Pricing and Hedging Interest Rate Options: Evidence from Cap-Floor Markets

46 Pages Posted: 20 Jun 2002

See all articles by Anurag Gupta

Anurag Gupta

Case Western Reserve University - Department of Banking & Finance

Marti G. Subrahmanyam

New York University (NYU) - Department of Finance

Date Written: April 2002

Abstract

This paper examines the pricing and hedging performance of interest rate option pricing models in the U.S. dollar interest rate cap and floor markets. We evaluate alternative one-factor and two-factor term structure models on daily data from March-December 1998, consisting of actual cap and floor prices across both strike rates and maturities. Results show that fitting the skew of the underlying interest rate distribution provides accurate pricing results within a one-factor framework. However, for hedging performance, introducing a second stochastic factor is more important than fitting the skew of the underlying distribution. Modeling the second factor allows a better representation of the dynamic evolution of the term structure by incorporating expected twists in the yield curve. Thus,the interest rate dynamics embedded in two-factor models appears to be closer to the one driving the actual economic environment, leading to more accurate hedges. This constitutes evidence against claims in the literature that correctly specified and calibrated one-factor models could replace multi-factor models for consistent pricing and hedging of interest rate contingent claims.

Keywords: Interest rate options, interest rate caps/floors, term structure of interest rates, hedging

JEL Classification: G12, G13, G19

Suggested Citation

Gupta, Anurag and Subrahmanyam, Marti G., Pricing and Hedging Interest Rate Options: Evidence from Cap-Floor Markets (April 2002). EFMA 2002 London Meetings. Available at SSRN: https://ssrn.com/abstract=314878 or http://dx.doi.org/10.2139/ssrn.314878

Anurag Gupta

Case Western Reserve University - Department of Banking & Finance ( email )

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Marti G. Subrahmanyam (Contact Author)

New York University (NYU) - Department of Finance ( email )

Stern School of Business,
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New York, NY 10012-1126
United States
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