An Examination of the Static and Dynamic Performance of Interest Rate Option Pricing Models in the Dollar Cap-Floor Markets

This paper examines the static and dynamic accuracy of interest rate option pricing models in the U.S. dollar interest rate cap and floor markets. Alternative one-factor and two-factor term structure models of the spot and the forward rate are evaluated on the basis of their out-of-sample predictive ability in terms of pricing and hedging performance. In addition, the models are evaluated based on the stability of their parameters, the presence of systematic biases, and their numerical complexity and computational efficiency. The tests are conducted 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 underlyingdistribution. Overall, the one-factor lognormal model for short term interest ratesoutperforms other competing models in pricing tests, while two-factor models perform significantly better than one-factor models in hedging tests. 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 specifiedand calibrated one-factor models could replace multi-factor models for consistentpricing and hedging of interest rate contingent claims