Abstract
This is the first comprehensive study of the SABR (stochastic alpha‐beta‐rho) model (Hagan, Kumar, Lesniewski, & Woodward, 2002) on the pricing and hedging of interest rate caps. I implement several versions of the SABR interest rate model and analyze their respective pricing and hedging performance using two years of daily data with seven different strikes and ten different tenors on each trading day. In‐sample and out‐of‐sample tests show that the fully stochastic version of the SABR model exhibits excellent pricing accuracy and, more importantly, captures the dynamics of the volatility smile over time very well. This is further demonstrated through examining delta‐hedging performance based on the SABR model. My hedging result indicates that the SABR model produces accurate hedge ratios that outperform those implied by the Black model. © 2012 Wiley Periodicals, Inc. Jrl Fut Mark 32:773‐791, 2012
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