An Examination of the Static and Dynamic Performance of Interest Rate Option Pricing Models
in the Dollar Cap-Floor Markets
August 2000
Anurag Gupta, and Marti G. Subrahmanyam
ABSTRACT
This paper examines the static and dynamic accuracy of interest rate option pricing models in the U.S. dollar interest
rate cap and floor markets. Alternative
one-factor and two-factor term structure models of the spot and the forward rate are evaluated on the basis of
their out-of-sample predictive ability in terms
of pricing and hedging performance. In addition, the models are evaluated based on the stability of their parameters,
the presence of systematic biases, and
their numerical complexity and computational efficiency. The tests are conducted 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 ne-factor framework.
However, for hedging performance, introducing a second stochastic factor is more important than fitting the skew
of the underlying distribution. Overall, the one-factor lognormal model for short term interest rates outperforms
other competing models in pricing tests, while two-factor models perform significantly better than one-factor models
in hedging tests. 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.
Subject: Investments/Fixed Income
Classifications: Theoretical
Anurag Gupta
Institution: Stern School of Business, New York University
Email: agupta0@stern.nyu.edu
Telephone: (212) 998-0326
Marti G. Subrahmanyam
Institution: Stern School of Business, New York University
Email: msubrahm@stern.nyu.edu
Telephone: (212) 998-0348
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