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

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.