Liquidity Effects and Volatility Smiles in Interest Rate Option Markets

We investigate the interaction of volatility smiles and liquidity in the euro (€) interest rate option markets, using an extensive data-set on daily bid and ask prices of interest rate caps and floors. We find that, in this market, the implied volatility smiles are asymmetric, and are steeper on the ask-side. Liquidity variables have significant explanatory power for both curvature and asymmetry of the smiles. This effect too is stronger on the ask side. Thus, liquidity effects contribute to explaining the smile in these interest rate options. The stronger influence of liquidity and other economic variables on the ask-side indicates that ask-prices are more relevant for these markets, consistent with the fact that most of the customers are buyers of these interest rate options. In addition, the shape of the implied volatility smile has information about future levels of the term structure and the uncertainty in the market. To our knowledge, this is the first study relating liquidity and other economic variables to implied volatility smiles in interest rate options. The results of our study have strong implications for academics and practitioners involved in the modeling and risk management of fixed income derivatives, and may also throw light on the pricing of liquidity risk in option markets in general. JEL Classification: G10, G12, G13, G15