Euribor options on futures and caplet volatilities

[gc]

This is a trivial problem (and many out there are doing this already), but I believe that there are a few tricks that I don't know yet, that make the difference between a price and a usable one!



There are lots of people out there doing spreads between 1y or 1x2 caps and strips of options on the LIFFE 3-month Euribor futures.



Therefore I'm am looking at the implied volatilities that our futures desk is observing on the market for options on futures, interpolate the values a bit, and derive in this way volatilties for caplets.



The way I interpolate the volatilities (or if i decide to bootstrap them instead) changes the values for the caplet a bit, so if someone has any hints to give me, I'll be very happy. But overall, I can almost hit the market with values very close to the ATM 1y caps and floors.



For the 1x2, the options are not that liquid anymore after DEC05, so the second cap is only partially covered. What people do in this case? Do they extrapolate the volatilities from the first caplets? Or do they look at the mid curve options for SEP04,DEC04,MAR05 rather than the options for SEP05, DEC05, MAR06?



And in any case, how shall I interpret the fact that, if I compare the smiles that our futures desk uses for the option on the SEP05 or the mid-curve option SEP05  (and therefore the same underlying future), the volatilities for the Mid curve are way above the volatilities for the simple option contract?



Any ideas, and suggestion, or any article, will be really welcome!



thanks



gc

[AndyM]

>>>And in any case, how shall I interpret the fact that, if I compare the smiles that our futures desk uses for the option on the SEP05 or the mid-curve option SEP05  (and therefore the same underlying future), the volatilities for the Mid curve are way above the volatilities for the simple option contract?>>>



Uncertainty tends to diminish as we approach the fixing, so the midcurves are capturing all the juicy moves, while the regular option also covers the dreary bit as we run into expiry. So generally, midcurve vol will be higher than the vols for the regular contract.

[xtrader]

As you note the back end contracts on the 1x2 are not that liquid on the exchange, however they are pretty liquid in the otc market.



In effect 1Y cap/floors more liquid on the exchange >2Y cap floors all otc.  The 1x2 is the sort of overlap area between the two so you need both sets of data.  Have a look at Reuters pages VCAP4 and VCAP5 to get started with some OTC pricing it's usually not too far off.



Also as Andy M rightly says the vol of contracts tends to fall very rapidly when they are the next 1 or 2 to expire, so the mid curve options are giving you the term structure of the caplet volatilties.