Empirical investigation of a field theory formula and Black's formula for the price of an interest-rate caplet

Belal E. Baaquie and Cui Liang

Physica A: Statistical Mechanics and its Applications, 2007, vol. 374, issue 1, 331-348

Abstract: The industry standard for pricing an interest-rate caplet is Black's formula. Another distinct price of the same caplet can be derived using a quantum field theory model of the forward interest rates. An empirical study is carried out to compare the two caplet pricing formulae. Historical volatility and correlation of forward interest rates are used to generate the field theory caplet price; another approach is to fit a parametric formula for the effective volatility using market caplet price. The study shows that the field theory model generates the price of a caplet and cap fairly accurately. Black's formula for a caplet is compared with field theory pricing formula. It is seen that the field theory formula for caplet price has many advantages over Black's formula.

Keywords: Caplet; Field theory model; Empirical (search for similar items in EconPapers)
Date: 2007
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Persistent link: https://EconPapers.repec.org/RePEc:eee:phsmap:v:374:y:2007:i:1:p:331-348

DOI: 10.1016/j.physa.2006.07.024

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