Interest Rate Option Markets: The Role of Liquidity in Volatility Smiles

52 Pages Posted: 5 Nov 2008

See all articles by Prachi Deuskar

Prachi Deuskar

Indian School of Business

Anurag Gupta

Case Western Reserve University - Department of Banking & Finance

Marti G. Subrahmanyam

New York University (NYU) - Department of Finance

Date Written: November 2004

Abstract

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

Suggested Citation

Deuskar, Prachi and Gupta, Anurag and Subrahmanyam, Marti G., Interest Rate Option Markets: The Role of Liquidity in Volatility Smiles (November 2004). NYU Working Paper No. S-DRP-04-03, Available at SSRN: https://ssrn.com/abstract=1295852

Prachi Deuskar (Contact Author)

Indian School of Business ( email )

Hyderabad, Gachibowli 500 019
India

Anurag Gupta

Case Western Reserve University - Department of Banking & Finance ( email )

10900 Euclid Ave.
Cleveland, OH 44106-7235
United States
216-368-2938 (Phone)
216-368-4776 (Fax)

Marti G. Subrahmanyam

New York University (NYU) - Department of Finance ( email )

Stern School of Business,
44 West 4th Street, Suite 9-68
New York, NY 10012-1126
United States
212-998-0348 (Phone)
212-995-4233 (Fax)

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