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

Anders B. Trolle, Eduardo S. Schwartz
2007 Social Science Research Network  
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 zerocoupon 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
more » ... ive panel dataset of interest rates, swaptions, and caps. In particular, the model matches the implied cap skews and the dynamics of implied volatilities. (JEL E43, G13) 1 Both papers estimate a stochastic volatility extension of the Chan et al. (1992) model given by dlogv(t) = κ 2 (µ 2 − logv(t))dt + σdW 2 (t), C The
doi:10.2139/ssrn.966364 fatcat:nbeiyxfgzfhm7kgu2pewx3sjne