Based on a multivariate extension of the constrained locally polynomial estimator of Ait-Sahalia and Duarte (2003), we provide nonparametric estimates of the probability densities of LIBOR rates under forward martingale measures and the state-price densities (SPDs) implicit in interest rate cap prices conditional on the slope and volatility factors of LIBOR rates. Both the forward densities and the SPDs depend significantly on the volatility of LIBOR rates, and there is a significant impact of mortgage prepayment activities on the forward densities. The SPDs exhibit a pronounced U-shape as a function of future LIBOR rates, suggesting that the state prices are high at both extremely low and high interest rates, which tend to be associated with periods of economic recessions and high inflations, respectively. Our results provide nonparametric evidence of unspanned stochastic volatility and suggest that the unspanned factors could be partly driven by refinancing activities in the mortgage markets.
Li, Haitao and Zhao, Feng, Nonparametric Estimation of State-Price Densities Implicit In
Interest Rate Cap Prices (July 1, 2007). AFA 2009 San Francisco Meetings Paper. Available at SSRN: http://ssrn.com/abstract=1106883
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