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

Anders B. Trolle; Eduardo S. Schwartz

doi:10.1093/rfs/hhn040

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

Anders B. Trolle¹; Eduardo S. Schwartz²

¹ Copenhagen Business School · ² University of California, Los Angeles

Review of Financial Studies 2009 open access

We develop a tractable and flexible stochastic volatility multifactor model of the term structure of interest rates. It features unspanned stochastic volatility factors, correlation between innovations to forward rates and their volatilities, quasi-analytical prices of zero-coupon bond options, and dynamics of the forward rate curve, under both the actual and risk-neutral measures, in terms of a finite-dimensional affine state vector. The model has a very good fit to an extensive panel dataset of interest rates, swaptions, and caps. In particular, the model matches the implied cap skews and the dynamics of implied volatilities.

DOI: 10.1093/rfs/hhn040
Volume: 22 (5)
Pages: 2007-2057
Language: en
Export: BibTeX
Sources: openalex crossref