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Stochastic Volatilities and Correlations of


Bond Yields ∗

Bing Han

Current Version: October 2004


Han is with the Fisher College of Business at the Ohio State University. I thank Martin Dierker,
Mark Grinblatt, Jean Helwege, Jason Hsu, Jingzhi Huang, Andrew Karolyi, Francis Longstaff, Monika
Piazzesi, Pedro Santa-Clara, Kenneth Singleton and seminar participants at the Ohio State University
for helpful comments and suggestions. Financial support from the Dice Center for Financial Economics
at the Ohio State University is grateful acknowledged.

Corresponding Address: Bing Han, Department of Finance; The Ohio State University; 700D Fisher
Hall; 2100 Neil Avenue; Columbus, OH 43210-1144. Phone: (614) 292-1875. E-mail: han.184@osu.edu;
Abstract

I develop an interest rate model with separate factors driving innovations in bond
yields and their volatilities. My model features flexible and tractable affine structure
for the covariances of bond yields. Maximum likelihood estimation of the model
with panel data on swaptions implies pricing errors that are almost always lower
than half of the bid-ask spread. Further, market prices of interest rate caps do not
deviate significantly from their no-arbitrage values implied by the swaptions under
my model. This supports conjectures by Collin-Dufresne and Goldstein (2003), Dai
and Singleton (2003), and Jagannathan, Kaplin and Sun (2003). I also extract
market’s view on the term structure of interest rate volatility and dynamics of bond
covariances.
1 Introduction
The turmoil in the bond markets and increased interest rate volatility since the 1980’s
have provided a boost for the rapid growth of hedging vehicles such as interest rate caps
and swaptions. As these interest-rate derivatives become more liquid, researchers start
using their prices to evaluate term-structure models. There is a rich cross-section of
swaptions and caps. Their prices are sensitive to both volatilities and correlations of the
bond yields and contain valuable information regarding market’s view on the evolution
of the yield curve that is not available from interest rate data such as Treasury bonds,
Eurodollar futures or swap rates.
Recent studies find that it is challenging to explain market prices of swaptions and
caps under many popular term-structure models, even for models that by construction
fit the bond prices exactly. For example, Longstaff, Santa-Clara and Schwartz (2001)
calibrate string-market models to the swaption data. They find that short-dated and
long-dated swaptions tend to be priced inconsistently, and cap prices periodically deviate
significantly from the no-arbitrage values implied by the swaptions. Other studies that
document large and systematic pricing errors for swaptions and caps include Driessen,
Klaassen and Melenberg (2003) and Fan, Gupta and Ritchken (2001) for multi-factor
HJM models, and De Jong, Driessen and Pelsser (1999), as well as Hull and White (1999)
for the Libor and swap market models.
For the models studied in these papers, when model parameters are held constant, the
covariances of interest rates are either deterministic or depend at most on the underlying
interest rates. In the empirical work, models are recalibrated each date in order to capture
time variation in the covariances. While the recalibrated models yield significantly better
fit to the data compared to the case when model parameters are held constant (see, e.g.,
Driessen, Klaassen and Melenberg 2003), it is not enough to continuously recalibrate
simplistic models.
The affine framework of Duffie and Kan (1996) accommodates stochastic covariances
of bond yields, but may imply too strong restrictions on the covariances structure. Dai
and Singleton (2000) find that for the affine models to be admissible, there is an important
trade-off between flexibility in modeling the factor volatilities and correlations. In addi-
tion, the covariances of bond yields are affine functions of the state variables governing
bond yields in most affine models. Thus, risk factors that drive bond covariances gener-
ally can be hedged by a portfolio consisting solely of bonds. However, Collin-Dufresne
and Goldstein (2002) and Heidari and Wu (2001) show that interest-rate option market
exhibits risk factors unspanned by, or independent of, the underlying yield curve.
Empirically, Jagannathan, Kaplin and Sun (2003) find that multi-factor CIR models

