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- Title
Interest Rate Caps “Smile” Too! But Can the LIBOR Market Models Capture the Smile?
- Authors
JARROW, ROBERT; LI, HAITAO; ZHAO, FENG
- Abstract
Using 3 years of interest rate caps price data, we provide a comprehensive documentation of volatility smiles in the caps market. To capture the volatility smiles, we develop a multifactor term structure model with stochastic volatility and jumps that yields a closed-form formula for cap prices. We show that although a three-factor stochastic volatility model can price at-the-money caps well, significant negative jumps in interest rates are needed to capture the smile. The volatility smile contains information that is not available using only at-the-money caps, and this information is important for understanding term structure models.
- Subjects
INTEREST rates; STOCHASTIC processes; MARKET volatility; INTEREST rate risk; FINANCIAL markets; RISK; FINANCE
- Publication
Journal of Finance (Wiley-Blackwell), 2007, Vol 62, Issue 1, p345
- ISSN
0022-1082
- Publication type
Article
- DOI
10.1111/j.1540-6261.2007.01209.x