Is It Possible to Reconcile the Caplet and Swaption Markets? Evidence from the U.S.-Dollar Market

We look at the prices of U.S.-dollar caplets and swaptions and ask whether the two markets (which ultimately share the same set of underliers) are internally consistent, given a flexible and parsimonious class of no-arbitrage pricing models. We find that it is difficult to reconcile the observed market prices of all swaptions with plausible assumptions about correlation and volatilities. We find instead that in all market conditions (normal and excited), the swaption market trades extremely close to the no-arbitrage boundaries implied by the chosen class of no-arbitrage models. We also identify under what conditions the prices of swap (ions can be replicated using early-stopping caplets, and we show that when these conditions are not met, the swaption prices will always be below this boundary. Empirically, we then find that the market prices of swaptions trade very close to this boundary in both normal and excited periods. When the no-arbitrage boundary is exceeded, reversion to the boundary is swift.