1
lead to pricing errors for caps and swaptions that are very large relative to the bid-
ask spread, although the fit to the swap rates are very good. They suggest that the
inability of the multi-factor CIR model to value caps and swaptions correctly may be
due to the restrictions it imposes on the nature of stochastic volatility, and it may be
necessary to consider models outside the affine class that are flexible in accommodating
stochastic volatility of more general forms. Collin-Dufresne and Goldstein (2003) and Dai
and Singleton (2003) conjecture that the ultimate resolution of the swaptions and caps
valuation puzzle may require time varying correlations and possibly factors affecting the
volatility of yields that do not affect bond prices.
In this paper, I develop a term structure model with properties in the conjectures
above. My model incorporates stochastic volatilities and correlations of bond yields.
The factors driving the covariances of bond yields are independent of the yield factors.
Empirically, I find that market prices of interest rate caps do not deviate significantly
from their no-arbitrage values implied from the swaptions under my model. This supports
the conjecture by Collin-Dufresne and Goldstein (2003), Dai and Singleton (2003) and
Jagannathan, Kaplin and Sun (2003). I am also the first to extract market’s view on the
term structure of interest rate volatility and dynamics of bond covariances from interest
rate derivatives. Such information is valuable for risk management and valuation of exotic
interest rate derivatives.
The rest of this paper is organized as follows. Section 2 introduces interest rate caps
and swaptions and the market convention for their valuations. In section 3, I develop the
model and derive closed-form pricing formulas for European swaptions and caps. The
main feature of the swaptions and caps data are discussed in section 4. Section 5 presents
the econometric method used to estimate the model and section 6 presents the empirical
results. Section 7 concludes the paper.

2 Swaptions and Interest Rate Caps


The swaptions studied in this paper are written on semi-annually settled interest rate
swaps. An interest rate swap can be viewed as an agreement to exchange a fixed rate
bond for a floating rate bond. Every six months till the maturity of the swap, one
counterparty receives a fixed annuity and makes a floating payment tied to the six-month
Libor rate to the other counterparty of the swap contract. The coupon rate on the fixed
leg of a swap, also known as the swap rate, is set so that the present value of the fixed
and floating legs are equal at the start of a swap.
Fix two dates T > τ . A European style τ by T (or τ into T − τ ) receivers swaption
is a single option giving its holder the right, but not the obligation, to enter into a T − τ

2
year interest rate swap at date τ and receive semi-annual fixed payments at a pre-agreed
coupon rate between date τ and T . Let D(t, T ) denote the time t price of a discount
Libor bond that matures at time T . Then at t < τ , the value of a forward swap that
starts at τ and matures at T with a coupon rate c is given by

c 2(TX
−τ )
V (t, τ, T, c) = D(t, τi ) + D(t, T ) − D(t, τ ) (1)
2 i=1

where τi = τ + 2i years. The sum of the first two terms is the present value of the fixed leg
of the swap, and the third term is the present value of the floating leg. It follows that the
payoff to the holder of a European style τ by T receivers swaption at its maturity date τ
is given by
 
c 2(TX
−τ )
M ax(V (τ, τ, T, c), 0) = M ax  D(τ, τi ) + D(τ, T ) − 1, 0 (2)
2 i=1

Thus, a swaption is an option on a portfolio of discount bonds.


A European style τ by T swaption is said to be at-the-money-forward when the coupon
rate c equals the corresponding forward swap rate F SR(0, τ, T )
à !
D(0, τ ) − D(0, T )
F SR(0, τ, T ) = 2 P2(T −τ ) (3)
i=1 D(0, τi )

There is a second type of swaption called payers swaption where the option holder has
the right to enter into a swap and pay fixed. For the at-the-money-forward swaptions, a
τ by T payer swaption is worth the same as a τ by T receivers swaption.1
European type at-the-money-forward swaptions are actively traded in the over-the-
counter derivatives market, and quoted in terms of implied volatilities relative to the Black
(1976) model as applied to the corresponding forward swap rate. The market price for a
τ by T at-the-money-forward swaption is obtained by plugging the quoted Black implied
volatility σ into the following formula
à √ √ !
σ τ σ τ
(D(0, τ ) − D(0, T )) N ( ) − N (− ) (4)
2 2

where N (·) is the cumulative density function of a standard normal random variable.
1
Standard no-arbitrage arguments show that the value of a forward swap must equal the value of
the corresponding receivers swaption minus the value of the payers swaption. By equation (1) and the
definition of forward swap rate (3), the date-0 value of a forward starting swap whose strike equals the
corresponding forward swap rate is zero.

