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Extracting Probabilistic Information from the Prices of Interest Rate Options: Tests of Distributional Assumptions

  • Kabir K. Dutta

    (Federal Reserve Bank of Boston)

  • David F. Babbel

    (Wharton School, University of Pennsylvania)

Return distributions in general and interest rates in particular have been observed to exhibit skewness and kurtosis that cannot be explained by the (log)normal distribution. Using g-and-h distribution we derived a closed-form option pricing formula for pricing European options. We measured its performance using interest rate cap data and compared it with the option prices based on the lognormal, Burr-3, Weibull, and GB2 distributions. We observed that the g-and-h distribution exhibited a high degree of accuracy in pricing options, much better than those other distributions in extracting probabilistic information from the option market.

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Article provided by University of Chicago Press in its journal Journal of Business.

Volume (Year): 78 (2005)
Issue (Month): 3 (May)
Pages: 841-870

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Handle: RePEc:ucp:jnlbus:v:78:y:2005:i:3:p:841-870
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