Volume 17 | Issue 1 | Article 5
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Volatility Estimation and the Performance of Multifactor Term Structure Models for Pricing and Hedging Euribor Options
This paper provides an empirical comparison of several competing term structure models in pricing and hedging of Euribor options with alternative approaches to volatility estimation using data of options prices or their underlying futures prices. The empirical results show that models using the option prices perform better than those using the futures prices in predicting Euribor option prices. In particular, when volatility is assumed to be time-varying, a more accurate prediction of option prices is obtained. When the volatility is further assumed to be time-varying and time-homogenous, it reduces the moneyness and maturity biases found in the literature. There is no clear pattern showing that one term structure model consistently predicts better than others under alternative approaches of volatility estimation. In contrast to prediction results, hedging results show that the stability of volatility is critical in ensuring hedging performance. The two-factor models produce better hedging performance than the one- and three-factor models in most cases. Finally, this study demonstrates that choosing an appropriate method of volatility estimation is more important than specifying the term structure model for pricing and hedging interest rate derivatives.
