What’s the point of extracting implied probabilities from options on federal fund futures?

I like telling fantastical story analogies. So here’s my attempt at explaining what’s the point behind extracting implied probabilities from option prices.

The story goes like this: Let’s say you worked for an arms and munition plant - R&D side of course. And that for some strange inexplicable reason you were caught in an airstrike while driving home one day. Now the missile that’s streaking across the sky is carrying 1000 high explosive anti-personnel bomblets designed to penetrate soft-skinned vehicles (like the one you’re driving for example). From your lab tests at work, and hours spent analyzing bomb dispersal patterns, you have a pretty good guess of the effective dispersal pattern of those bomblets. Given the missile’s trajectory (you had a sensor installed in your car which tracks the movement of Air-to-Ground missiles being fired), you can guess which areas, ceteris paribus, would encounter the greatest concentration of bomblets.

By analogy, the missile’s flight trajectory is the possible direction of interest movements – i.e. either it goes up, down or remains at the same level. Your market macroeconomic indicators are your missile/ interest rate sensors. That bomb dispersal pattern that I was talking about, are my implied probability distribution functions. I want to map out which levels are interest rates most likely to climb or fall to.

In this case I’m looking to map out the regions of probabilities that the interest rate would climb to levels A, B or C.

Extracting implied probabilities from options

Link <http://www.bankofengland.co.uk/statistics/impliedpdfs/> to Bank of England's efforts at estimating probability density functions (pdfs) from the prices of option contracts traded on equity indices and interest rate futures contracts (see 'Notes on Bank of England Option Implied PDFs' for examples).

Thesis: Extracting Implied Probabilities from Options on Futures and OneNote2007

Currently working on a dissertation. Started out wanting to do a paper on regional Tobin Q, ended up with another, more interesting idea: extracting implied probabilities from options on futures on Fed Fund rates.

Its been done before in the US, but my supervisor suggested I try doing the same for Australia instead.

The idea's pretty straightforward, but reading up on the math isn't. As I move along I'll blog about the entire process more. Its pretty much work in progress.