3
An interest rate cap provides insurance against the rate of interest on a floating rate
loan rising above the cap rate and gives its holder a series of European call options or
caplets on the underlying Libor rates. Each caplet has the same strike price as the others,
but a different expiration date. For example, a T -year cap on the six-month Libor rate
consists of 2T −1 caplets:2 the first caplet matures in one year, and the last caplet matures
in T years. Let ti = 2i years, ai be the actual number of days between ti and ti+1 and Li
denote the six-month Libor rate applicable to period [ti , ti+1 ]. Then the cash flow on the
ai
caplet maturing at ti+1 is 360 max(0, K − Li ). Alternatively, each caplet can be viewed as
a put option on a Libor discount bond. An interest rate cap is thus a portfolio of options
on discount bonds.
For date t < τ < T , let F (t, τ, T ) denote the Libor forward rate at time t applicable to
the period from τ to T . Since Li = F (ti , ti , ti+1 ), the ith caplet is an option on the forward
rate F (t, ti , ti+1 ). Assuming that each forward Libor rates F (ti , ti , ti+1 ) is lognormal with
known volatility σi , the Black model price of a cap with cap rate R is
2T
X −1
ai ³ √ ´
D(0, ti+1 ) F (0, ti , ti+1 )N (di ) − RN (di − σi ti ) (5)
i=1 360

where
ln(F (0, ti , ti+1 )/R) + σi2 ti /2
di = √
σi ti
The market convention is to quote the price of a cap in terms of an implied volatility σ,
which is constant across caplets, so that the Black model price above at σi = σ equals the
market price of the cap. A T -year cap is said to be at-the-money if the cap rate R equals
the current T -year swap rate. Only at-the-money European-type interest rate caps and
swaptions are actively traded in the over-the-counter market. These are the data I use in
the empirical study.
Although swaptions and interest rate caps are traded as separate products, they are
linked by no-arbitrage relations through the correlation structure of bond yields. The
relative valuation of caps and swaptions is a decreasing function of bond correlations. It
is important to note that the relative valuation of swaptions and caps can only be judged
under a term-structure model, and not by a simple comparison of their Black implied
volatilities quoted in the market.3
2
Note that although the cashflow of this caplet is paid at time ti+1 , the applicable Libor rate Li is
determined at ti . For this reason, the cashflow for the first caplet maturing in six months is non-stochastic
and thus omitted by market convention.
3
The reason is that the Black implied volatilities apply to different underlying interest rates that
are assumed to be lognormally distributed: forward swap rates in the case of swaptions and forward
Libor rates in the case of interest rate caps. However, each forward swap rate is approximately a linear
combination of the underlying forward Libor rates. Thus, forward swap rates and forward Libor rates

4
3 The Valuation Framework
With empirical work in mind, I now develop a term structure model with flexible and
intuitive specifications for the stochastic volatilities and correlations of bond yields. One
notable feature of my model is that bond covariances are affine in a set of volatility
state variables. My model also captures the empirical evidences of unspanned stochastic
volatility (USV) documented in Collin-Dufresne and Goldstein (2002) and Heidari and
Wu (2001). In my model, there are separate factors driving the innovations in bond yields
and covariances of bond yields. Thus, my modelling framework is reminiscent of the large
literature on stochastic volatility (e.g., Heston 1993) that specifies the joint dynamics of
a traded asset and its volatility.

3.1 Model
Assume all bonds are traded. I directly model the risk-neutral dynamics of bond prices.
The risk-neutral drifts of bond prices are determined by the no-arbitrage condition that the
expected rate of return on all bonds equals the spot rate under the risk-neutral measure.
The focus of my model is bond covariances. I show in section 3.2 that once bond prices
are given, prices of swaptions and interest rate caps are determined only by the dynamics
of bond covariances.
By Girsanov’s theorem, the instantaneous bond covariances are invariant with respect
to an equivalent change of probability measure. Thus, I can utilize information contained
in the historical estimates of bond covariances. It is well known that most of the observed
variation in historical bond prices are explained by a few common factors (e.g., Litterman
and Scheinkman 1991, and Dai and Singleton 2000). The explanatory power of these
factors are stable and the factor loadings show a persistent pattern. However, Bliss
(1997) and Perignon and Villa (2003) find significant time-variation in the variances of
the common factors.
Motivated by these findings, I assume that the yield curve is driven by N common
factors with time-invariant weights but possibly stochastic volatilies. The risk-neutral
dynamics of the discount bond prices are expressed as

dD(t, T ) XN q
= rt dt − Bk (T − t) νk (t) dZk (t) (6)
D(t, T ) k=1

where rt is the instantaneous short rate. For each k = 1, · · · , N , dZk is a Brownian motion
term representing shocks to the kth factor driving the yield curve, and νk is the variance
can not be simultaneously lognormally distributed.

