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
Date Written: July 1, 2007
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: Suggested Citation