The Economic Determinants of Interest Rate Option Smiles
33 Pages Posted: 12 Apr 2007
There are 2 versions of this paper
The Economic Determinants of Interest Rate Option Smiles
The Economic Determinants of Interest Rate Option Smiles
Date Written: March 2007
Abstract
We address three questions relating to the interest rate options market: What is the shape of the smile? What are the economic determinants of the shape of the smile? Do these determinants have predictive power for the future shape of the smile and vice versa? We investigate these issues using daily bid and ask prices of euro () interest rate caps/floors. We find a clear smile pattern in interest rate options. The shape of the smile varies over time and is affected in a dynamic manner by yield curve variables and the future uncertainty in the interest rate markets; it also has information about future aggregate default risk. Our findings are useful for the pricing, hedging and risk management of these derivatives.
Keywords: Volatility smiles, interest rate options, euro interest rate markets, Euribor market
JEL Classification: G10, G12, G13, G15
Suggested Citation: Suggested Citation
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