5
of the kth yield factor. Without loss of generality, the yield factors are orthogonal to each
other. Bk (T − t) describes the loadings of the bond with maturity T on the kth yield
factor at time t. It is a deterministic function of the time-to-maturity T − t only. This
ensures that the term structure dynamics under my model is time-homogeneous.
It follows from equation (6) and the Ito’s lemma that the date t instantaneous covari-
ances of log-bond prices for a set of bonds with maturity τ1 , · · · , τn can be written as a
product of three matrices
Bt Diag(νt ) Bt0
where Bt is a n by N matrix whose (i, k)th element is Bk (τi − t), and Diag(νt ) is a N by
N diagonal matrix whose diagonal elements are the instantaneous variances of the yield
factors νk (t), k = 1, · · · , N . The covariance matrix above is guaranteed to be positive
semi-definite. Further, the covariance between any two discount bonds is linear in the
variances of the N yield factors ν1 (t), · · · , νN (t).
There are two sources for the time-variation in bond covariances under my model.
One is predictable: as time pass by, the time-to-maturities of bonds decrease, and hence
their loadings on the yield factors change correspondingly. Another source of movement
in the covariances of bond yields is the stochastic volatilities of the yield factors, which I
model next.
Consider the general case when K of the N yield factors (K ≤ N ) display stochastic
variances, and the remaining N − K factors have constant variances. Let IK denote the
index of yield factors with stochastic variances. For i ∈
/ IK , denote the variance of the ith
factor by a positive constant θi . For each i ∈ IK , I model the variance of the ith factor
as a square root process:
q
dνi (t) = κi (θi − νi (t))dt + σi νi (t) dWit , ∀i ∈ IK (7)

Model parameters κi and θi are respectively the mean reversion speed and the long run
mean for the variance of the ith yield factor.
Ball and Torous (1999), Chen and Scott (2001), and Heidari and Wu (2001) find that
innovations in interest rate levels are almost uncorrelated correlated with innovations in
the volatility of interest rates. Motivated by this finding, I assume that each Brownian
motion dWit driving the variances of the yield factors is uncorrelated with the dZ’s in
equation (6). This assumption implies that bond innovations are not contemporaneously
affected by volatility innovations. Therefore, bonds cannot be used to hedge volatility risk
instantaneously and thus my model exhibits unspanned stochastic volatility in the sense
Collin-Dufresne and Goldstein (2002). It also implies that dynamics for the variances of
the yield factors are the same under the risk neutral measure and all forward measures

6
(see Goldstein, 2000).
In the rest of the paper, for a pair of integers K ≤ N , I denote by GAN,K the model
with risk-neutral evolution of bond prices given by equations (6) and (7). Under the
GAN,K , there are N factors that drive innovations in the yield curve, the first K of which
display unspanned stochastic volatility, and the others have constant volatility.4 The
conditional covariances of bond yields are affine in the instantaneous variances of the first
K yield factors.
Risk-neutral bond prices dynamics are enough for deriving prices of swaptions and
interest rate caps (see section 3.2). For the purpose of carrying out a maximum likelihood
estimation of my model, I also need the dynamics of the volatility state variables under

the physical measure. The volatility risk premium can be modeled as λi νi (see, e.g.,
Heston (1993) for an equilibrium justification based on the representative agent’s utility).
Under this assumption, νi also follows an affine process under the physical measure:
q
dνi (t) = κ̂i (θ̂i − νi (t))dt + σi νi (t) dŴit (8)

κi θi
where κ̂i = κi −λi , θ̂i = κi −λi
, and dŴit is a standard Brownian motion under the physical
measure.

3.2 Model Valuation of Swaptions and Caps


Here I derive closed-form formulas for the prices of European swaptions and caps. My
model’s tractability greatly facilitates its econometric estimation with panel data of swap-
tions to be carried out later in this study.
Interest rate derivatives can be valued by taking expectation of their discounted payoffs
under the spot risk-neutral measure. Unlike the equity derivatives, one can not assume
a constant short rate, since the entire term structure is stochastic. In general, the short
rate process is non-Markovian under the HJM type models, and thus difficult to work
with.5 As the payoffs of swaptions and interest rate caps are homogeneous of degree 1 in
4
As in principal component analysis, I label the factors so that for i < j, the ith factor has higher
unconditional variance than the j factor. Theoretically, for a given pair (N, K), IK = {1, · · · , K} is only
one of the possible choices for the index of yield factors which display stochastic volatility. Empirically,
this choice fits the swaptions and interest caps data the best.
5
It can be shown that under my GAN,K model, the risk-neutral dynamics for the short rate r is
Z µZ ¶ Z
t t−s t p
rt = y(0, t) + c(t − s)V (s) c(τ )0 dτ ds + c(t − s) V (s) dZsQ
0 0 0

