Closed form equilibrium evaluation of interest rate caps and related derivatives in a real business cycle setting

Jostein Tvedt

Applied Mathematical Finance, 2016, vol. 23, issue 4, 261-277

Abstract: The objective of this study is to provide closed form solutions to financial derivatives on mean-reverting cash flows. The general equilibrium real business cycle specification implies that underlying prices follow geometric mean reversion processes. Option-pricing formulas are derived, in terms of macroeconomic parameters or observable market prices, both for consumption goods and interest rates. The framework offers a rich specification of the economy’s yield curve and caplet volatility surface, which seems to fit well with criteria suggested by the empirical literature. The methodology may be useful for studying the effects of real economy changes on financial markets.

Date: 2016
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DOI: 10.1080/1350486X.2016.1243012

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