A General Stochastic Volatility Model for the Pricing and Forecasting of Interest Rate Derivatives

Anders B. Trolle and Eduardo S. Schwartz

No 12337, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We develop a tractable and flexible stochastic volatility multi-factor model of the term structure of interest rates. It features correlations between innovations to forward rates and volatilities, quasi-analytical prices of zero-coupon bond options and dynamics of the forward rate curve, under both the actual and risk-neutral measure, in terms of a finite-dimensional affine state vector. The model has a very good fit to an extensive panel data set of interest rates, swaptions and caps. In particular, the model matches the implied cap skews and the dynamics of implied volatilities. The model also performs well in forecasting interest rates and derivatives.

JEL-codes: E43 G13 (search for similar items in EconPapers)
Date: 2006-06
New Economics Papers: this item is included in nep-ecm, nep-ets, nep-fin, nep-fmk, nep-for and nep-mac
Note: AP
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Citations: View citations in EconPapers (2)

Published as Anders B. Trolle & Eduardo S. Schwartz, 2009. "A General Stochastic Volatility Model for the Pricing of Interest Rate Derivatives," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 22(5), pages 2007-2057, May.

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