Implementation of the Bdt Model with Different Volatility Estimators: Applications to Eurodollar Futures Options

Abstract

This paper concentrates on the effects of different class of volatility estimators in pricing interest rate sensitive options using the single-factor Black, Derman, and Toy [1990] model. We employ the moving average, such as constantly-weighted and exponentially-weighted moving average, and the time-series models, such as Generalized Autoregressive Conditional Heteroscedasticity (GARCH) and the integrated GARCH (IGARCH), in estimating the volatility of short rates. Empirical results, based on 4,228 estimated prices, indicate that valuation of Eurodollar futures options is sensitive to the volatility model used and the time-series models provide a more accurate representation of the underlying time-varying volatility structure than the moving average models.

JEL Classification: G13