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

64 Pages Posted: 14 Jul 2006 Last revised: 18 Sep 2022

See all articles by Anders B. Trolle

Anders B. Trolle

Copenhagen Business School

Eduardo S. Schwartz

University of California, Los Angeles (UCLA) - Finance Area; Simon Fraser University (SFU); National Bureau of Economic Research (NBER)

Date Written: June 2006

Abstract

We develop a tractable and flexible stochastic volatility multi-factor model of the term structure of interest rates. It features correlations between innovations to forward rates and volatilities, quasi-analytical prices of zero-coupon bond options and dynamics of the forward rate curve, under both the actual and risk-neutral measure, in terms of a finite-dimensional affine state vector. The model has a very good fit to an extensive panel data set of interest rates, swaptions and caps. In particular, the model matches the implied cap skews and the dynamics of implied volatilities. The model also performs well in forecasting interest rates and derivatives.

Suggested Citation

Trolle, Anders B. and Schwartz, Eduardo S. and Schwartz, Eduardo S., A General Stochastic Volatility Model for the Pricing and Forecasting of Interest Rate Derivatives (June 2006). NBER Working Paper No. w12337, Available at SSRN: https://ssrn.com/abstract=912447

Anders B. Trolle

Copenhagen Business School ( email )

Solbjerg Plads 3
Frederiksberg C, DK - 2000
Denmark

Eduardo S. Schwartz (Contact Author)

Simon Fraser University (SFU) ( email )

8888 University Drive
Burnaby, British Columbia V5A 1S6
Canada

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825-1953 (Phone)
310-206-5455 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States