An Arbitrage-Free Nelson-Siegel Model with Unspanned Stochastic Volatility for the Pricing of Interest Rate Derivatives

46 Pages Posted: 14 Oct 2014

See all articles by Rui Chen

Rui Chen

Central University of Finance and Economics (CUFE)

Ke Du

Institute of Financial Studies (IFS), Southwestern University of Finance and Economics (SWUFE)

Xiaoneng Zhu

Shanghai University of Finance and Economics

Date Written: October 9, 2014

Abstract

We propose a generalized arbitrage-free Nelson-Siegel model under the HJM framework. It features unspanned stochastic volatility factors while maintaining a Nelson-Siegel factor loading structure. The price of the interest rate derivatives, including European options, Caps and Swaptions are then obtained in semi closed-form. We calibrate the model using an extensive panel data, including the US Libor rates, Swap rates, caps and swaptions. By estimating our model via the extended Kalman filter, we find strong evidence that our model prices interest rates and their derivatives accurately.

Keywords: Term structures, Bond market, Arbitrage-free model, Unspanned stochastic volatility, Interest rate derivatives

JEL Classification: E43, G13

Suggested Citation

Chen, Rui and Du, Ke and Zhu, Xiaoneng, An Arbitrage-Free Nelson-Siegel Model with Unspanned Stochastic Volatility for the Pricing of Interest Rate Derivatives (October 9, 2014). Available at SSRN: https://ssrn.com/abstract=2509327 or http://dx.doi.org/10.2139/ssrn.2509327

Rui Chen (Contact Author)

Central University of Finance and Economics (CUFE) ( email )

39 South College Road
Haidian District
Beijing, Beijing 100081
China

Ke Du

Institute of Financial Studies (IFS), Southwestern University of Finance and Economics (SWUFE) ( email )

55 Guanghuacun St,
Chengdu, Sichuan 610074
China

Xiaoneng Zhu

Shanghai University of Finance and Economics ( email )

777 Guoding Road
Shanghai, AK Shanghai 200433
China

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