. Proposes and estimates and affine term structure model with stochastic skewness
4. Moments and risk premia linked to survey measures of real growth rates and
inflation expectations
Data

A European swaption gives the owner the right to enter into a fixed versus floating
forward starting interest rate swap at a predetermined rate on the fixed leg.

1. Swaption cube:
I maturity of underlying interest rates swap (2, 5, 10, 20, 30 years)
I option tenor (1, 3, 6, 9 months, 1, 2, 5, 10 years)
I strikes (up to 15 values)
2. Date range: Jun./Dec. 2001 – Jan. 2010
3. Cross section: USD + EUR
4. Source: ICAP
Data
Implementation

1. Computing the model-free moments requires interpolating and extrapolating the

swaption implied volatilities.
I Extrapolation scheme becomes progressively more important for higher moments
(skewness, kurtosis).
2. Both recessions in this sample were recessionary (2001:3-2001:11,
2007:12-2009:6).
3. Data on USD and EUR swaptions facilitates comparison of different central bank
rules (dual mandate vs. price stability).
4. Inter-dealer quotes are not always representative of market (dealer-to-hedge fund
repo terms vs. tri-party repo vs. interdealer repo).
5. Data on inflation swaps and swaptions?
Model

The stylized facts:

1. Three-factors in interest rate term structure (Litterman and Scheinkman (1991)).
2. Time-varying swap rate volatility.
3. Hump-shaped term structure of yield volatilities difficult to match in A1 (3) and
A2 (3) model (Dai and Singleton (2003))
I Original motivation for quadratic term structure models (Ahn, Dittmar, and Gallant
(2002)) → here model is almost affine.
I This paper: Imposed by specifying forward rate volatilities.
4. Option-implied skewness changes sign
I Time-varying intensities of positive / negative jumps (Bakshi, Carr and Wu (2005))
I Two volatility components exhibiting different correlations with the underlying yield
factors (this paper)
I What is necessary to get stochastic skewness in a QTSM?
Model

Bond price and volatility dynamics:

are combined with “standard” affine or extended affine specification of bond and
volatility risk premia (Duffie and Kan (1996), Cheridito, Filipovic and Kimmel (2007))

Estimation disclaimers:
I Parameter values for bond risk premia unreported → estimation is known to
occasionally produce implausibly large implied Sharpe ratios.
I Standard errors based on outer-product estimator of covariance matrix. Hessian is
“somewhat numerically unstable.”
Model

Comparison of one- and two-factor stochastic volatility models:

Model
Estimation results
Results
Inflation/deflation fears

I The first (second) volatility factor induces negative (positive) skewness in bond
returns → inflation (deflation) fear factors.
Results
Inflation/deflation fears

I The first (second) volatility factor induces negative (positive) skewness in bond
returns → inflation (deflation) fear factors.

I Variation in the magnitudes of the two volatility factors should help reconcile
pricing of inflation-indexed and nominal bonds.
I Do model-implied quantities help forecast bond excess returns?
I Contribution of real rate risk premia and inflation risk premia to explaining violations of
the expectations hypothesis in US + UK data.
Results
Inflation/deflation fears

I The first (second) volatility factor induces negative (positive) skewness in bond
returns → inflation (deflation) fear factors.

I Variation in the magnitudes of the two volatility factors should help reconcile
pricing of inflation-indexed and nominal bonds.
I Do model-implied quantities help forecast bond excess returns?
I Contribution of real rate risk premia and inflation risk premia to explaining violations of
the expectations hypothesis in US + UK data.

I Campbell, Sunderam and Viceira (2010) link the Cochrane-Piazzesi factor

(2005) to the covariance of nominal and real variables in the US.
I Different correlation structure suggests different optimal combination of forward yields
in EUR for the CoPi factor.
I What is this combination in the model? In the data?
Results
Variance and skewness

I Variance risk premia appear modest in comparison to equity markets

I Crude Sharpe ratios for the inflation (US: 0.07 / EUR: 0.07) and deflation factors (US:
0.23 / EUR: 0.23) are low.

I Authors push for a model that replicates the unspanned stochastic skewness
features identified in the model-free analysis, but ...
I Feature does not survive in unrestricted estimation → is the minimal set of necessary
restrictions rejected?
I What is the economic magnitude of the skewness risk premium?
Results
Variance and skewness

I Variance risk premia appear modest in comparison to equity markets

I Crude Sharpe ratios for the inflation (US: 0.07 / EUR: 0.07) and deflation factors (US:
0.23 / EUR: 0.23) are low.

I Authors push for a model that replicates the unspanned stochastic skewness
features identified in the model-free analysis, but ...
I Feature does not survive in unrestricted estimation → is the minimal set of necessary
restrictions rejected?
I What is the economic magnitude of the skewness risk premium?

I Dynamics of variance and skewness – and the associated risk premia – are linked
to investor uncertainty about economic fundamentals.
I Real GDP growth (inflation) uncertainty is key in determining USD (EUR) swap rate
distributions.
I Is there evidence for shifts in the relative importance of the two channels as a function
of magnitude of each factor’s deviation from its “equilibrium” value?