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The Economic Determinants of Interest Rate Option Smiles

33 Pages Posted: 12 Apr 2007  

Prachi Deuskar

Indian School of Business

Anurag Gupta

Case Western Reserve University - Department of Banking & Finance

Marti G. Subrahmanyam

New York University - Stern School of Business

Multiple version iconThere are 2 versions of this paper

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

Deuskar, Prachi and Gupta, Anurag and Subrahmanyam, Marti G., The Economic Determinants of Interest Rate Option Smiles (March 2007). Available at SSRN: https://ssrn.com/abstract=979005 or http://dx.doi.org/10.2139/ssrn.979005

Prachi Deuskar

Indian School of Business ( email )

Hyderabad, Gachibowli 500 019
India

Anurag Gupta (Contact Author)

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 - Stern School of Business ( 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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