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Using implied volatility to measure uncertainty about interest rates

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Abstract

Option prices can be used to infer the level of uncertainty about future asset prices. The first two parts of this article explain such measures (implied volatility) and how they can differ from the market's true expectation of uncertainty. The third then estimates the implied volatility of three-month eurodollar interest rates from 1985 to 2001 and evaluates its ability to predict realized volatility. Implied volatility shows that uncertainty about short-term interest rates has been falling for almost 20 years, as the levels of interest rates and inflation have fallen. And changes in implied volatility are usually coincident with major news about the stock market, the real economy, and monetary policy.

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  • Christopher J. Neely, 2005. "Using implied volatility to measure uncertainty about interest rates," Review, Federal Reserve Bank of St. Louis, vol. 87(May), pages 407-425.
    • Handle: RePEc:fip:fedlrv:y:2005:i:may:p:407-425:n:v.87no.3
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    Cited by:

    1. Karel Brůna, 2009. "Měnová politika a predikce variability úrokových sazeb na peněžním trhu [Monetary policy and prediction of variability]," Politická ekonomie, Prague University of Economics and Business, vol. 2009(3), pages 361-382.
    2. Chan, Kam Fong & Bowman, Robert G. & Neely, Christopher J., 2017. "Systematic cojumps, market component portfolios and scheduled macroeconomic announcements," Journal of Empirical Finance, Elsevier, vol. 43(C), pages 43-58.
    3. Christopher J. Neely, 2005. "An analysis of recent studies of the effect of foreign exchange intervention," Review, Federal Reserve Bank of St. Louis, vol. 87(Nov), pages 685-718.
    4. Michael D Bauer & Aeimit Lakdawala & Philippe Mueller, 2022. "Market-Based Monetary Policy Uncertainty," The Economic Journal, Royal Economic Society, vol. 132(644), pages 1290-1308.
    5. Lakdawala, Aeimit, 2021. "The growing impact of US monetary policy on emerging financial markets: Evidence from India," Journal of International Money and Finance, Elsevier, vol. 119(C).
    6. Deniz Erdemlioglu & Sébastien Laurent & Christopher J. Neely, 2013. "Econometric modeling of exchange rate volatility and jumps," Chapters, in: Adrian R. Bell & Chris Brooks & Marcel Prokopczuk (ed.), Handbook of Research Methods and Applications in Empirical Finance, chapter 16, pages 373-427, Edward Elgar Publishing.
    7. Christopher J. Neely, 2011. "A survey of announcement effects on foreign exchange volatility and jumps," Review, Federal Reserve Bank of St. Louis, vol. 93(Sep), pages 361-385.
    8. William R. Emmons & Aeimit K. Lakdawala & Christopher J. Neely, 2006. "What are the odds? option-based forecasts of FOMC target changes," Review, Federal Reserve Bank of St. Louis, vol. 88(Nov), pages 543-562.
    9. Gabriel Arce‐Alfaro & Boris Blagov, 2023. "Monetary Policy Uncertainty and Inflation Expectations," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 85(1), pages 70-94, February.
    10. Ryan Rholes & Luba Petersen, 2020. "Should central banks communicate uncertainty in their projections?," Discussion Papers dp20-01, Department of Economics, Simon Fraser University.
    11. Marion Kohler, 2010. "Exchange rates during financial crises," BIS Quarterly Review, Bank for International Settlements, March.
    12. Nikolay Gospodinov & Ibrahim Jamali, 2018. "Monetary policy uncertainty, positions of traders and changes in commodity futures prices," European Financial Management, European Financial Management Association, vol. 24(2), pages 239-260, March.
    13. Rholes, Ryan & Petersen, Luba, 2021. "Should central banks communicate uncertainty in their projections?," Journal of Economic Behavior & Organization, Elsevier, vol. 183(C), pages 320-341.
    14. Kathleen Walsh & David Tan, 2008. "Monetary Policy Surprises and the Bank Bill Term Premium," Australian Journal of Management, Australian School of Business, vol. 33(2), pages 231-260, December.
    15. Sauter, Oliver, 2012. "Assessing uncertainty in Europe and the US: is there a common uncertainty factor?," MPRA Paper 38031, University Library of Munich, Germany.
    16. Bo Young Chang & Bruno Feunou, 2013. "Measuring Uncertainty in Monetary Policy Using Implied Volatility and Realized Volatility," Staff Working Papers 13-37, Bank of Canada.
    17. Arce-Alfaro, Gabriel & Blagov, Boris, 2021. "Monetary policy uncertainty and inflation expectations," Ruhr Economic Papers 899, RWI - Leibniz-Institut für Wirtschaftsforschung, Ruhr-University Bochum, TU Dortmund University, University of Duisburg-Essen.

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