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Libor Market Models versus Swap Market Models for Pricing Interest Rate Derivatives: An Empirical Analysis |
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| Authors: | De Jong Frank; Driessen Joost; Pelsser Antoon |
| Institution: | 1 Finance Group, University of Amsterdam Roetersstraat 11, 1018 WB, Amsterdam, The Netherlands E-mail: fdejong{at}fee.uva.nl 2 Finance Group, University of Amsterdam Roetersstraat 11, 1018 WB, Amsterdam, The Netherlands E-mail: jdriess{at}fee.uva.nl 3 Nationale-Nederlanden, Actuarial Dept PO Box 796, 3000 AT Rotterdam, The Netherlands E-mail: antoon.pelsser{at}nn.nl |
| Abstract: | We empirically compare Libor and Swap Market Models for thepricing of interest rate derivatives, using panel data on pricesof US caplets and swaptions. A Libor Market Model can directlybe calibrated to observed prices of caplets, whereas a SwapMarket Model is calibrated to a certain set of swaption prices.For both models we analyze how well they price caplets and swaptionsthat were not used for calibration. We show that the Libor MarketModel in general leads to better prediction of derivative pricesthat were not used for calibration than the Swap Market Model.Also, we find that Market Models with a declining volatilityfunction give much better pricing results than a specificationwith a constant volatility function. Finally, we find that modelsthat arechosen to exactly match certain derivative prices areoverfitted; more parsimonious models lead to better predictionsfor derivative prices that were not used for calibration. JELClassification: G12, G13, E43. |
| Keywords: | Term structure models interest rate derivatives lognormal pricing models Black formula |
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