Working Paper: NBER ID: w12337
Authors: Anders B. Trolle; Eduardo S. Schwartz
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.
Keywords: stochastic volatility; interest rate derivatives; pricing; forecasting
JEL Codes: E43; G13
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| stochastic volatility multifactor model (C58) | interest rates and derivatives (E43) |
| model captures factors influencing term structure (E43) | variation in the term structure (E43) |
| swaptions undervalued relative to caps (G13) | market pricing and model's predictions (C59) |
| correlations between innovations to term structure and volatility factors (C58) | dynamics of implied volatilities and cap skews (C69) |
| extended affine market price of risk specification (G19) | model's performance in forecasting (E17) |
| model's ability to forecast accurately (C53) | reliability at longer horizons (C41) |
| specified correlations (C10) | improved model fit and forecasting accuracy (C53) |