where B(T − t) = [B1 (T − t) · · · BN (T − t)]0 ; V (t) is N by N diagonal matrix whose ith diagonal element
is νi (t); dZtQ is a N dimensional Brownian motion stacking dZkQ (t), k = 1, · · · , N ; c is a row vector of

7
discount bond prices, it turns out that it is more convenient to use the forward risk-neutral
measure defined by Jamshidian (1987) to value swaptions and caps.
Let D(t, τ, T ) denote the date-t price of a forward contract to buy at date τ a bond
that matures at T . In the absence of arbitrage, the forward bond prices are related to the
discount bond prices by D(t, τ, T ) = D(t, T )/D(t, τ ). The forward risk-neutral measure
corresponding to date τ and denoted by Qτ uses the Libor discount bond that matures
at τ as the numeraire asset. By definition, each forward bond price D(t, τ, T ), T > τ ,
follows a martingale under Qτ . Thus, the dynamics of the forward bond prices under the
corresponding forward risk-neutral measure are determined by their covariances.
Below, I first show that given the initial bond prices, price of an European swap-
tion is determined by the covariances of a set of discrete-tenor forward bonds under the
corresponding forward risk-neutral measure. Then I explain how to operationalize the
modeling assumption in section 3.1 for the covariances of forward bonds. Finally, I derive
closed-form formulas for the prices of swaptions and caps.
It is straight-forward to show that the payoff of a τ by T at-the-money-forward re-
ceivers swaption, previously given in equation (2) (with coupon rate c being equal to the
corresponding forward swap rate F SR(0, τ, T ) given in equation (3)), can be rewritten in
terms of the forward bond prices as
³ ´
M ax Ã(τ ) − 1, 0 (9)

where
2(T −τ )
X D(t, τ, τj ) j
Ã(t) = ω̃j Sj (t), Sj (t) = , τj = τ +
j=1 D(0, τ, τj ) 2
ωj D(0, τ, τj )
ω̃j = P2(T −τ ) (10)
k=1 ωk D(0, τ, τk )
Kc c
ωj = , for j = 1, . . . , 2(T − τ ) − 1, and ω2(T −τ ) = (1 + )W
2 2
1
W =
1 + (T − τ )c
P
Note that the ω̃j ’s are positive constants and j ω̃j = 1.
The no-arbitrage price of a contingent claim, which settles at time τ , is given by first
taking the expectation of its payoff under the forward risk-neutral measure, and then
multiplying it by D(0, τ ) (see, e.g., Lemma 13.2.3 of Musiela and Rutkowski, 1997). It
∂B(τ )
functions defined to be the derivative of B: c(τ ) = ∂τ ; and y(0, t) = − log D(0, t)/t.

8
follows that the date-0 price of a τ by T at-the-money-forward receivers swaption is:
τ
h ³ ´i
P (τ, T ) = D(0, τ ) EQ M ax Ã(τ ) − 1, 0 (11)

where Qτ is the forward risk-neutral measure. Thus, the valuation of swaption is reduced
to computing the expectation under the forward risk-neutral measure of an arithmetic
sum of a set of random variables Sj (τ ), for j = 1, . . . , 2(T − τ ). Since each Sj (t) is just
a constant multiple of D(t, τ, τj ), its drift under Qτ is zero. Therefore, the covariances of
{D(t, τ, τj )}, τj = τ + 2j , j = 1, . . . , 2(T − τ ), determines their joint distributions under
the forward risk-neutral measure Qτ , which in turns determines the price of a τ by T
European swaption by equation (11).
Note that to value swaptions and caps, I need the covariances of forward bonds with
fixed maturities, but it is more convienient to first model the covariances of bonds with
fixed time to maturity (e.g., multiples of six-months).6 Let Ωt be the date t instantaneous
covariance matrix of changes in the logarithm of the six-month forward Libor bond prices
i
{D(t, t + ti , t + ti+1 )}19
i=0 , where ti = 2 years. Let H be the corresponding unconditional
covariance matrix. Since H is a semi-definite symmetric matrix, it can be decomposed as
0
H = U Λ0 U , where Λ0 is a diagonal matrix whose diagonal elements are the eigenvalues
of H, and columns of U are the corresponding eigenvectors.7 The conditional covariance
matrix under the GAN,K model is given by

