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Variance Optimal Cap Pricing Models

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  • Laurent, J.P.

    (CREST)

  • Scaillet, O.

    (UNIVERSITE CATHOLIQUE DE LOUVAIN, Institut de Recherches Economiques et Sociales (IRES); UNIVERSITE CATHOLIQUE DE LOUVAIN, Institut d’Administration et de Gestion (IAG))

Abstract

We propose new closed-form pricing formulas for interest rate options which guarantee perfect compatibility with volatility smiles. These cap pricing formulas are computed under variance optimal measures in the framework of the market model or the Gaussian model and achieve an exact calibration of observed market prices. They are presented in a general setting allowing to study model and numéraire choice effects on the computed prices. Numéraire dependence is particularly emphasized. A numerical example and an empirical application on market data are given to illustrate the practical use of the calibration procedure.

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Bibliographic Info

Paper provided by Université catholique de Louvain, Institut de Recherches Economiques et Sociales (IRES) in its series Discussion Papers (IRES - Institut de Recherches Economiques et Sociales) with number 1999002.

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Length: 41
Date of creation: 01 Dec 1997
Date of revision: 01 Jan 1999
Handle: RePEc:ctl:louvir:1999002

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Keywords: Discount bond option; cap pricing formula; volatility smile; variance optimal measure; implied pricing model;

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Cited by:
  1. Jean-Luc PRIGENT & Olivier RENAULT & Olivier SCAILLET, 2002. "Option Pricing with Discrete Rebalancing," FAME Research Paper Series rp55, International Center for Financial Asset Management and Engineering.

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