Nonparametric Interest Rate Cap Pricing: Implications for the 'Unspanned Stochastic Volatility'

32 Pages Posted: 24 Jan 2011 Last revised: 2 Mar 2011

See all articles by Tao L. Wu

Tao L. Wu

Illinois Institute of Technology

Date Written: January 23, 2011

Abstract

Asset prices depend on two elements: the dynamics of the state variables and the pricing kernel. Traditional term structure models differ in factor dynamics. However, most of them imply a log-linear pricing kernel. We investigate empirically the role of factor dynamics and pricing kernel in pricing interest rate derivatives using a nonparametric approach. We find that interest rate cap prices are very sensitive to the specification of factor dynamics, especially when they are close to expiration. In addition, nonlinear log-pricing kernels improve the pricing of long-maturity caps, although significant pricing errors remain. Recent research document models that fit LIBOR and swap rates but do not price derivatives well, leading to the so called "unspanned stochastic volatility puzzle". Additional volatility factors seem to be needed to explain cap prices. However, the relative mispricing between interest rate caps and underlying LIBOR and swap rates could also potentially be due to mis-specifications of the parametric models used. Our paper provides evidence for unspanned stochastic volatility from a nonparametric perspective.

Keywords: Term Structure of Interest Rates, Unspanned Stochastic Volatility, Interest Rate Derivatives

JEL Classification: G12

Suggested Citation

Wu, Tao L., Nonparametric Interest Rate Cap Pricing: Implications for the 'Unspanned Stochastic Volatility' (January 23, 2011). Available at SSRN: https://ssrn.com/abstract=1746450 or http://dx.doi.org/10.2139/ssrn.1746450

Tao L. Wu (Contact Author)

Illinois Institute of Technology ( email )

Stuart Graduate School of Business
565 W. Adams St.
Chicago, IL 60661
United States

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