This paper examines the convexity bias, caused by the non-linearity of payoffs, in the pricing of interest rate swaps off the Eurocurrency futures curve. The evidence from four major currencies – $, £, DM and ¥ – during 1987–1996 suggests that swaps were initially being priced off the futures curve (ignoring the convexity adjustment); subsequently, the market swap rates drifted below the rates implied by futures prices. After rejecting alternative explanations, we use alternative term structure models to show that the convexity bias is related to the empirically observed swap-futures differential. We interpret these results as evidence of mispricing of swap contracts during the early years, which was eliminated over time.

We examine the pricing and hedging performance of interest rate option pricing models using daily data on US dollar cap and floor prices across both strike rates and maturities. Our results show that fitting the skew of the underlying interest rate probability distribution provides accurate pricing results within a one-factor framework. However, for hedging performance, introducing a second stochastic factor is more important than fitting the skew of the underlying distribution. This constitutes evidence against claims in the literature that correctly specified and calibrated one-factor models could replace multi-factor models for consistent pricing and hedging of interest rate contingent claims.

This paper examines whether higher order multifactor models, with state variables linked solely to underlying LIBOR‐swap rates, are by themselves capable of explaining and hedging interest rate derivatives, or whether models explicitly exhibiting features such as unspanned stochastic volatility are necessary. Our research shows that swaptions and even swaption straddles can be well hedged with LIBOR bonds alone. We examine the potential benefits of looking outside the LIBOR market for factors that might impact swaption prices without impacting swap rates, and find them to be minor, indicating that the swaption market is well integrated with the LIBOR‐swap market.

We address three questions relating to the interest rate options market: What is the shape of the smile? What are the economic determinants of the shape of the smile? Do these determinants have predictive power for the future shape of the smile and vice versa? We investigate these issues using daily bid and ask prices of euro (€) interest rate caps/floors. We find a clear smile pattern in interest rate options. The shape of the smile varies over time and is affected in a dynamic manner by yield curve variables and the future uncertainty in the interest rate markets; it also has information about future aggregate default risk. Our findings are useful for the pricing, hedging and risk management of these derivatives.