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| Volatility and Jump Risk Premia in Emerging Market Bonds by John M. Matovu of Makerere University April 2007 Abstract: There is strong evidence that interest rates and bond yield movements exhibit both stochastic volatility and unanticipated jumps. The presence of frequent jumps makes it natural to ask whether there is a premium for jump risk embedded in observed bond yields. The objectives of this paper are two fold: first, to identify a class of jump-diffusion models that are successful in approximating the short term interest rates of emerging markets. Second, to reconcile the parameters of the term structure of interest rates with the associated bond yields by estimating the volatility and jump risk premia in highly volatile markets. Using a two stage estimation procedure, we first estimate the data generating process for the daily short-term interest rates using the simulated method of moments (SMM). In the second stage we use time series for bond yields and the estimated parameters for the state price density to identify the risk premia for different risk factors. Results suggest that all variants of models which do not take into account stochastic volatility and unanticipated jumps cannot generate the non-normalities consistent with the observed interest rates. On average, we find that jumps occur (8, 10) times a year in Argentina and Brazil, respectively. The size and variance of these jumps is also of statistical significance. By taking into account the volatility and jump risk premia this is sufficient to replicate the key salient features of the term structure of bond yields. Keywords: Volatility, Jumps and Risk Premia. Previously titled: Credit Spreads Modeling: Randomized Merton Model Books Referenced in this Paper: (what is this?)
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