Pricing and Hedging Interest Rate Options: Evidence from Cap-Floor Markets

Abstract

This paper examines the pricing and hedging performance of interest rate option pricing models in the U.S. dollar interest rate cap and floor markets. We evaluate alternative one-factor and two-factor term structure models on daily data from March-December 1998, consisting of actual cap and floor prices across both strike rates and maturities. Results show that fitting the skew of the underlying interest rate distribution provides accurate pricing results within a one-factor framework. However, for hedging performance, introducing a second stochastic factor is more important than fitting the skew of the underlying distribution. Modeling the second factor allows a better representation of the dynamic evolution of the term structure by incorporating expected twists in the yield curve. Thus,the interest rate dynamics embedded in two-factor models appears to be closer to the one driving the actual economic environment, leading to more accurate hedges. This constitutes evidence against claims in the literature that correctly specified and calibrated one-factor models could replace multi-factor models for consistent pricing and hedging of interest rate contingent claims.