On the information in the interest rate term structure and option prices
AbstractWe examine whether the information in cap and swaption prices is consistent with realized movements of the interest rate term structure. To extract an option-implied interest rate covariance matrix from cap and swaption prices, we use Libor market models as a modelling framework. We propose a flexible parameterization of the interest rate covariance matrix, which cannot be generated by standard low-factor term structure models. The empirical analysis, based on US data from 1995 to 1999, shows that option prices imply an interest rate covariance matrix that is significantly different from the covariance matrix estimated from interest rate data. If one uses the latter covariance matrix to price caps and swaptions, one significantly underprices these options. We discuss and analyze several explanations for our findings.
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Bibliographic InfoPaper provided by Tilburg University in its series Open Access publications from Tilburg University with number urn:nbn:nl:ui:12-3159390.
Date of creation: 2004
Date of revision:
Publication status: Published in Review of Derivatives Research (2004) v.7, p.99-127
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Other versions of this item:
- Frank de Jong & Joost Driessen & Antoon Pelsser, 2004. "On the Information in the Interest Rate Term Structure and Option Prices," Review of Derivatives Research, Springer, vol. 7(2), pages 99-127, 08.
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