Pricing caps with HJM models: The benefits of humped volatility

Jury Falini

European Journal of Operational Research, 2010, vol. 207, issue 3, 1358-1367

Abstract: In this paper we compare different multifactor HJM models with humped volatility structures, to each other and to models with strictly decreasing volatility. All the models are estimated on Euribor and swap rates panel data maximizing the quasi-likelihood function obtained from the Kalman filter. We develop the analysis in two steps: first we study the in-sample properties of the estimated models, then we test the pricing performance on caps. We find the humped volatility specification to greatly improve the model estimation and to provide sufficiently accurate cap prices, although the models has been calibrated on interest rates data and not on cap prices. Moreover, we find the two-factor humped volatility model to outperform the three-factor models in pricing caps.

Keywords: Finance; Interest; rates; Humped; volatility; Kalman; filter; Cap; and; floor; pricing (search for similar items in EconPapers)
Date: 2010
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Citations: View citations in EconPapers (7)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:ejores:v:207:y:2010:i:3:p:1358-1367

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