The Valuation of American-Style Swaptions in a Two-factor Spot-Futures Model

Sandra Peterson, Richard C. Stapleton and Marti G. Subrahmanyam

New York University, Leonard N. Stern School Finance Department Working Paper Seires from New York University, Leonard N. Stern School of Business-

Abstract: We build a no-arbitrage model of the term structure of interest rates using two stochastic factors, the short-term interest rate and the premium of the futures rate over the short-term interest rate. The model provides and extension of the lognormal interest rate model of Black and Karasinski (1991) to two factors, both of which can exhibit mean-reversion. The method is computationally efficient for several reasons. First, the model is based on Libor futures prices, enabling us to satisfy the no-arbitrage condition without resorting to iterative methods. Second, we modify and implement the binomial approximation methodology of Nelson and Ramaswamy (1990) and Ho, Stapleton and Subrahmanyam (1995) to compute a multiperiod tree of rates with the no-arbitrage property. The method uses a recombining two-dimensional binomial lattice of interest rates that minimizes the number of states and term structures over time. In addition to these computational advantages, a key feature of the model is that it is consistent with the observed term structure of futures rates as well as the term structure of volatilities implied by the prices of interest rate caps and floors. These prices are shown to be highly sensitive to the existence of the second factor and its volatility characteristics.

Date: 1999-12-08
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

Downloads: (external link)
http://www.stern.nyu.edu/fin/workpapers/papers99/wpa99078.pdf (application/pdf)
Our link check indicates that this URL is bad, the error code is: 404 Not Found (http://www.stern.nyu.edu/fin/workpapers/papers99/wpa99078.pdf [301 Moved Permanently]--> https://www.stern.nyu.edu/fin/workpapers/papers99/wpa99078.pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:fth:nystfi:99-078

Access Statistics for this paper

More papers in New York University, Leonard N. Stern School Finance Department Working Paper Seires from New York University, Leonard N. Stern School of Business- U.S.A.; New York University, Leonard N. Stern School of Business, Department of Economics . 44 West 4th Street. New York, New York 10012-1126. Contact information at EDIRC.
Bibliographic data for series maintained by Thomas Krichel ().