Abstract
We analyze the pricing accuracy and risk properties of the constant-elasticity-volatility (CEV) market model. It is shown that the calibration results to both caps and swaptions show small pricing errors. The whole model fit confirms the existence of strike bias in the US interest rate derivative market (the bias is much weaker in the corresponding Euro market). Daily VaRs are computed using Monte Carlo simulation. The back testing results suggest an underestimation problem for the cap-calibration-based model while the problem is reduced in the swaption-calibration-based model. Stress test regarding price sensitivities to yield curve shape changes is conducted. The results indicate that delta-gamma hedged portfolio has strong resistance to forward curve changes.
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