Jumps in Interest Rates and Pricing of Jump Risk - Evidence from the Eurodollar Market

We investigate systematically the presence of jumps and the pricing of jump risk in interest rates and interest rate derivatives. We develop a dynamic term structure model with stochastic volatility and jumps in both level and slope of the term structure. We estimate the model on an extensive panel data set of Eurodollar futures and options on Eurodollar futures using Bayesian MCMC methods. Jumps significantly affect the tails of the conditional risk-neutral and physical distributions of interest rates, making jumps important for pricing and risk management of interest rate derivatives. Jump risk premia increase the implied volatility of OTM options by a sizable amount