Non-technical summary of ESM Working Paper 66: Option-implied bond spread risk

Anticipating changes in bond yields as well as movements of sovereign spreads represents an important challenge for economists, investors, and policy makers. Below the surface of directly observable benchmark government bond yields, markets also carry a wealth of information about expectations of future bond yields.  In particular, options reflect the range of expectations and show the market-implied probability of certain outcomes within a given time frame.  Option contracts can be seen as “bets” placed by market participants on the future price of the underlying asset. Investors might have different preferences, different information, or there could be disagreement about the expected state of the economy. 

In this working paper, we describe a methodology to derive option-implied risk-neutral probability distributions. We construct distributions of market-implied expectations 30, 45, 60, and 90 calendar days ahead for German, French and Italian governments bond yields, as well as for French and Italian spreads to Germany. These are informative not only with regard to the level of the expected sovereign yields and spreads between them, but also the uncertainty characterising these expectations. They also provide a measure of bond yield and spread fluctuations that markets are prepared for in a given macroeconomic environment.  

Furthermore, bond option pricing evolves over time, and the implied probability distributions change. We find that these changes in option-implied distributions correlate with global economic conditions, inflation expectations, monetary policy surprises, asset purchases, and stock market volatility. When comparing option-implied metrics to similar measures of uncertainty based on backward-looking models, we find the former to be more responsive than the latter to changes in economic conditions. Furthermore, their ability to predict both average and tail interest rate realisations is in most of the cases either comparable or higher than the one characterising backward-looking models. As new information comes in, investors change their views about the state of the economy, hence their expectations and preferences might be impacted.  

The market-implied range of future bond yields widens when uncertainty is on the rise. In stress or uncertain environment, disagreement among market participants increases. The difference between the “bets” on higher and lower yields widens, the distribution becomes wider, and the tail risk increases. These distributions allow us to quantify the probability and magnitude of potential moves and can be used for risk assessment and early warning frameworks.