Review of Financial Studies Vol. 22 No. 5 2009

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

Abstract

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

Issue

5

Pages

2007-2057

Language

en

Sources

openalex crossref

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