An Evaluation of Multi-Factor CIR Models Using LIBOR, Swap Rates, and Cap and Swaption Prices / Ravi Jagannathan, Andrew Kaplin, Steve Guoqiang Sun.

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Jagannathan, Ravi

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Material type: Text

TextSeries: Working Paper Series (National Bureau of Economic Research) ; no. w8682.Publication details: Cambridge, Mass. National Bureau of Economic Research 2001.Description: 1 online resource: illustrations (black and white)Subject(s):

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Abstract: We evaluate the classical Cox, Ingersoll and Ross (1985) (CIR) model using data on LIBOR, swap rates and caps and swaptions. With three factors the CIR model is able to fit the term structure of LIBOR and swap rates rather well. The model is able to match the hump shaped unconditional term structure of volatility in the LIBOR-swap market. However, statistical tests indicate that the model is misspecified. In particular the pricing errors are related to the slope of the swap yield curve. The economic importance of these shortcomings is highlighted when the model is confronted with data on cap and swaption prices. Pricing errors are large relative to the bid-ask spread in these markets. The model tends to overvalue shorter maturity caps and undervalue longer maturity caps. With only one or two factors, the model also tends to undervalue swaptions. Our findings point out the need for evaluating term structure models using data on derivative prices.

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Item type	Home library	Collection	Call number	Status	Date due	Barcode	Item holds
Working Paper	Biblioteca Digital	Colección NBER	nber w8682 (Browse shelf(Opens below))	Not For Loan

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December 2001.

We evaluate the classical Cox, Ingersoll and Ross (1985) (CIR) model using data on LIBOR, swap rates and caps and swaptions. With three factors the CIR model is able to fit the term structure of LIBOR and swap rates rather well. The model is able to match the hump shaped unconditional term structure of volatility in the LIBOR-swap market. However, statistical tests indicate that the model is misspecified. In particular the pricing errors are related to the slope of the swap yield curve. The economic importance of these shortcomings is highlighted when the model is confronted with data on cap and swaption prices. Pricing errors are large relative to the bid-ask spread in these markets. The model tends to overvalue shorter maturity caps and undervalue longer maturity caps. With only one or two factors, the model also tends to undervalue swaptions. Our findings point out the need for evaluating term structure models using data on derivative prices.