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Can option smiles forecast changes in interest rates? An application to the US, the UK and the euro area

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  • Marcello Pericoli

    ()
    (Bank of Italy, Economic Research Department)

Abstract

This paper evaluates the use of risk-neutral probability density functions implied in 3-month interest-rate futures options to assess market perceptions regarding future monetary policy moves options allow the information content implied in simpler derivatives to be extended by providing indicators for asymmetry and extreme values. First, a cubic spline is implemented to evaluate the densities. Second, the methodology is applied to quotes on deposits denominated in US dollars, euros and sterling from January 1999 toMay 2004 results show that markets correctly forecast the monetary easing of 2001 in the United States in the course of the second half of 2000, but not in the euro area and the United Kingdom. The evidence for the tightening cycle of 1999 is mixed: markets expected an increase in euro area policy rates at the beginning of 1999 expectations were less clear for the United StatesÂ’ interest-rate increases. In the case of the United Kingdom the increase was not foreseen.

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Bibliographic Info

Paper provided by Bank of Italy, Economic Research and International Relations Area in its series Temi di discussione (Economic working papers) with number 545.

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Date of creation: Feb 2005
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Handle: RePEc:bdi:wptemi:td_545_05

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Keywords: risk-neutral density; cubic spline; monetary policy; interest-rate futures options;

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References

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  1. Söderlind, Paul & Svensson, Lars E.O., 1997. "New Techniques to Extract Market Expectations from Financial Instruments," Seminar Papers 621, Stockholm University, Institute for International Economic Studies.
  2. Jondeau, Eric & Rockinger, Michael, 2000. "Reading the smile: the message conveyed by methods which infer risk neutral densities," Journal of International Money and Finance, Elsevier, vol. 19(6), pages 885-915, December.
  3. Luigi Guiso & Giuseppe Parigi, 1999. "Investment And Demand Uncertainty," The Quarterly Journal of Economics, MIT Press, vol. 114(1), pages 185-227, February.
  4. Yacine Aït-Sahalia & Andrew W. Lo, . "Nonparametric Estimation of State-Price Densities Implicit in Financial Asset Prices," CRSP working papers 332, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  5. Fornari, F. & Violi, R., 1998. "The Probability Density Function of Interest Rates Implied in the Price of Options," Papers 339, Banca Italia - Servizio di Studi.
  6. Raymond E. Owens & Roy H. Webb, 2001. "Using the federal funds futures market to predict monetary policy actions," Economic Quarterly, Federal Reserve Bank of Richmond, issue Spr, pages 69-77.
  7. Barone-Adesi, Giovanni & Whaley, Robert E, 1987. " Efficient Analytic Approximation of American Option Values," Journal of Finance, American Finance Association, vol. 42(2), pages 301-20, June.
  8. Ait-Sahalia, Yacine & Wang, Yubo & Yared, Francis, 2001. "Do option markets correctly price the probabilities of movement of the underlying asset?," Journal of Econometrics, Elsevier, vol. 102(1), pages 67-110, May.
  9. Jose M. Campa & P. H. Kevin Chang, 1997. "The Forecasting Ability of Correlations Implied in Foreign Exchange Options," NBER Working Papers 5974, National Bureau of Economic Research, Inc.
  10. Bliss, Robert R. & Panigirtzoglou, Nikolaos, 2002. "Testing the stability of implied probability density functions," Journal of Banking & Finance, Elsevier, vol. 26(2-3), pages 381-422, March.
  11. 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.
  12. 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.
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Cited by:
  1. Rosa, Carlo, 2011. "The high-frequency response of exchange rates to monetary policy actions and statements," Journal of Banking & Finance, Elsevier, vol. 35(2), pages 478-489, February.

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