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Distributions implied by American currency futures options: A ghost's smile?
Author(s) -
Cincibuch Martin
Publication year - 2004
Publication title -
journal of futures markets
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.88
H-Index - 55
eISSN - 1096-9934
pISSN - 0270-7314
DOI - 10.1002/fut.10098
Subject(s) - futures contract , currency , implied volatility , volatility (finance) , volatility smile , generalization , economics , market liquidity , futures market , econometrics , financial economics , sabr volatility model , monetary economics , mathematics , mathematical analysis
A new and easily applicable method for estimating risk‐neutral distributions (RND) implied by American futures options isproposed. It amounts to inverting the Barone‐Adesi and Whaley method (BAW method) to get the BAW implied volatility smile. Extensiveempirical tests show that the BAW smile is equivalent to the volatility smile implied by corresponding European options. Therefore, the procedureleads to a legitimate RND estimation method. Further, the investigation of the currency options traded on the Chicago Mercantile Exchange and OTCmarkets in parallel provides us with insights on the structure and interaction of the two markets. Unequally distributed liquidity in the OTC marketseems to lead to price distortions and an ensuing interesting “ghost‐like” shape of the RND density implied by CME options.Finally, using the empirical results, we propose a parsimonious generalization of the existing methods for estimating volatility smiles from OTCoptions. A single free parameter significantly improves the fit. © 2004 Wiley Periodicals, Inc. Jrl Fut Mark 24:147–178, 2004