International Finance Discussion Papers (IFDP)

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October 2016

Option-Implied Libor Rate Expectations across Currencies

Nick Gebbia

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

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

PDF: Full Paper

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Last Update: June 19, 2020