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The Information Content of Interest Rate Futures Options

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  • Mc Manus, Des
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    Abstract

    Options prices are being increasingly employed to extract market expectations and views about monetary policy. In this paper, eurodollar options are monitored to examine the evolution of market sentiment over the possible future values of eurodollar rates. Risk-neutral probability functions are employed to synopsize the information contained in the prices of euro/dollar futures options. Several common methods of estimating risk-neutral probability density functions are examined. A method based on a mixture of lognormals density is found to rank first and a method based on a Hermite polynomial approximation is found to rank second. Several standard summary statistics are also examined, namely volatility, skewness, and kurtosis. The volatility measure is fairly robust across methods, while the skewness and kurtosis measure are model-sensitive. As an example, the days surrounding the September 1998 Federal Open Market Committee are examined.

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    File URL: http://www.bankofcanada.ca/wp-content/uploads/2010/05/wp99-15.pdf
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    Bibliographic Info

    Paper provided by Bank of Canada in its series Working Papers with number 99-15.

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    Length: 55 pages
    Date of creation: 1999
    Date of revision:
    Handle: RePEc:bca:bocawp:99-15

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    Related research

    Keywords: Financial markets; Interest rates;

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    References

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    1. Jose M. Campa & P.H. Kevin Chang & Robert L. Reider, 1997. "Implied Exchange Rate Distributions: Evidence from OTC Option Markets," NBER Working Papers 6179, National Bureau of Economic Research, Inc.
    2. Soderlind, P & Svensson, L-E-O, 1996. "New Techniques to Extract Market Expectations from Financial Instruments," Papers 621, Stockholm - International Economic Studies.
    3. Michael P. Leahy & Charles P. Thomas, 1996. "The sovereignty option: the Quebec referendum and market views on the Canadian dollar," International Finance Discussion Papers 555, Board of Governors of the Federal Reserve System (U.S.).
    4. Dilip B. Madan & Frank Milne, 1992. "Contingent Claims Valued and Hedged by Pricing and Investment in a Basis," Working Papers 868, Queen's University, Department of Economics.
    5. Peter A. Abken & Dilip B. Madan & Sailesh Ramamurtie, 1996. "Estimation of risk-neutral and statistical densities by Hermite polynomial approximation: with an application to Eurodollar futures options," Working Paper 96-5, Federal Reserve Bank of Atlanta.
    6. Bates, David S, 1991. " The Crash of '87: Was It Expected? The Evidence from Options Markets," Journal of Finance, American Finance Association, vol. 46(3), pages 1009-44, July.
    7. Frank Milne & Dilip Madan, 1994. "Contingent Claims Valued And Hedged By Pricing And Investing In A Basis," Working Papers 1158, Queen's University, Department of Economics.
    8. Buchen, Peter W. & Kelly, Michael, 1996. "The Maximum Entropy Distribution of an Asset Inferred from Option Prices," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 31(01), pages 143-159, March.
    9. Malz, Allan M., 1996. "Using option prices to estimate realignment probabilities in the European Monetary System: the case of sterling-mark," Journal of International Money and Finance, Elsevier, vol. 15(5), pages 717-748, October.
    10. Melick, William R. & Thomas, Charles P., 1997. "Recovering an Asset's Implied PDF from Option Prices: An Application to Crude Oil during the Gulf Crisis," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 32(01), pages 91-115, March.
    11. Ball, Clifford A. & Torous, Walter N., 1983. "A Simplified Jump Process for Common Stock Returns," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 18(01), pages 53-65, March.
    12. Ball, Clifford A & Torous, Walter N, 1985. " On Jumps in Common Stock Prices and Their Impact on Call Option Pricing," Journal of Finance, American Finance Association, vol. 40(1), pages 155-73, March.
    13. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
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    Cited by:
    1. Gustavo Abarca & José Gonzalo Rangel & Guillermo Benavides, 2010. "Exchange Rate Market Expectations and Central Bank Policy: The case of the Mexican Peso-US Dollar from 2005-2009," Working Papers 2010-17, Banco de México.
    2. Robert R Bliss & Nikolaos Panigirtzoglou, 2000. "Testing the stability of implied probability density functions," Bank of England working papers 114, Bank of England.
    3. Martin Mandler, 2002. "Extracting Market Expectations from Option Prices: Two Case Studies in Market Perceptions of the ECB's Monetary Policy 1999/2000," Swiss Journal of Economics and Statistics (SJES), Swiss Society of Economics and Statistics (SSES), vol. 138(II), pages 165-189, June.
    4. Marian Micu, 2005. "Extracting expectations from currency option prices: a comparison of methods," Computing in Economics and Finance 2005 226, Society for Computational Economics.
    5. Marie Brière & Kamal Chancari, 2004. "Perception des risques sur les marchés, construction d'un indice élaboré à partir des smiles d'options et test de stratégies," Revue d'économie politique, Dalloz, vol. 0(4), pages 527-555.
    6. Marie Briere, 2006. "Market Reactions to Central Bank Communication Policies :Reading Interest Rate Options Smiles," Working Papers CEB 38, ULB -- Universite Libre de Bruxelles.
    7. Steven A. Weinberg, 2001. "Interpreting the volatility smile: an examination of the information content of option prices," International Finance Discussion Papers 706, Board of Governors of the Federal Reserve System (U.S.).
    8. Ruijun Bu & Kaddour Hadri, 2005. "Estimating the Risk Neutral Probability Density Functions Natural Spline versus Hypergeometric Approach Using European Style Options," Research Papers 200510, University of Liverpool Management School.

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