CMS Spread Options Pricing under the CHH Model

Abstract

Based on the Chen, Hsieh, and Huang (2017) interest rate model, this research explores the analytical approach for pricing CMS spread options. We first derive a complex joint density for two swap rates composed of sequential forward rates and approximate the joint density by bivariate normals. After applying the methods of Pearson (1995) and Li, Deng, and Zhou (2008), we obtain two analytical pricing models and examine their accuracy using numerical analysis. Finally, we empirically show the predictive power of the implied volatility of CMS options for future economic states.