Implied Interest Rate Skew, Term Premiums, and the “Conundrum”

Abstract

The skew, irrespective of the mean and variance, of investors' interest rate expectations may affect required bond yields over expected short rates. Indeed, evidence suggests that the near-term skew of the option-implied distribution of expected short-term interest rates correlates with distant-horizon term premiums, as derived from a latent-factor affine term structure model (ATSM). Reduced-form models that include skew generally fit the data well and actually better "explain" variation in the term premium during the so-called "conundrum" than during other periods of the

Interest Rate Skewness and Biased Beliefs

“…Our methodology for using options to measure skewness follows Bakshi and Madan (2000) and Neuberger (2012). In an early paper on time‐varying skewness in interest rates, Durham (2008) shows that skewness implied by Eurodollar options is related to estimates of the term premium in long‐term yields. Trolle and Schwartz (2014) study swaption‐implied skewness and document some variation over their 2002 to 2009 sample, but do not relate skewness to bond returns or survey forecasts of yields.…”