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Libor Market Models versus Swap Market Models for Pricing Interest Rate Derivatives: An Empirical Analysis
Authors:Frank De Jong  Joost Driessen and Antoon Pelsser
Institution:(1) Frank de Jong, Finance Group, University of Amsterdam, Roetersstraat 11, 1018 WB Amsterdam, The Netherlands;(2) Joost Driessen, Finance Group, University of Amsterdam, Roetersstraat 11, 1018 WB Amsterdam, The Netherlands;(3) Actuarial Dept, Antoon Pelsser, Nationale-Nederlanden, PO Box 796, 3000 AT Rotterdam, The Netherlands
Abstract:We empirically compare Libor and Swap Market Models for the pricing of interest rate derivatives, using panel data on prices of US caplets and swaptions. A Libor Market Model can directly be calibrated to observed prices of caplets, whereas a Swap Market Model is calibrated to a certain set of swaption prices. For both models we analyze how well they price caplets and swaptions that were not used for calibration. We show that the Libor Market Model in general leads to better prediction of derivative prices that were not used for calibration than the Swap Market Model. Also, we find that Market Models with a declining volatility function give much better pricing results than a specification with a constant volatility function. Finally, we find that models that are chosen to exactly match certain derivative prices are overfitted; more parsimonious models lead to better predictions for derivative prices that were not used for calibration.
Keywords:Term structure models  interest rate derivatives  lognormal pricing models  Black formula
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