Ωt = U Λt U 0 (12)

where Λt is a diagonal matrix whose first N main diagonal elements are the conditional
variances of the N yield factors. Among them, the first K yield factors have stochastic
variances which I model as CIR processes as in equation (7). The remaining N −K factors
have constant variances. All other elements of Λt are zero.
The covariances of forward bonds with fixed maturities can be obtained from Ωt in
two steps. First,

log(D(t, τ, τj )) = log(D(t, τ, τ1 )) + log(D(t, τ1 , τ2 )) + · · · + log(D(t, τj−1 , τj ))


6
Note that the swap rates, swaptions and caps data are all “refreshed” each date, in the sense that they
have constant time-to-maturities rather than fixed maturity. The longest total maturity of the swaptions
in my dataset is ten years. Therefore I consider bonds with time-to-maturity no more than ten years.
7
I normalize U to have unit length for each column. The ith column of U and the ith main diagonal
element of Λ0 are the weights and the unconditional variances of the ith common factor driving the yield
curve. Further, a rotation of these factors (obtained by multiplying a orthogonal matrix) does not change
the factor variances (νi ’s). Since all structural parameters in my model are for the dynamics of the νi ’s,
they are properly identified.

9
Second, every six months from date 0 till τ , τj − t’s are multiples of six-month. On these
dates, the instantaneous covariances of the bonds on the right hand side of last equation
can be read off from Ωt = {cij (t)}ij . On other dates, I linearly interpolate the covariances
to preserve the continuity of the covariances as functions of time-to-maturity. 8 More
precisely, fix integer i, j such that 1 ≤ i < j < 20; at any time t ≤ ti = 2i , let k be the
integer such that tk ≤ t < tk+1 . Then I assume

Cov(D(t, ti , ti+1 ), D(t, tj , tj+1 )) = (1 − 2(t − tk )) ci−k,j−k (t) + 2(t − tk ) ci−k−1,j−k−1 (t) (13)

Now I continue with the valuation of an European τ by T swaption given by equa-


tion (11). Based on the assumption that the volatility state variables are instantaneously
uncorrelated with innovations in the yield curve, I can use an argument similar to Hull
and White (1987) to show that each Sj (τ ) is lognormal conditional on average values of
νk (k = 1, · · · , N ) between date 0 and τ . Ã(τ ), an arithmetic sum of {Sj (τ )}j , is not con-
Q2(T −τ ) ω̃
ditionally lognormal. However, the corresponding geometric sum, G̃(t) = j=1 Sj j (t),
is. Upon replacing the difference of Ã(τ ) and G̃(τ ) by the mean of the difference,9 the
price of an τ by T swaption approximately equals:
τ
h ³ ´i
P (τ, T ) = D(0, τ ) EQ M ax G̃(τ ) − g, 0 (14)

τ
where g = 1 + EQ [G̃(τ ) − Ãτ ]. I apply the law of iterative expectation and derive the
following approximate closed-form formula for prices of at-the-money-forward European
swaptions (see the appendix for details):

Proposition 1 Under the GAN,K model, the price of a τ by T European at-the-money-


forward swaption is given approximately by:
· µ q ¶ ¸
1
P (τ, T ) = D(0, τ ) 2N ω̃ 0 Σ̂ ω̃τ − 1) (15)
2
−1 h i
1 2τX 0 0 0 0 0 0
Σ̂ = Al U Diag1l U Al + Al+1 U Diag2l U Al+1 − Al U Diag2l U Al (16)
τ l=0

where N (·) is the cumulative density function of a standard normal random variable. The
weights ω˜j , j = 1, · · · , 2(T − τ ), as given by (10), depend on τ, T as well as the current
8
I experiment with alternative interpolating schemes using functions that are exponentially decaying
in time-to-maturity, and find that the interpolation scheme has a negligible influence on the prices of
swaptions and caps.
9
This approximation technique has been applied to price Asian options and basket options. It is known
to be very accurate (see, e.g., Vorst (1992)). In my case, simulations show that the typical approximation
error is less than 0.1%, even for maturity as long as τ = 10, and for values of the volatility state variables
that generate bond yield volatilities that are twice as high as those observed in the data.

