Interest Rate Caps Smile Too! But Can the LIBOR Market Models Capture It?
AbstractUsing more than two years of daily interest rate cap price data, this paper provides a systematic documentation of a volatility smile in cap prices. We find that Black (1976) implied volatilities exhibit an asymmetric smile (sometimes called a sneer) with a stronger skew for in-the-money caps than out-of-the-money caps. The volatility smile is time varying and is more pronounced after September 11, 2001. We also study the ability of generalized LIBOR market models to capture this smile. We show that the best performing model has constant elasticity of variance combined with uncorrelated stochastic volatility or upward jumps. However, this model still has a bias for short- and medium-term caps. In addition, it appears that large negative jumps are needed after September 11, 2001. We conclude that the existing class of LIBOR market models can not fully capture the volatility smile
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Bibliographic InfoPaper provided by Econometric Society in its series Econometric Society 2004 North American Winter Meetings with number 431.
Date of creation: 11 Aug 2004
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LIBOR market models; volatility smile; interest rate caps;
Find related papers by JEL classification:
- C4 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics
- C5 - Mathematical and Quantitative Methods - - Econometric Modeling
- G1 - Financial Economics - - General Financial Markets
This paper has been announced in the following NEP Reports:
- NEP-ALL-2004-12-02 (All new papers)
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