Effect o f Liquidity on the Imp lied Volatility S urface in Interest Rate Options Markets

The volatility implied in the option price exhibits the systematic bias with respect to different levels of exercise prices for different maturities, and this anomaly has been arousing the attentions of many financial economists. This paper investigates the bias of volatility surface implied in options markets, and relates it to various measures of liquidities in Eurodollar futures and futures options markets. We find the effects of liquidity and the level of previous period implied volatility on the shape and change of volatility are significant in the interest rate options market. The implied volatility bias is larger for deep in-the-money and out-of-the-money options and for short maturity options than for at-the-money and for long maturity options.