A Pricing Kernel Approach to Valuing Interest Rate Options

This paper investigates parametric pricing kernels for interest rate options within the intertemporal CAPM framework. The usual GMM estimation produces problematic pricing kernels that either fail statistical robustness tests or are inconsistent with economic theory in terms of being hump-shaped and having negative segments. Adopting the second Hansen-Jagannathan (HJ) distance, the four-term polynomial pricing kernels clearly dominate the nonlinear iso-elastic pricing kernels. The preferred pricing kernel has two significant state variables,the real interest rate and maximum Sharpe ratio. It is always strictly positive and everywhere monotonically decreasing in market returns in conformity with economic theory.