Pricing and hedging volatility smile under multifactor interest rate models Original Research

First Online: 12 March 2010 DOI :
10.1007/s11156-010-0172-5

Cite this article as: Kuo, I. Rev Quant Finan Acc (2011) 36: 83. doi:10.1007/s11156-010-0172-5 Abstract The paper extends Amin and Morton (1994 ), Zeto (2002 ), and Kuo and Paxson (2006 ) by considering jump-diffusion model of Das (1999 ) with various volatility functions in pricing and hedging Euribor options across strikes and maturities. Adding the jump element into a diffusion model helps capturing volatility smiles in the interest rate options markets, but specifying the mean-reversion volatility function improves the most. A humped volatility function with the additional jump component yields better in-sample and out-of-sample valuation, but level-dependent volatility becomes more crucial for hedging. The specification of volatility function is more crucial than merely adding jumps into any model and the effect of jumps declines as the maturity of options is longer.

Keywords Jump-diffusion models HJM models Volatility smile Euribor options

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Authors and Affiliations 1. Department of Finance Tunghai University Taichung Taiwan