The Performance of Multi-Factor Term Structure Models for Pricing and Hedging Caps and Swaptions

52 Pages Posted: 6 Nov 2000

See all articles by Joost Driessen

Joost Driessen

Tilburg University - Tilburg University School of Economics and Management; Tilburg University - Center for Economic Research (CentER)

Pieter Klaassen

UBS AG

Bertrand Melenberg

Tilburg University - Center for Economic Research (CentER)

Date Written: January 2002

Abstract

In this paper we empirically compare a wide range of different term structure models when it comes to the pricing and, in particular, hedging of caps and swaptions. We analyze the influence of the number of factors on the hedging and pricing results, and investigate which type of data "interest rate data or derivative price data" should be used to estimate the model parameters to obtain the best hedging and pricing results. We use data on interest rates, and cap and swaption prices from 1995 to 1999. The empirical results on the hedging of caps and swaptions show that, if the number of hedge instruments is equal to the number of factors, the multi-factor models outperform one-factor models in hedging caps and swaptions. However, if one uses a large set of hedge instruments, one-factor models perform as well as multi-factor models. In terms of pricing, we find that models with two or three factors imply better out-of-sample predictions of cap and swaption prices than one-factor models. Also, estimation on the basis of current derivative prices leads to more accurate out-of-sample prediction of cap and swaption prices than estimation on the basis of interest rate data.

Keywords: Term Structure Models; Interest Rate Derivatives; Option Pricing; Hedging

JEL Classification: G12, G13, E43

Suggested Citation

Driessen, Joost and Klaassen, Pieter and Melenberg, Bertrand, The Performance of Multi-Factor Term Structure Models for Pricing and Hedging Caps and Swaptions (January 2002). Available at SSRN: https://ssrn.com/abstract=249020 or http://dx.doi.org/10.2139/ssrn.249020

Joost Driessen (Contact Author)

Tilburg University - Tilburg University School of Economics and Management ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

Tilburg University - Center for Economic Research (CentER) ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

Pieter Klaassen

UBS AG ( email )

Postfach
Zurich, 8076
Switzerland

Bertrand Melenberg

Tilburg University - Center for Economic Research (CentER) ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands
+31 13 466 2730 (Phone)

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