On the Information in the Interest Rate Term Structure and Option Prices

40 Pages Posted: 28 Feb 2002 Last revised: 8 May 2011

See all articles by Frank De Jong

Frank De Jong

Tilburg University - Department of Finance

Joost Driessen

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

Antoon Pelsser

Maastricht University; Netspar

Date Written: January 1, 2002

Abstract

Cap and swaption prices contain information on interest rate volatilities and correlations. In this paper, we examine whether this information in cap and swaption prices is consistent with realized movements of the interest rate term structure. To extract an option-implied interest rate covariance matrix from cap and swaption prices, we use Libor market models or discrete-tenor string models as modeling framework. We propose a flexible parameterization of the interest rate covariance matrix, which cannot be generated by standard low-factor term structure models. The empirical analysis is based on weekly US data from 1995 to 1999. Our empirical results show that the option prices imply a covariance matrix of interest rates that is significantly different from the covariance matrix implied by realized interest rate changes. In particular, if one uses the latter covariance matrix to price caps and swaptions, one significantly underprices these options. We discuss and analyze several explanations for our findings.

Keywords: Term Structure Models, Interest Rate Derivatives, Volatility Hump, Caps and Swaptions

JEL Classification: G12, G13, E43

Suggested Citation

De Jong, Frank and Driessen, Joost and Pelsser, Antoon A. J., On the Information in the Interest Rate Term Structure and Option Prices (January 1, 2002). Review of Derivatives Research, Vol. 7, No. 2, 2004, Available at SSRN: https://ssrn.com/abstract=298160 or http://dx.doi.org/10.2139/ssrn.298160

Frank De Jong

Tilburg University - Department of Finance ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

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

Antoon A. J. Pelsser

Maastricht University ( email )

P.O. Box 616
Maastricht, 6200 MD
Netherlands

HOME PAGE: http://https://sites.google.com/site/apelsseraca/

Netspar ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

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