Options on federal funds futures and interest rate volatility

Abstract

This study examines the response of the spot and futures interest rates on the fed funds, Eurodollar, and Libor to the listing of CME fed funds options. With the exception of the Libor futures, the introduction of options is associated with a decrease in the conditional volatility of the interest rates in the sample. There is also evidence that the volume of options trading has a negative effect on the fed funds and the Eurodollar spot rates. In contrast, the fed funds and the Eurodollar futures rates respond positively to the volume of options trading. Overall, strong generalization of the effects of options listing and options trading across the markets is not possible. These results remain robust even after controlling for several exogenous variables including changes in the Fed's target for the fed funds rate, the TED spread, the 9/11 terrorist attacks, and day-of-the-week effects.