Microeconomics: Decision-Making under Risk & Uncertainty eJournal | 2021
Implied Market Expectations on Interest Rate Derivatives Market
Abstract
This paper examines the forecast power of subsets of the option-implied interest rate derivatives’ expectations. We use a string market model with three factors to extract the implied risk-neutral volatility of the short-end interest rate term structure. Using data from the Brazil derivatives interest rate market, which uniquely contains only two overlapping option instruments on the interbank rate, we show that out-of-the-money options had a better forecast performance than the future market rates and at-the-money option implied expectations. Our method provides a framework for academics and policymakers to study the volatility during political and economic events using the dataset of the interest rate term-structure derivatives.