A Pricing Kernel Approach to Valuing Options on Interest Rate Futures

39 Pages Posted: 3 Jun 2011

See all articles by Xiaoquan Liu

Xiaoquan Liu

Essex Business School

Jerry Coakley

University of Essex - Essex Business School

Jing-Ming Kuo

University of Birmingham - Birmingham Business School

Date Written: May 8, 2011

Abstract

This paper builds on existing asset pricing models in an intertemporal CAPM 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 (HJD) 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 3-term polynomial pricing kernel with three non-wealth related state variables - the real interest rate, maximum Sharpe ratio, and implied volatility - clearly dominates the other candidates. The pricing kernel is always strictly positive and everywhere monotonically decreasing in market returns in conformity with economic theory.

Keywords: Pricing Kernels, Simulation-based Bayesian Approach, LIBOR Futures Options

JEL Classification: C11, G12, G13

Suggested Citation

Liu, Xiaoquan and Coakley, Jerry and Kuo, Jing-Ming, A Pricing Kernel Approach to Valuing Options on Interest Rate Futures (May 8, 2011). Available at SSRN: https://ssrn.com/abstract=1857418 or http://dx.doi.org/10.2139/ssrn.1857418

Xiaoquan Liu (Contact Author)

Essex Business School ( email )

Wivenhoe Park
Colchester, CO4 3SQ
United Kingdom

Jerry Coakley

University of Essex - Essex Business School ( email )

Wivenhoe Park
Colchester, CO4 3SQ
United Kingdom
+44 1206 872455 (Phone)
+44 1206 873429 (Fax)

HOME PAGE: http://www.essex.ac.uk/afm/staff/coakley.shtm

Jing-Ming Kuo

University of Birmingham - Birmingham Business School ( email )

Edgbaston Park Road
University House
Birmingham, Birmingham B15 2TT
United Kingdom

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