Using Options to Forecast LIBOR

Abstract:     
In this paper we try to forecast short-term interest rates using options on futures on 3-month Euribor. Given that different maturities and different strikes are available, we are able to estimate the implied probability density of the 3-month Euribor with a forecasting horizon up to two years. The availability of a probability density has many advantages over traditional forecasting methods: i) many estimators of the future rate are jointly available (mean, mode, median); ii) higher order moments can be easily calculated in order to estimate volatility, skewness and kurtosis and their temporal dynamics; iii) the estimates are available and monitored on a day-by-day basis, helping to assess the degree of uncertainty in the market view and its evolution over time.

The recovered natural probability, obtained using a power utility function, does not improve the forecasting performance. The estimated relative risk aversion is near to 1 (log-utility), substantially below the estimates available in the financial literature, obtained from stock market data. Our results outperform, in term of forecasting error, other estimates like Consensus forecasts and futures interest rates.

Number of Pages in PDF File: 28

Keywords: Option pricing, futures-style, smile, risk-neutral probability density, interest rate forecast

JEL Classification: G13, C53

working papers series