Estimation of bid-ask prices for options on LIBOR based instruments

Interest rate options are the most liquid traded derivatives in the markets. We observe the following from the markets: (i) Market dealers usually quote the mid-price. The mid-price is a subjective and hypothetical price. (ii) OTC interest rate options market are incomplete, and options cannot always be costlessly replicated. (iii) The bid-ask prices are not widely available for the market as a whole. With these observations in mind, we propose an approach to estimate the bid-ask prices for options on LIBOR based instruments. In particular, we assess the proposed approach in the determination of premiums for caps and floors. (C) 2016 Elsevier Inc. All rights reserved.