Abstract
When the fixed income market exhibits unspanned stochastic volatility, interest rate options play a unique role in dynamic portfolio strategies. They expand the investment opportunity set and provide ways of hedging variations in investment opportunities. To quantify these effects, we estimate a dynamic term structure model featuring unspanned stochastic volatility using a panel data set of interest rates and cap prices. We then solve the dynamic portfolio choice problem for a long term bond investor with and without access to interest rate derivatives and find substantial welfare gains from participation in the interest rate derivatives market.
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