No. 545 - Can option smiles forecast changes in interest rates? An application to the US, the UK and the Euro Area

This paper evaluates the use of risk-neutral probability density functions implied in 3- month interest-rate futures options to assess market perceptions regarding future monetary policy moves_ options allow the information content implied in simpler derivatives to be extended by providing indicators for asymmetry and extreme values. First, a cubic spline is implemented to evaluate the densities. Second, the methodology is applied to quotes on deposits denominated in US dollars, euros and sterling from January 1999 toMay 2004_ results show that markets correctly forecast the monetary easing of 2001 in the United States in the course of the second half of 2000, but not in the euro area and the United Kingdom. The evidence for the tightening cycle of 1999 is mixed: markets expected an increase in euro area policy rates at the beginning of 1999_ expectations were less clear for the United States’ interest-rate increases. In the case of the United Kingdom the increase was not foreseen.