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

We develop a tractable and flexible stochastic volatility multifactor 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 measures, in terms of a finite-dimensional 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.


Published in:
Review of Financial Studies, 22, 5, 2007-2057
Year:
2009
Publisher:
Oxford University Press
ISSN:
0893-9454
Laboratories:




 Record created 2010-04-24, last modified 2018-09-13

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