A General Stochastic Volatility Model for the Pricing of Interest Rate Derivatives

We develop a tractable and flexible stochastic volatility multifactor model of the term structure of interest rates. It features unspanned stochastic volatility factors, correlation between innovations to forward rates and their volatilities, quasi-analytical prices of zero-coupon bond options, and dynamics of the forward rate curve, under both the actual and risk-neutral measures, in terms of a finite-dimensional affine state vector. The model has a very good fit to an extensive panel dataset of interest rates, swaptions, and caps. In particular, the model matches the implied cap skews and the dynamics of implied volatilities. The Author 2008. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org, Oxford University Press.