10
prices of discount bonds. U is the matrix of eigenvectors of the unconditional covariance
matrix of changes in the logarithm of the six-month forward Libor bonds. For each non-
negative integer l ≤ 2τ − 1, Diag1l and Diag2l are 20-by-20 matrices whose entries are zero
except the first N diagonal elements

1 e−κi l/2 − eκi (l+1)/2


Diag1l (i, i) = θi + (νi (0) − θi ), i = 1, · · · , K
2 κi
1
Diag1l (i, i) = θi , i = K + 1, · · · , N
2
à κi !
l 1 −κi l/2 2 e− 2 2 − κi
Diag2 (i, i) = θi + e − − 2 e 2 (νi (0) − θi ), i = 1, · · · , K
4 κ2i κi κi
1
Diag2l (i, i) = θi , i = K + 1, · · · , N
4
For i = 1, · · · , K, νi (0) denotes the spot variance of the ith common yield factor. For each
l, Al is a 2(T − τ )-by-20 matrix. The 2τ − l + 1 to 2T − l column of Al forms a lower
triangular matrix whose elements on and below diagonal are 1. All other elements of Al
are zero.

The valuation of an interest rate cap is easier. The price of a cap is the sum of the
prices of its constituent caplets. Each caplet can be viewed as a put options on the
corresponding forward bond.

Proposition 2 The price of an at-the-money cap on the six-month Libor rate with time
to maturity T is:
2T
X −1
1
D(0, ti )N (−d2i ) − (1 + R)D(0, ti+1 )N (−d1i ) (17)
i=1 2
log(D(0, ti , ti+1 )(1 + 21 R)) + 12 σ̄i2 ti q
d1i = q and d2i = d1i − σ̄i2 ti
σ̄i2 ti

where ti = 2i year, the cap rate R equals the T year swap rate and σ̄i 2 is the average expected
variance over [0, ti ] of changes in the logarithm of forward bond price D(t, ti , ti+1 ), given
by equation (16) with τ = ti and T − τ = 12 .

3.3 Relation to Other Term-Structure Models


I now discuss how my model relates to models in previous and contemporaneous studies.
First, the dynamics of discount bond prices under my model as given by equation (6) can
be derived from the affine model of Duffie and Kan (1996). To see this, consider an affine

11
model with N factors driving the short rate:

rt = δ0 + δ1 Xt

The risk-neutral dynamics of the risk factors Xt are given by


q
dXt = κ(θ − Xt )dt + Σ S(t)dZtQ (18)

where κ and Σ are N by N matrices, and S is a diagonal matrix with components

Sii (t) = αi + βi X(t)

The discount bond prices are given by


0
D(t, T ) = eA(T −t)−B(T −t) X(t) (19)

where A(τ ) and B(τ ) can be solved from a system of ODE’s with A(0) = 0, B(0) = 0.
By equation (18), equation (19) and the Ito’s lemma, the risk-neutral dynamics for the
discount bond prices under the affine model are

dD(t, T ) q
= rt dt − B(T − t)0 Σ S(t) dZtQ (20)
D(t, T )

which is of the same shape as bond prices dynamics under my model.


Just like under the affine model, the covariances of bond yields in my model are
affine in the volatility state variables. The difference is that in my model, innovations in
bond yields are not contemporaneously affected by volatility innovations. In contrast, the
stochastic volatility factors in the affine framework typically enter into bond prices, and
can be represented as linear combinations of bond yields. In other words, the volatility
factors in the traditional affine framework drive both the cross-sectional differences in bond
yields and changes in conditional volatility. My model and affine models with unspanned
stochastic volatility both break this dual role of stochastic volatility.10 Thus, my model can
be viewed as a “reduced-form” representation of affine model with unspanned stochastic
volatility.
My model takes the current term structure of interest rates as given, and focus on
understanding what drives stochastic covariances of bond yields and the valuation of
10
See Collin-Dufresne and Goldstein (2002) for examples of affine models that display unspanned
stochastic volatility. Collin-Dufresne, Goldstein and Jones (2004) compare traditional affine models to
an affine model with unspanned stochastic volatility. They show that the latter generates much more
realistic volatility estimates without sacrificing fit to the cross-sectional bond prices.

