Derivatives and the Market Price of Risk
Journal of Futures Markets 17, p.839-854, 1997

Nicolas P.B. Bollen

Risk-neutral derivative valuation often requires the identification of an unobservable market price of risk. A popular approach to this problem assumes a risk specification and estimates its parameters using the prices of traded securities. Derivatives are then valued using the parameterized price of risk. This paper shows that the results of such an approach are quite sensitive to the assumed risk specification. First, I calibrate several widely used specifications of the price of interest rate risk using a common dataset of discount bond prices. I then value coupon bonds and bond options and find that values vary significantly across risk specifications. Second, I calibrate the risk specifications using Eurodollar futures options data and find that a term structure of risk tightens in-sample fit and reduces out-of-sample valuation error. These results highlight the importance of testing assumptions about the price of risk when using risk-neutral valuation.