Libor and Swap Market Models for the Pricing of Interest Rate Derivatives: An Empirical Analysis
AbstractIn this paper we empirically analyze and compare the Libor and Swap Market Models, developed by Brace, Gatarek, and Musiela (1997) and Jamshidian (1997), using paneldata on prices of US caplets and swaptions.A Libor Market Model can directly be calibrated to observed prices of caplets, whereas a Swap Market Model is calibrated to a certain set of swaption prices.For both one-factor and two-factor models we analyze how well they price caplets and swaptions that were not used for calibration.We show that the Libor Market Models in general lead to better prediction of derivative prices that were not used for calibration than the Swap Market Models.A one-factor Libor Market Model that exhibits mean-reversion gives a good fit of the derivative prices, and adding a second factor only decreases pricing errors to a small extent.We also find that models that are chosen to exactly match certain derivative prices are overfitted. Finally, a regression analysis reveals that the pricing errors are correlated with the shape of the term structure of interest rates.
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Bibliographic InfoPaper provided by Tilburg University, Center for Economic Research in its series Discussion Paper with number 2000-35.
Date of creation: 2000
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Term Structure Models; Interest Rate Derivatives; Lognormal Pricing Models; Black Formula;
Find related papers by JEL classification:
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
- E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
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