Investor sentiment and interest rate volatility smile: evidence from Eurodollar options markets

Investor sentiment and interest rate volatility smile: evidence from Eurodollar options markets This paper studies the extent to which investor sentiment affects the Eurodollar option smile and finds that there is the dynamic interplay between sentiment-driven investors and arbitrageurs. The results reveal a significant relation between investor sentiment and interest rate volatility smile. The significant relations are stronger for put options, for short-maturity options, and for periods with higher uncertainty. The results are robust when considering controlling variables, net buying pressure, different interest rate option models, model-free method, or excluding rational components from the sentiment measures. Our findings favor the limits to arbitrage hypothesis against the positive feedback hypothesis, suggesting that the sentiment effect is transitory. Change in investor sentiment explains the time-varying smile that can be explained neither by rational interest rate models nor by net buying pressure. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Review of Quantitative Finance and Accounting Springer Journals

Investor sentiment and interest rate volatility smile: evidence from Eurodollar options markets

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Publisher
Springer US
Copyright
Copyright © 2013 by Springer Science+Business Media New York
Subject
Economics / Management Science; Finance/Investment/Banking; Accounting/Auditing; Econometrics; Operations Research/Decision Theory
ISSN
0924-865X
eISSN
1573-7179
D.O.I.
10.1007/s11156-013-0376-6
Publisher site
See Article on Publisher Site

Abstract

This paper studies the extent to which investor sentiment affects the Eurodollar option smile and finds that there is the dynamic interplay between sentiment-driven investors and arbitrageurs. The results reveal a significant relation between investor sentiment and interest rate volatility smile. The significant relations are stronger for put options, for short-maturity options, and for periods with higher uncertainty. The results are robust when considering controlling variables, net buying pressure, different interest rate option models, model-free method, or excluding rational components from the sentiment measures. Our findings favor the limits to arbitrage hypothesis against the positive feedback hypothesis, suggesting that the sentiment effect is transitory. Change in investor sentiment explains the time-varying smile that can be explained neither by rational interest rate models nor by net buying pressure.

Journal

Review of Quantitative Finance and AccountingSpringer Journals

Published: Apr 19, 2013

References

  • Investor sentiment and the cross-section of stock returns
    Baker, M; Wurgler, J
  • Spanning and derivative security valuation
    Bakshi, G; Madan, D
  • Stock return characteristics, skew laws, and the differential pricing of individual equity options
    Bakshi, G; Kapadia, N; Madan, D
  • Explaining credit default swap premia
    Benkert, C
  • Does net buying pressure affect the shape of implied volatility functions?
    Bollen, NP; Whaley, RE
  • Market liquidity and funding liquidity
    Brunnermeier, MK; Pedersen, LH

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