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Unspanned Stochastic Volatility: Evidence from Hedging Interest Rate Derivatives
Author(s) -
LI HAITAO,
ZHAO FENG
Publication year - 2006
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/j.1540-6261.2006.00838.x
Subject(s) - economics , econometrics , straddle , bond , moneyness , interest rate , interest rate derivative , yield curve , volatility (finance) , implied volatility , volatility smile , local volatility , sabr volatility model , stochastic volatility , term (time) , short rate , financial economics , monetary economics , finance , physics , quantum mechanics
Most existing dynamic term structure models assume that interest rate derivatives are redundant securities and can be perfectly hedged using solely bonds. We find that the quadratic term structure models have serious difficulties in hedging caps and cap straddles, even though they capture bond yields well. Furthermore, at‐the‐money straddle hedging errors are highly correlated with cap‐implied volatilities and can explain a large fraction of hedging errors of all caps and straddles across moneyness and maturities. Our results strongly suggest the existence of systematic unspanned factors related to stochastic volatility in interest rate derivatives markets.