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Are Interest Rate Derivatives Spanned by the Term Structure of Interest Rates?

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Author Info

  • Massoud Heidari

    (Caspian Capital)

  • Liuren WU

    (Fordham University)

Abstract

We investigate whether the same finite dimensional dynamic system spans both interest rates (the yield curve) and interest rate options (the implied volatility surface). We find that the options market exhibits factors independent of the underlying yield curve. While three common factors are adequate to capture the systematic movement of the yield curve, we need three additional factors to capture the movement of the implied volatility surface.

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File URL: http://128.118.178.162/eps/fin/papers/0207/0207013.pdf
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Bibliographic Info

Paper provided by EconWPA in its series Finance with number 0207013.

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Length: 48 pages
Date of creation: 30 Aug 2002
Date of revision:
Handle: RePEc:wpa:wuwpfi:0207013

Note: Type of Document - pdf; prepared on MikTex; to print on postscript; pages: 48 ; figures: included. produced via dvipdfm
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Web page: http://128.118.178.162

Related research

Keywords: Factors; principal component; LIBOR; swaps; swaptions; yield curve; implied volatility surface.;

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References

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  17. Damir Filipovic, 2001. "A general characterization of one factor affine term structure models," Finance and Stochastics, Springer, vol. 5(3), pages 389-412.
  18. Ole E. Barndorff-Nielsen & Neil Shephard, 2001. "Non-Gaussian Ornstein-Uhlenbeck-based models and some of their uses in financial economics," Journal of the Royal Statistical Society Series B, Royal Statistical Society, vol. 63(2), pages 167-241.
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Citations

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Cited by:
  1. Enlin Pan & Liuren Wu, 2004. "Taking Positive Interest Rates Seriously," Finance 0409013, EconWPA.
  2. Liuren Wu & Frank Xiaoling Zhang, 2005. "A no-arbitrage analysis of economic determinants of the credit spread term structure," Finance and Economics Discussion Series 2005-59, Board of Governors of the Federal Reserve System (U.S.).
  3. Gupta, Anurag & Subrahmanyam, Marti G., 2005. "Pricing and hedging interest rate options: Evidence from cap-floor markets," Journal of Banking & Finance, Elsevier, vol. 29(3), pages 701-733, March.
  4. Massoud Heidari & Liuren Wu, 2002. "Term Structure of Interest Rates, Yield Curve Residuals, and the Consistent Pricing of Interest Rates and Interest Rate Derivatives," Finance 0207010, EconWPA, revised 05 Sep 2002.

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