Title: Option-implied bond spread risk
Summary: This paper uses bond-option data to gauge market uncertainty and the magnitude of potential yield and spread moves in case of shocks to sovereign debt markets.
Authors: Gergely Hudecz, Edmund Moshammer, and Marco Onofri (all ESM)
Abstract: Government bond yield futures and related option contracts contain information on the asymmetry of interest rate risks. We construct probability distributions of market- implied bond yield expectations up to 90 calendar days ahead between January 2018 and December 2023. We derive daily distributions for German, French, and Italian bond yields as well as bivariate distributions using a copula to analyse tail risks in bond spread movement. We confirm options to be useful in predicting bond yields and spreads when benchmarking against backward-looking models. Furthermore, we find tail spread measures to be correlated with stock market volatility, inflation expectations, monetary policy surprises, and global economic conditions. In the period under scrutiny, the correlation between these indicators and the Italian spread tail is stronger than the one with the French measure. While changes in global economic conditions and central bank asset purchases strongly correlate with the Italian spread tail, these are less relevant for the French one.
Disclaimer: This Working Paper should not be reported as representing the views of the ESM. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the ESM or ESM policy. No responsibility or liability is accepted by the ESM in relation to the accuracy or completeness of the information, including any data sets, presented in this Working Paper.
Keywords: Financial market, sovereign bond yield, risk premium, euro area, option contract, risk-neutral distribution, probability density function, copula model
JEL codes: G13, G17