Implied Interest Rates

Abstract

One of the most important assumptions in financial economics models is the existence of a risk-free rate, available for borrowing and lending. In any economy, however, the borrowing rate does not coincide with the lending rate even for the short run. The difference between the rates is considered a compensation for intermediation that is necessary in the imperfect real world. In a well-functioning financial market this difference would be small, and the smaller it is, the better off is the economy. The two short-term rates that best approximate riskless lending and borrowing rates are the Treasury-bill rate and the brokers' loan-call rate, respectively. With the introduction of put and call options a new risk-free instrument has been created. Using options alone or options combined with the underlying asset' one could turn to these markets for his borrowing or lending needs, thereby With the introduction of put and call options a new risk-free asset has been created. The objective of this study is to estimate the rate implied in option prices and compare it to other riskless instruments. We have used transactions data on Chicago Board Options Exchange options taking into account the American feature of these options. We find that options markets provide rates that are competitive with other short-term rates. These rates are closer to the borrowing rate than to the lending rate.