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Please use this identifier to cite or link to this item:
http://hdl.handle.net/2451/26636
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| Title: | An Examination of the Static and Dynamic Performance of Interest Rate
Option Pricing Models In the Dollar Cap-Floor Markets |
| Authors: | Guptaa, Anurag
Subrahmanyamb, Marti G. |
| Keywords: | Interest rate options
interest rate caps/floors
term structure of interest rates |
| Issue Date: | Aug-2000 |
| Series/Report no.: | FIN-00-010 |
| Abstract: | This paper examines the static and dynamic accuracy of interest rate
option pricing models in the U.S. dollar interest rate cap and floor
markets. Alternative one-factor and two-factor term structure models of
the spot and the forward rate are evaluated on the basis of their
out-of-sample predictive ability in terms of pricing and hedging
performance. In addition, the models are evaluated based on the
stability of their parameters, the presence of systematic biases, and
their numerical complexity and computational efficiency. The tests are
conducted on daily data from March-December 1998, consisting of actual
cap and floor prices across both strike rates and maturities. Results
show that fitting the skew of the underlying interest rate distribution
provides accurate pricing results within a one-factor framework.
However, for hedging performance, introducing a second stochastic factor
is more important than fitting the skew of the underlying distribution.
Overall, the one-factor lognormal model for short term interest rates
outperforms other competing models in pricing tests, while two-factor
models perform significantly better than one-factor models in hedging
tests. Modeling the second factor allows a better representation of the
dynamic evolution of the term structure by incorporating expected twists
in the yield curve. Thus, the interest rate dynamics embedded in
two-factor models appears to be closer to the one driving the actual
economic environment, leading to more accurate hedges. This constitutes
evidence against claims in the literature that correctly specified and
calibrated one-factor models could replace multi-factor models for
consistent pricing and hedging of interest rate contingent claims. |
| URI: | http://hdl.handle.net/2451/26636 |
| Appears in Collections: | Finance Working Papers
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