Abstract

http://ssrn.com/abstract=1294590
 
 

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An Examination of the Static and Dynamic Performance of Interest Rate Option Pricing Models in the Dollar Cap-Floor Markets


Anurag Gupta


Case Western Reserve University - Department of Banking & Finance

Marti G. Subrahmanyam


New York University - Stern School of Business

September 2001

NYU Working Paper No. FIN-01-044

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 economicenvironment, 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.

Number of Pages in PDF File: 49

Keywords: Interest rate options, interest rate caps/floors, term structure of interest rates

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Date posted: November 3, 2008  

Suggested Citation

Gupta, Anurag and Subrahmanyam, Marti G., An Examination of the Static and Dynamic Performance of Interest Rate Option Pricing Models in the Dollar Cap-Floor Markets (September 2001). NYU Working Paper No. FIN-01-044. Available at SSRN: http://ssrn.com/abstract=1294590

Contact Information

Anurag Gupta (Contact Author)
Case Western Reserve University - Department of Banking & Finance ( email )
10900 Euclid Ave.
Cleveland, OH 44106-7235
United States
216-368-2938 (Phone)
216-368-4776 (Fax)
Marti G. Subrahmanyam
New York University - Stern School of Business ( email )
Stern School of Business,
44 West 4th Street, Suite 9-68
New York, NY 10012-1126
United States
212-998-0348 (Phone)
212-995-4233 (Fax)
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