Interest Rate Option Markets: The Role of Liquidity in Volatility Smiles
52 Pages Posted: 5 Nov 2008
Date Written: November 2004
We investigate the interaction of volatility smiles and liquidity in the euro (¬) interest rate option markets, using daily bid and ask prices of interest rate caps/floors. We find that liquidity variables have significant explanatory power for both curvature and asymmetry of the implied volatility smiles. This effect is generally stronger on the ask side, indicating that ask-prices are more relevant for these markets. In addition, the shape of the implied volatility smile has some information about future levels and volatility of the term structure. Our results have important implications for the modeling and risk management of fixed income derivatives.
Keywords: Volatility smiles, liquidity, interest rate options, euro interestrate markets, Euribor market
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