An Evaluation of Multi-Factor CIR Models Using LIBOR, Swap Rates, and Cap and Swaption Prices

Ravi Jagannathan, Andrew Kaplin and Steve Guoqiang Sun

No 8682, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We evaluate the classical Cox, Ingersoll and Ross (1985) (CIR) model using data on LIBOR, swap rates and caps and swaptions. With three factors the CIR model is able to fit the term structure of LIBOR and swap rates rather well. The model is able to match the hump shaped unconditional term structure of volatility in the LIBOR-swap market. However, statistical tests indicate that the model is misspecified. In particular the pricing errors are related to the slope of the swap yield curve. The economic importance of these shortcomings is highlighted when the model is confronted with data on cap and swaption prices. Pricing errors are large relative to the bid-ask spread in these markets. The model tends to overvalue shorter maturity caps and undervalue longer maturity caps. With only one or two factors, the model also tends to undervalue swaptions. Our findings point out the need for evaluating term structure models using data on derivative prices.

JEL-codes: C13 C32 (search for similar items in EconPapers)
Date: 2001-12
New Economics Papers: this item is included in nep-fmk
Note: AP
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Citations: View citations in EconPapers (16)

Published as Jagannathan, Ravi & Kaplin, Andrew & Sun, Steve, 2003. "An evaluation of multi-factor CIR models using LIBOR, swap rates, and cap and swaption prices," Journal of Econometrics, Elsevier, vol. 116(1-2), pages 113-146.

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