Survey sentiment and interest rate option smile

Chen, C. Y.-H. and Kuo, I.-D. K. (2015) Survey sentiment and interest rate option smile. International Review of Economics and Finance, 37, pp. 125-137. (doi:10.1016/j.iref.2014.11.018)

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Abstract

This paper finds that the presence of interest rate smile can be fully explained neither by the model misspecification nor by the buying pressure. First, volatility smile obtained from alternative interest rate models is not flat and interest rate smile significantly relates to survey sentiment after controlling for fundamental and liquidity variables. Second, a dynamic relation between sentiment proxies and interest rate smiles meets the limit to arbitrage hypothesis, which is the focal point of market friction. Third, the relation between survey sentiment proxies and option smiles is more pronounced during the crisis period than the pre-crisis and post-crisis period. While investor sentiment drives the smile curve, interest rate models cannot fully capture the smile since these models are formulated in a frictionless environment.

Item Type:Articles
Status:Published
Refereed:Yes
Glasgow Author(s) Enlighten ID:Chen, Professor Cathy Yi-Hsuan
Authors: Chen, C. Y.-H., and Kuo, I.-D. K.
College/School:College of Social Sciences > Adam Smith Business School > Accounting and Finance
Journal Name:International Review of Economics and Finance
Publisher:Elsevier
ISSN:1059-0560
Published Online:27 November 2014

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