The Economic Determinants of Interest Rate Option Smiles.pdf

The Economic Determinants * of Interest Rate Option Smiles 1 2 PRACHI DEUSKAR ANURAG GUPTA MARTI G. SUBRAHMANYAM3 Journal of Banking and Finance, forthcoming March 2007 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. JEL Classification: G10, G12, G13, G15 Keywords: Volatility smiles; interest rate options; euro interest rate markets; Euribor market. 1 Department of Finance, College of Business, University of Illinois at Urbana-Champaign, 304C David Kinley Hall, 1407 West Gregory Drive, Urbana, IL 61801. Ph: (217) 244-0604, Fax: (217) 244-9867, E- mail: pdeuskar@uiuc.ed