A General Stochastic Volatility Model for the Pricing of Interest Rate Derivatives

Review of Financial Studies, vol. 22, no. 5, p. 2007-2057, 2009

66 Pages Posted: 6 Mar 2007 Last revised: 11 Feb 2016

See all articles by Anders B. Trolle

Anders B. Trolle

HEC Paris - Finance Department

Eduardo S. Schwartz

Simon Fraser University (SFU); University of California, Los Angeles (UCLA) - Finance Area; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: July 1, 2007

Abstract

We develop a tractable and flexible stochastic volatility multi-factor model of the term structure of interest rates. It features unspanned stochastic volatility factors, correlation between innovations to forward rates and their volatilities, quasi-analytical prices of zero-coupon bond options, and dynamics of the forward rate curve, under both the actual and risk-neutral measure, in terms of a finitedimensional affine state vector. The model has a very good fit to an extensive panel data set of interest rates, swaptions and caps. In particular, the model matches the implied cap skews and the dynamics of implied volatilities.

Keywords: Stochastic volatility, HJM model, Kalman filter, swaptions, caps

JEL Classification: E43, G13

Suggested Citation

Trolle, Anders B. and Schwartz, Eduardo S., A General Stochastic Volatility Model for the Pricing of Interest Rate Derivatives (July 1, 2007). Review of Financial Studies, vol. 22, no. 5, p. 2007-2057, 2009. Available at SSRN: https://ssrn.com/abstract=966364 or http://dx.doi.org/10.2139/ssrn.966364

Anders B. Trolle (Contact Author)

HEC Paris - Finance Department ( email )

France
+33 (0)1 39 67 98 70 (Phone)

HOME PAGE: http://sites.google.com/view/anderstrolle

Eduardo S. Schwartz

Simon Fraser University (SFU) ( email )

8888 University Drive
Burnaby, British Columbia V5A 1S6
Canada

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825-1953 (Phone)
310-206-5455 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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