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Please use this identifier to cite or link to this item:
http://hdl.handle.net/2451/26913
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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: | Gupta, Anurag
Subrahmanyam, Marti G. |
| Keywords: | Interest rate options
interest rate caps/floors
term structure of interest rates |
| Issue Date: | Sep-2001 |
| Series/Report no.: | S-DRP-01-18 |
| 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. We evaluate alternative one-factor and two-factor term
structure models of the spot and the forward interest rates on the basis
of their out-of-sample predictive ability in terms of pricing and
hedging performance. The one-factor models analyzed consist of two
spot-rate specifications (Hull and White (1990) and Black-Karasinski
(1991), five forward rate specifications (within the general Heath,
Jarrow and Morton (1990b) class), and one LIBOR market model (Brace,
Gatarek and Musiela (1997) [BGM]). For two-factor models, two
alternative forward rate specifications are implemented within the HJM
framework. We conduct tests 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/2451/26913 |
| Appears in Collections: | Derivatives Research
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