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The Relative Valuation of Caps and Swaptions: Theory and Empirical Evidence

  • Longstaff, Francis A
  • Santa-Clara, Pedro
  • Schwartz, Eduardo S
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    Although traded as distinct products, caps and swaptions are linked by no-arbitrage relations through the correlation structure of interest rates. Using a string market model framework, we solve for the correlation matrix implied by the swaptions market and examine the relative valuation of caps and swaptions. The results indicate that swaption prices are generated by four factors and that implied correlations are generally lower than historical correlations. We find evidence that long-dated swaptions are priced inconsistently and that there were major distortions in the swaptions market during the hedge-fund crisis of late 1998. We also find that cap prices periodically deviate significantly from the no-arbitrage values implied by the swaptions market.

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    Paper provided by Anderson Graduate School of Management, UCLA in its series University of California at Los Angeles, Anderson Graduate School of Management with number qt65f1914p.

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    Date of creation: 01 Sep 2000
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    Handle: RePEc:cdl:anderf:qt65f1914p
    Contact details of provider: Postal: 110 Westwood Plaza, Los Angeles, CA. 90095
    Web page: http://www.escholarship.org/repec/anderson_fin/

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    1. Sun, Tong-sheng & Sundaresan, Suresh & Wang, Ching, 1993. "Interest rate swaps: An empirical investigation," Journal of Financial Economics, Elsevier, vol. 34(1), pages 77-99, August.
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    11. Driessen, Joost & Klaassen, Pieter & Melenberg, Bertrand, 2003. "The Performance of Multi-Factor Term Structure Models for Pricing and Hedging Caps and Swaptions," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 38(03), pages 635-672, September.
    12. Bicksler, James & Chen, Andrew H, 1986. " An Economic Analysis of Interest Rate Swaps," Journal of Finance, American Finance Association, vol. 41(3), pages 645-55, July.
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    16. Litzenberger, Robert H, 1992. " Swaps: Plain and Fanciful," Journal of Finance, American Finance Association, vol. 47(3), pages 831-50, July.
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    18. Goldstein, Robert S, 2000. "The Term Structure of Interest Rates as a Random Field," Review of Financial Studies, Society for Financial Studies, vol. 13(2), pages 365-84.
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