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Interest Rate Derivatives (interest + rate_derivative)

Distribution by Scientific Domains

Business, Economics, Finance and Accounting	100%

Selected Abstracts

Stochastic Volatility Corrections for Interest Rate Derivatives

MATHEMATICAL FINANCE, Issue 2 2004
Peter Cotton
We study simple models of short rates such as the Vasicek or CIR models, and compute corrections that come from the presence of fast mean-reverting stochastic volatility. We show how these small corrections can affect the shape of the term structure of interest rates giving a simple and efficient calibration tool. This is used to price other derivatives such as bond options. The analysis extends the asymptotic method developed for equity derivatives in Fouque, Papanicolaou, and Sircar (2000b). The assumptions and effectiveness of the theory are tested on yield curve data. [source]

Unspanned Stochastic Volatility: Evidence from Hedging Interest Rate Derivatives

THE JOURNAL OF FINANCE, Issue 1 2006
HAITAO LI
ABSTRACT Most existing dynamic term structure models assume that interest rate derivatives are redundant securities and can be perfectly hedged using solely bonds. We find that the quadratic term structure models have serious difficulties in hedging caps and cap straddles, even though they capture bond yields well. Furthermore, at-the-money straddle hedging errors are highly correlated with cap-implied volatilities and can explain a large fraction of hedging errors of all caps and straddles across moneyness and maturities. Our results strongly suggest the existence of systematic unspanned factors related to stochastic volatility in interest rate derivatives markets. [source]

Board Composition And Corporate Use Of Interest Rate Derivatives

THE JOURNAL OF FINANCIAL RESEARCH, Issue 2 2004
Kenneth A. Borokhovich
Abstract We provide new evidence on the motives for corporate hedging by examining the relation between the quality of the firms' monitoring mechanisms and the quantity of interest rate derivatives employed. Because the capital structure decision and hedging decision are considered to be endogenous, the firm's capital structure and level of interest rate derivative use are modeled simultaneously. We show a positive relation between the relative influence of outside directors and the quantity of derivatives used. This evidence indicates that outside directors take an active role in derivatives usage and that firms employ hedging in the shareholders' best interests. [source]

The Term Structure of Simple Forward Rates with Jump Risk

MATHEMATICAL FINANCE, Issue 3 2003
Paul Glasserman
This paper characterizes the arbitrage-free dynamics of interest rates, in the presence of both jumps and diffusion, when the term structure is modeled through simple forward rates (i.e., through discretely compounded forward rates evolving continuously in time) or forward swap rates. Whereas instantaneous continuously compounded rates form the basis of most traditional interest rate models, simply compounded rates and their parameters are more directly observable in practice and are the basis of recent research on "market models." We consider very general types of jump processes, modeled through marked point processes, allowing randomness in jump sizes and dependence between jump sizes, jump times, and interest rates. We make explicit how jump and diffusion risk premia enter into the dynamics of simple forward rates. We also formulate reasonably tractable subclasses of models and provide pricing formulas for some derivative securities, including interest rate caps and options on swaps. Through these formulas, we illustrate the effect of jumps on implied volatilities in interest rate derivatives. [source]

On the Rate of Convergence of Discrete-Time Contingent Claims

MATHEMATICAL FINANCE, Issue 1 2000
Steve Heston
This paper characterizes the rate of convergence of discrete-time multinomial option prices. We show that the rate of convergence depends on the smoothness of option payoff functions, and is much lower than commonly believed because option payoff functions are often of all-or-nothing type and are not continuously differentiable. To improve the accuracy, we propose two simple methods, an adjustment of the discrete-time solution prior to maturity and smoothing of the payoff function, which yield solutions that converge to their continuous-time limit at the maximum possible rate enjoyed by smooth payoff functions. We also propose an intuitive approach that systematically derives multinomial models by matching the moments of a normal distribution. A highly accurate trinomial model also is provided for interest rate derivatives. Numerical examples are carried out to show that the proposed methods yield fast and accurate results. [source]

Unspanned Stochastic Volatility: Evidence from Hedging Interest Rate Derivatives

Hedging in the Possible Presence of Unspanned Stochastic Volatility: Evidence from Swaption Markets

THE JOURNAL OF FINANCE, Issue 5 2003
Rong Fan
This paper examines whether higher order multifactor models, with state variables linked solely to underlying LIBOR-swap rates, are by themselves capable of explaining and hedging interest rate derivatives, or whether models explicitly exhibiting features such as unspanned stochastic volatility are necessary. Our research shows that swaptions and even swaption straddles can be well hedged with LIBOR bonds alone. We examine the potential benefits of looking outside the LIBOR market for factors that might impact swaption prices without impacting swap rates, and find them to be minor, indicating that the swaption market is well integrated with the LIBOR-swap market. [source]

Board Composition And Corporate Use Of Interest Rate Derivatives

A two-mean reverting-factor model of the term structure of interest rates

THE JOURNAL OF FUTURES MARKETS, Issue 11 2003
Manuel Moreno
This article presents a two-factor model of the term structure of interest rates. It is assumed that default-free discount bond prices are determined by the time to maturity and two factors, the long-term interest rate, and the spread (i.e., the difference) between the short-term (instantaneous) risk-free rate of interest and the long-term rate. Assuming that both factors follow a joint Ornstein-Uhlenbeck process, a general bond pricing equation is derived. Closed-form expressions for prices of bonds and interest rate derivatives are obtained. The analytical formula for derivatives is applied to price European options on discount bonds and more complex types of options. Finally, empirical evidence of the model's performance in comparison with an alternative two-factor (Vasicek-CIR) model is presented. The findings show that both models exhibit a similar behavior for the shortest maturities. However, importantly, the results demonstrate that modeling the volatility in the long-term rate process can help to fit the observed data, and can improve the prediction of the future movements in medium- and long-term interest rates. So it is not so clear which is the best model to be used. © 2003 Wiley Periodicals, Inc. Jrl Fut Mark 23: 1075,1105, 2003 [source]