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Average Interest Rate Caps

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Abstract

There exist a number of approximation methods for the price of average rate options, when the underlying asset is a currency or equity. Realistic pricing models for average interest rate caps based on interbank offered rates have not yet been published. In this paper we propose to adapt the methods of Levy (1992), Vorst (1992) and Rogers and Shi (1995) for average rate options to price average interest rate caps, and we compare their computational efficiencies. All three methods are very fast, compared to the Monte Carlo simulation. Two of them are fast enough for on-the-fly calculations. The underlying interest rate model we use is consistent with the observed term structure of the interest rate. Hence, the models developed here are suitable for practical implementation.

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Authors and Affiliations

  1. Capital Management, ING Group, P.O. Box 1800, 1000 BV, Amsterdam, The Netherlands

    Terry H.F. Cheuk

  2. Department of Finance, Erasmus University Rotterdam, and Erasmus Center for Financial Research, P.O. Box 1738, 3000 DR, Rotterdam, The Netherlands

    Ton C.F. Vorst

Authors
  1. Terry H.F. Cheuk
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  2. Ton C.F. Vorst
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Cheuk, T.H., Vorst, T.C. Average Interest Rate Caps. Computational Economics 14, 183–196 (1999). https://doi.org/10.1023/A:1008752006974

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  • DOI: https://doi.org/10.1023/A:1008752006974

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