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Interest rate option pricing and volatility forecasting: An application to Brazil

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  • Takami, Marcelo Yoshio
  • Tabak, Benjamin Miranda

Abstract

Assessing the markets perception of future interest and inflation rate volatility is of crucial importance to assess the evolution of expectations in an inflation targeting framework. This article aims to evaluate the information content of implied volatilities extracted from a Brazilian interest-rate call option. We compared the predictive performance of three different approaches: one using the traditional [Black F. The pricing of commodity contracts. J Financ Econ 1976;3:167–79] method, another one using the extended-Vasicek model, and in the third approach, we use a GARCH(2,1) model. The empirical evidence was more favorable to the extended-Vasicek method. Moreover, extended-Vasicek’s implied volatilities could predict around 33% (adjusted R2) of the variations in realized volatility. Further research could test for the predictive content of long memory options such as those suggested in Wang et al. [Wang X-T, Qiu W-Y, Ren F-Y. Option pricing of fractional version of the Black–Scholes model with Hurst exponent H being in 13,12. Chaos, Solitons & Fractals 2001;12:599–608; Wang X-T, Ren F-Y, Liang X-Q. A fractional version of the Merton model. Chaos, Solitons & Fractals 2003;15:455–63].

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  • Takami, Marcelo Yoshio & Tabak, Benjamin Miranda, 2008. "Interest rate option pricing and volatility forecasting: An application to Brazil," Chaos, Solitons & Fractals, Elsevier, vol. 38(3), pages 755-763.
    • Handle: RePEc:eee:chsofr:v:38:y:2008:i:3:p:755-763
    DOI: 10.1016/j.chaos.2007.01.038
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