Zero bound, option-implied PDFs, and term structure models
Abstract: This paper points out that several known ways of modeling non-negative nominal interest rates lead to different implications for the risk-neutral distribution of the short rate that can be checked with options data. In particular, Black's boundary models (\"interest rates as options\") imply a probability density function (pdf) that contains a Dirac delta function and a cumulative distribution function (cdf) that is nonzero at the zero boundary, while models like the CIR and positive-definite quadratic-Gaussian (QG) models have a zero cdf at the boundary. Eurodollar futures options data are found to favor Black's boundary models: the CIR/QG models, even multifactor versions, have difficulty capturing option prices accurately not only in low interest rate environments but also in higher interest rate environments, and data in early 2008 provide an almost tangible signature of the Dirac delta function in Black's boundary pdf models. Options data also contradict the prediction of well-known models whose cdf is zero at the zero boundary, namely that the risk-neutral pdf is always positively skewed.
File(s): File format is text/html http://www.federalreserve.gov/pubs/feds/2008/200831/200831abs.html
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Part of Series: Finance and Economics Discussion Series
Publication Date: 2008