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May/June 2005, 
Vol. 87, No. 3
Posted 2005-05-01

Using Implied Volatility to Measure Uncertainty About Interest Rates

This article explains implied volatility (IV) and how it can differ from the market's true expectation of uncertainty. It also estimates IV of 3-month eurodollar interest rates from 1985 to 2001 and evaluates its ability to predict realized volatility. IV shows that uncertainty about short-term interest rates has been falling for almost 20 years, as the levels of interest rates and inflation have fallen; and changes in IV are usually coincident with major news about the stock market, the real economy, and monetary policy.