Compensation for Volatility Risk in Interest Rate Derivatives

Abstract

We use volatilities implied from interest rate swaptions to assess the size, the sign and the behavior through time of the compensation for volatility risk, for dollar, euro and pound rates at a daily frequency, between October 1998 and August 2006. The measurement of the volatility risk premium rests on a simple model according to which variance forecasts can be generated under the physical measure. Results show that between September 2001 and mid-2004 dollar implieds were embodying a large - negative - compensation for volatility risk, a component which was much smaller for the other two currencies. While the negative compensation for volatility risk is in line with previous studies focusing on other asset classes, we also document that it exhibits a significant term structure, more evident for dollar and euro rates than for pound rates. The volatility risk premium is strongly changing through time but much less than implied volatilities. Estimates of risk aversion based on the physical skewness and kurtosis of interest rate changes suggest that (minus) the vrp can almost directly be read as risk aversion, as the proportionality between the two is about 0.8. Also, compensation for volatility risk is positively related to expected volatility, although the relation is not completely linear. Daily compensation for volatility risk is influenced, as expected, by the level of the short term rate and its volatility as well as by a small but robust number of macroeconomic surprises. The latter induce more sizeable changes on compensation for volatility risk of dollar rates than in euro or pound rates.