The Economic Determinants of Interest Rate Option Smiles
Indian School of Business
Case Western Reserve University - Department of Banking & Finance
Marti G. Subrahmanyam
New York University - Stern School of Business
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.
Number of Pages in PDF File: 33
Keywords: Volatility smiles, interest rate options, euro interest rate markets, Euribor market
JEL Classification: G10, G12, G13, G15
Date posted: April 12, 2007
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