Mixing Gaussian Models to Price CMS Derivatives

Abstract:     
In this article, we propose a simple interest rate model, which can well accommodate swaption smiles, while recovering market prices of CMS swap spreads. The model is based on a (possibly multi-factor) Gaussian short rate model coupled with parameter uncertainty. Examples of calibration to real market data will be presented as well as the pricing of some typical CMS-based derivatives.

Keywords: swaption, CMS, volatility smile, volatility skew, convexity adjustment, Gaussian model, Hull and White model, stochastic volatility, uncertain volatility, calibration

JEL Classifications: C15, C61, G12, G13

Working Paper Series