Interest Rate Models for Pricing Derivatives: The Case of Cap Contracts

22 Pages Posted: 27 Jan 2010 Last revised: 30 Sep 2010

See all articles by Antonio De Simone

Antonio De Simone

CSEF - University of Naples Federico II - Centre for Studies in Economics and Finance (CSEF)

Date Written: 2010

Abstract

This paper deals with issues related to the choice of the interest rate model to price interest rate derivatives. After the development of the market models, choosing the interest rate model is become almost a trivial task. However their use not always is possible, so that the problem of choosing the right methodology still attains.

The aim of this paper is to compare some of the most used interest rate derivatives pricing models to understand what are the issues and the drawbacks connected to each one.

It is shown why and in which cases the use of each model does not give appreciable results and when, on the other hand, the opposite occurs. More exactly, it will be shown that the lack of data on the implied volatilities or the inefficiencies in the financial market can prevent the use of the market models, because a satisfying calibration of the interest rate trajectories cannot be guaranteed. Moreover it is shown how the smile effect in the interest rate options market can affect the price provided by each model and, more exactly, that the difference between the price provided by the models and the observed market prices gets larger, as the strike price increases.

Keywords: Cox Ingersoll and Ross, Black Derman and Toy, Libor Market Model, Lognormal Forward-Libor Model, Cap, Interest Rate Risk

JEL Classification: G12, C53, C65

Suggested Citation

De Simone, Antonio, Interest Rate Models for Pricing Derivatives: The Case of Cap Contracts (2010). Available at SSRN: https://ssrn.com/abstract=1543131 or http://dx.doi.org/10.2139/ssrn.1543131

Antonio De Simone (Contact Author)

CSEF - University of Naples Federico II - Centre for Studies in Economics and Finance (CSEF) ( email )

Via Cintia
Complesso Monte S. Angelo
Naples, Naples 80126
Italy

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