Interest Rate Options in Multi-Factor Cox-Ingersoll-Ross Models of the Term Structure
Posted: 25 Aug 1998
Fast closed form solutions using Fourier inversion methods are developed for interest rate options in multi-factor versions of the Cox-Ingersoll-Ross model. The options include European options on discount bonds, European options on Eurodollar futures, and caps on floating interest rates. Valuation models for options on coupon bonds and coupon bond futures are also discussed. The multi-factor Cox-Ingersoll-Ross models generate prices for interest rate options that differ significantly from prices generated by Black's model when options with long term expirations are valued. When a multi-factor model is used for hedging, the hedge portfolio requires additional securities and conventional formulas for hedge ratios must be modified.
JEL Classification: G12, G13, G14
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