A pricing kernel approach to valuing options on interest rate futures

Abstract

This paper builds on existing asset pricing models in an intertemporal capital asset pricing model framework to investigate the pricing of options on interest rate futures. It addresses the issues of selecting the preferred pricing kernel model by employing the second Hansen–Jagannathan distance criterion. This criterion restricts the set of admissible models to those with a positive stochastic discount factor that ensures the model is arbitrage-free. The results indicate that the three-term polynomial pricing kernel with three non-wealth-related state variables, namely the real interest rate, maximum Sharpe ratio, and implied volatility, clearly dominates the other candidates. This pricing kernel is always strictly positive and everywhere monotonically decreasing in market returns in conformity with economic theory.