Volume 15 | Issue 4 | Article 2
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Pricing and Hedging Euribor Options with Multifactor Interest Rate Models
A general volatility function with one- to three-factor models in the HJM framework is used to examine their pricing and hedging Euribor options across strikes and maturities from January 1, 2003, to December 31, 2005. The primary contributions of this article are (a) to propose the general volatility function that incorporates mean-reversion, level-dependent and hump effects and to test four multifactor models not considered by Amin and Morton (1994), Zeto (2002), Gupta and Subrahmanyam (2005), and Kuo and Paxson (2006); (b) to find that the class of multifactor models outperforms the classes of one- and two-factor models in in-sample fitting, out-sample prediction and hedging with two rebalanced intervals; and (c) to find that models with hump volatility function perform the best in all criteria compared with other models. Pricing with three-factor models gives the benefit of eliminating most moneyness and maturity biases and reducing hedging errors for ATM and ITM options particularly. Correctly specified and calibrated, the single-factor hump model may be superior to inappropriate multi-factor square-root and exponential models in pricing and hedging.
