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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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    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. 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, Federal Reserve Bank of Atlanta 96-5, Federal Reserve Bank of Atlanta.
    2. Soderlind, P & Svensson, L-E-O, 1996. "New Techniques to Extract Market Expectations from Financial Instruments," Papers, Stockholm - International Economic Studies 621, Stockholm - International Economic Studies.
    3. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
    4. 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, Elsevier, vol. 15(5), pages 717-748, October.
    5. Dilip B. Madan & Frank Milne, 1992. "Contingent Claims Valued and Hedged by Pricing and Investment in a Basis," Working Papers, Queen's University, Department of Economics 868, Queen's University, Department of Economics.
    6. 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.
    7. 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, American Finance Association, vol. 40(1), pages 155-73, March.
    8. Frank Milne & Dilip Madan, 1994. "Contingent Claims Valued And Hedged By Pricing And Investing In A Basis," Working Papers, Queen's University, Department of Economics 1158, Queen's University, Department of Economics.
    9. 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.
    10. 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.
    11. 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.
    12. Michael P. Leahy & Charles P. Thomas, 1996. "The sovereignty option: the Quebec referendum and market views on the Canadian dollar," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 555, Board of Governors of the Federal Reserve System (U.S.).
    13. Bates, David S, 1991. " The Crash of '87: Was It Expected? The Evidence from Options Markets," Journal of Finance, American Finance Association, American Finance Association, vol. 46(3), pages 1009-44, July.
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    Cited by:
    1. Robert R Bliss & Nikolaos Panigirtzoglou, 2000. "Testing the stability of implied probability density functions," Bank of England working papers 114, Bank of England.
    2. Marian Micu, 2005. "Extracting expectations from currency option prices: a comparison of methods," Computing in Economics and Finance 2005, Society for Computational Economics 226, Society for Computational Economics.
    3. Marie Briere, 2006. "Market Reactions to Central Bank Communication Policies :Reading Interest Rate Options Smiles," Working Papers CEB, ULB -- Universite Libre de Bruxelles 38, ULB -- Universite Libre de Bruxelles.
    4. 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.
    5. Ruijun Bu & Kaddour Hadri, 2005. "Estimating the Risk Neutral Probability Density Functions Natural Spline versus Hypergeometric Approach Using European Style Options," Research Papers, University of Liverpool Management School 200510, University of Liverpool Management School.
    6. 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, Dalloz, vol. 0(4), pages 527-555.
    7. Steven A. Weinberg, 2001. "Interpreting the volatility smile: an examination of the information content of option prices," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 706, Board of Governors of the Federal Reserve System (U.S.).
    8. 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), Swiss Society of Economics and Statistics (SSES), vol. 138(II), pages 165-189, June.

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