The Importance of Forward Rate Volatility Structures in Pricing Interest Rate-Sensitive Claims

JOURNAL OF DERIVATIVES, Fall 1995

Posted: 22 Aug 1998

See all articles by Peter H. Ritchken

Peter H. Ritchken

Case Western Reserve University - Department of Banking & Finance

L. Sankarasubramanian

affiliation not provided to SSRN

Abstract

Studies of the sensitivity of the prices of interest rate claims to alternative specifications of the volatility of spot and forward interest rates have drawn different conclusions. One possible explanation for this is that it is difficult to adjust the volatility structure without disturbing the initial set of bond prices. In this article we use a term structure-constrained model that lets us change the volatility structure for spot and forward rates without altering either their initial values or the set of initial bond prices. Consequently, any differences in prices of interest rate-sensitive claims can be attributed solely to alternative assumptions on the structure of spot and forward rate volatilities, rather than to variations in the initial conditions. We show that even when the initial conditions are common, option prices on interest rates and on bonds are sensitive to the specification of the volatility structure of spot rates. Further, we find that using a simple generalized Vasicek model to price claims can lead to significant mispricings if interest rate volatilities do indeed depend on their levels.

JEL Classification: E43

Suggested Citation

Ritchken, Peter H. and Sankarasubramanian, L., The Importance of Forward Rate Volatility Structures in Pricing Interest Rate-Sensitive Claims. JOURNAL OF DERIVATIVES, Fall 1995. Available at SSRN: https://ssrn.com/abstract=6914

Peter H. Ritchken (Contact Author)

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

10900 Euclid Ave.
Cleveland, OH 44106-7235
United States
216-368-3849 (Phone)
216-368-4776 (Fax)

L. Sankarasubramanian

affiliation not provided to SSRN

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