New Methodologies in the Valuation of Interest Rate Options

Abstract

This paper values interest rate options using an improved parametric pricing kernel in the Merton (1973) intertemporal capital asset pricing model framework. In contrast to Liu, Kuo and Coakley (2007), the pricing kernel is driven by the following three state variables: the real interest rate, the Jensen's alpha, and the market volatility. Parameters in the pricing kernel are estimated using the Hansen (1982) two-step generalized method of moments. The results show that all three state variables are significant in the pricing kernel of LIBOR options. The Chebyshev polynomial pricing kernel dominates the iso-elastic power function pricing kernel. Finally, the five-term polynomial pricing kernel is superior to the fourth order polynomial which in turn is superior to the three-term expansion in the Hansen and Jagannathan (1997) distance measure comparison.