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Generating Options-Implied Probability Densities to Understand Oil Market Events
We investigate the informational content of options-implied probability density functions (PDFs) for the future price of oil. Using a semiparametric variant of the methodology in Breeden and Litzenberger (1978), we investigate the fit and smoothness of distributions derived from alternative PDF estimation methods, and develop a set of robust summary statistics. Using PDFs estimated around episodes of high geopolitical tensions, oil supply disruptions, and macroeconomic data releases, we explore the extent to which oil price movements are expected or unexpected, and whether agents believe ...
Option-implied term structures
This paper proposes a nonparametric sieve regression framework for pricing the term structure of option spanning portfolios. The framework delivers closed-form, nonparametric option pricing and hedging formulas through basis function expansions that grow with the sample size. Novel confidence intervals quantify term structure estimation uncertainty. The framework is applied to estimating the term structure of variance risk premia and finds that a short-run component dominates market excess return predictability. This finding is inconsistent with existing asset pricing models that seek to ...
Interest Rate Derivatives and Monetary Policy Expectations
Market expectations of the path of future policy rates can have important implications for financial markets and the economy. Because interest rate derivatives enable market participants to hedge against or speculate on potential changes in various short-term U.S.interest rates, they are a rich and timely source of information on market expectations. In this post, we describe how information about market expectations can be derived from interest rate futures and forwards, focusing on three main instruments: federal funds futures, overnight index swaps (OIS), and Eurodollar futures. We also ...
Equity Volatility Term Premia
This paper estimates the term-structure of volatility risk premia for the stock market. Realized variance term premia are increasing in systematic risk and predict variance swap returns. Implied volatility term premia are decreasing in risk initially, but then increase at a lag, predicting VIX futures returns. By modeling the logarithm of realized variance, the paper derives a closed-form relationship between the prices of variance swaps and VIX futures. The model provides accurate pricing and highlights periods of dislocation between the index options and VIX futures markets. Term premia ...