Central Bank Policy Impacts on the Distribution of Future Interest Rates

The century low, near-zero short-term interest rates in the USA, Euro Area, the UK and Japan after the Great Recession of 2008/2009 and the European Sovereign Debt Crisis of 2010-2013 make the non-normality and non-lognormality of short-term interest rates quite clear. To uncover the changing implicit state prices and risk-neutral densities for future short-term interest rates, we use the prices of interest rate caps and floors with various strike rates and maturities from 2 to 10 years. We show that butterfly spreads of time spreads of cap and floor prices give sensible implied risk-neutral densities and state prices that reflect key moves made by the Federal Reserve, the European Central Bank and the Bank of England. The state prices and risk-neutral densities computed are largely distribution-free, preference-free and model-free results, building from the arbitrage-based computations of state prices from option prices that were presented in Breeden and Litzenberger (1978).