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Interest Rate Caps "Smile" Too! But Can the LIBOR Market Models Capture the Smile?


Using 3 years of interest rate caps price data, we provide a comprehensive documentation of volatility smiles in the caps market. To capture the volatility smiles, we develop a multifactor term structure model with stochastic volatility and jumps that yields a closed-form formula for cap prices. We show that although a three-factor stochastic volatility model can price at-the-money caps well, significant negative jumps in interest rates are needed to capture the smile. The volatility smile contains information that is not available using only at-the-money caps, and this information is important for understanding term structure models. Copyright 2007 by The American Finance Association.

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Article provided by American Finance Association in its journal The Journal of Finance.

Volume (Year): 62 (2007)
Issue (Month): 1 (02)
Pages: 345-382

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Handle: RePEc:bla:jfinan:v:62:y:2007:i:1:p:345-382
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