The Relative Valuation of Caps and Swaptions: Theory and Empirical Evidence
Anderson School at UCLA Working Paper #4-00
45 Pages Posted: 9 Jun 2000
Date Written: February 2000
Although traded as distinct products, caps and swaptions are linked by no-arbitrage relations through the correlation structure of interest rates. Using a string model framework, we solve for the correlation matrix implied by the swaptions market and examine the relative valuation of caps and swaptions. The results indicate that swaption prices are generated by four factors and that implied correlations are generally lower than historical correlations. We find evidence that long-dated swaptions are priced inconsistently and that there were major distortions in the swaptions market during the hedge-fund crisis of late 1998. We also find that cap prices periodically deviate significantly from the no-arbitrage values implied by the swaptions market.
JEL Classification: G12, G13
Suggested Citation: Suggested Citation