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Empirical performance of multifactor term structure models for pricing and hedging Eurodollar futures options
Author(s) -
Kuo IDoun,
Lin YuehNeng
Publication year - 2009
Publication title -
review of financial economics
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.347
H-Index - 41
eISSN - 1873-5924
pISSN - 1058-3300
DOI - 10.1016/j.rfe.2007.12.001
Subject(s) - futures contract , economics , econometrics , valuation of options , eurodollar , heath–jarrow–morton framework , stochastic volatility , black–scholes model , volatility (finance) , moneyness , implied volatility , volatility smile , affine term structure model , yield curve , financial economics , interest rate , finance
This article compares two one‐factor, two two‐factor, two three‐factor models in the HJM class and Black's [Black, F. (1976). The pricing of commodity contracts. Journal of Financial Economics, 3, 167–179.] implied volatility function in terms of their pricing and hedging performance for Eurodollar futures options across strikes and maturities from 1 Jan 2000 to 31 Dec 2002. We find that three‐factor models perform the best for 1‐day and 1‐week prediction, as well as for 5‐day and 20‐day hedging. The moneyness bias and the maturity bias appear for all models, but the three‐factor models produce lower bias. Three‐factor models also outperform other models in hedging, in particular for away‐from‐the‐money and long‐dated options. Making Black's volatility a square root or exponential function performs similar to one‐factor HJM models in pricing, but not in hedging. Correctly specified and calibrated multifactor models are thus important and cannot be replaced by one‐factor models in pricing or hedging interest rate contingent claims.