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On the implied volatility layers under the future risk-free rate uncertainty

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  • Lin-Yee Hin
  • Nikolai Dokuchaev

Abstract

This paper suggests a method of estimation of the implied volatility smile uncertainty of the observed options prices due to future risk-free rate uncertainty. The purpose is to quantify the range of uncertainty under different scenarios. We consider the setting where both the implied volatility and the risk free rate are calculated jointly from the observed option prices. Due to the cumulative risk-free rate uncertainty, the corresponding system of equations is underdetermined, leading to uncertainty in the volatility surface. We estimate the size of implied volatility layers between the surfaces representing the upper and lower bounds for the implied volatilities for the future risk-free rate uncertainty, defined by current Libor rate and the size of fluctuation estimated from the historical data.

Suggested Citation

  • Lin-Yee Hin & Nikolai Dokuchaev, 2014. "On the implied volatility layers under the future risk-free rate uncertainty," International Journal of Financial Markets and Derivatives, Inderscience Enterprises Ltd, vol. 3(4), pages 392-408.
    • Handle: RePEc:ids:ijfmkd:v:3:y:2014:i:4:p:392-408
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    Cited by:

    1. Nikolai Dokuchaev, 2018. "On the implied market price of risk under the stochastic numéraire," Annals of Finance, Springer, vol. 14(2), pages 223-251, May.

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