Working Paper

Option-Implied Libor Rate Expectations across Currencies

Abstract: In this paper, I study risk-neutral probability densities regarding future Libor rates denominated in British pounds, euros, and US dollars as implied by option prices. I apply Breeden and Litzenberger?s (1978) result regarding the relationship between option prices and implied probabilities for the underlying to estimate full probability density functions for future Libor rates. I use these estimates in case studies, detailing the evolution of probabalistic expectations for future Libor rates over the course of several important market events. Next, I compute distributional moments from density functions estimated for fixed horizons and test for Granger causality across the three Libor rate distributions considering their mean, standard deviation, skewness, and kurtosis. I further break these relationships down by various fixed horizon lengths, as well as the slope and curvature in the term structure of moments over different horizons. The results show a rich interconnectedness among these three Libor rates that extends well beyond levels of future mean expectations.

Keywords: Options; Futures; Libor; Pdf; Distribution; Moments; Granger causality;

JEL Classification: C14; E43; G13;

https://doi.org/10.17016/IFDP.2016.1182

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: International Finance Discussion Papers

Publication Date: 2016-10-13

Number: 1182

Pages: 44 pages