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Empirical performance of multifactor term structure models for pricing and hedging Eurodollar futures options

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  • Kuo, I-Doun
  • Lin, Yueh-Neng
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    Abstract

    This article compares two one-factor, two two-factor, two three-factor models in the HJM class and Black's [Black, F. (1976). The pricing of commodity contracts. Journal of Financial Economics, 3, 167-179.] implied volatility function in terms of their pricing and hedging performance for Eurodollar futures options across strikes and maturities from 1 Jan 2000 to 31 Dec 2002. We find that three-factor models perform the best for 1-day and 1-week prediction, as well as for 5-day and 20-day hedging. The moneyness bias and the maturity bias appear for all models, but the three-factor models produce lower bias. Three-factor models also outperform other models in hedging, in particular for away-from-the-money and long-dated options. Making Black's volatility a square root or exponential function performs similar to one-factor HJM models in pricing, but not in hedging. Correctly specified and calibrated multifactor models are thus important and cannot be replaced by one-factor models in pricing or hedging interest rate contingent claims.

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    Bibliographic Info

    Article provided by Elsevier in its journal Review of Financial Economics.

    Volume (Year): 18 (2009)
    Issue (Month): 1 (January)
    Pages: 23-32

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    Handle: RePEc:eee:revfin:v:18:y:2009:i:1:p:23-32

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    Web page: http://www.elsevier.com/locate/inca/620170

    Related research

    Keywords: Multifactor HJM model Volatility function Eurodollar futures option;

    References

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