12
interest rate derivatives. This aspect of my model is similar to the HJM (1992) framework
or its generalization such as the string or random field framework (see, e.g., Goldstein 2000,
and Santa-Clara and Sornette, 2001). If a model fits the bond prices with errors, such
errors will get carried over to the interest rate derivatives and confound the inferences
about the factors driving the bond covariances.
My model is closely related to the string-market model of Longstaff, Santa-Clara
and Schwartz (2001) who also directly model the risk-neutral dynamics of discount bond
prices. The two models share the property that the instantaneous covariance matrix of
bond yields and the unconditional historical covariance matrix are diagonalized by the
same matrix. The difference is that Longstaff, Santa-Clara and Schwartz (2001) consider
only constant covariances while I explicitly model the dynamics of the risk factors driving
the stochastic bond covariances.
Two contemporaneous theoretical papers contain models similar to mine. First, Kim-
mel (2004) develops a class of random field models in which the volatility of forward rates
depends on a set of latent variables, not the level or shape of the forward curve. The latent
volatility variables themselves follow general diffusion process. He focuses on conditions
necessary for the existence and uniqueness of the forward rate process, characterizing
the behavior of the latent variable random field model and deriving theoretic results for
derivative pricing. For tractability of empirical work, I choose bond prices rather than
forward rates as model fundamentals, and focus on affine process for the state variables
that drive the stochastic covariances of bond yields. These state variables also have eco-
nomic meaning in my model: they are the instantaneous variance of common factors that
drive the yield curve innovations. Second, my model is closely related to the generalized
affine framework proposed by Collin-Dufresne and Goldstein (2003), which also allows
unspanned stochastic volatility but maintains the tractability of the affine models.

4 Data
A panel dataset of interest rates and implied volatility for at-the-money-forward European
type swaptions is used to estimate my model. The interest rates include six-month and
one-year Libor rates as well as two, three, four, five, seven, ten and fifteen-year swap rates.
The total maturity of the swaptions I use is no greater than ten years and there are 34
such swaptions. The maturities of the swaptions range from six months to five years and
the tenors of the underlying swaps are between one and seven years. Implied volatilities
for Libor interest-rate caps of maturity two, three, four, five, seven and ten years are used
in the study of relative valuation of swaptions and caps. All data are collected from the
Bloomberg system and represent the average of best bid and ask among many large swap

13
and swap derivatives brokers. There are 220 weekly observations for each series, sampled
every Friday from January 24, 1997 to April 6, 2001.
Discount bond prices (with maturity that are multiples of six-months) in the Libor-
swap market are needed in order to compute the market prices and model prices for
swaptions and caps. I apply a least-square cubic spline approximation to the Libor and
swap rates to get the par yield curve, and then bootstrap the discount bond prices from
the par yield curve.11 The unconditional covariance matrix of forward bond yields is
computed using the discount bond prices between January 17, 1992 and January 17,
1997. Its eigenvector matrix U is used in forming instantaneous covariances as specified
in (12).
Table 1 reports the mean and standard deviation of swaption implied volatilities.
On average, the implied volatility is humped as a function of swaption maturity, with a
maximum at two years. On high volatility dates, the swaption implied volatility tends
to decrease monotonically with option maturity. Consistent with mean reversion in the
interest rates, the implied volatility of swaption is usually monotonically decreasing as a
function of the tenor of the underlying swap. Further, the standard deviation of swaption
implied volatility decreases with option maturity as well as the tenor of the underlying
swap. For example, although the implied volatilities of 0.5 into 1 and 5 into 5 swaption
have about the same sample mean, the first is almost three times as volatile as the latter.
Figure 1 confirms that there is a fair amount of time-series variation in the swaption
implied volatilities, especially for short-dated swaptions. My sample period includes the
Asian crisis, the Russian moratorium and the Long Term Capital Management crisis,
the crash of technology stocks, as well as quiet periods of low interest rate volatility.
These different volatility environments help us to estimate the dynamics of bond-yield
covariances.
Figure 1 also shows that implied volatilities for short-dated and long-dated swaptions
do not always track each other closely. For example, the sample correlation between the
implied volatility for the 0.5 into 1 swaption and that for the 5 into 5 swaption is only
0.51. A principal component analysis also suggests there are at least two factors driving
the innovations in the swaption implied volatilities.
11
The least-squares cubic spline approximation fits the swap rates very well, with average absolute
fitted error about 0.76 basis points. Interpolation schemes that exactly fit observed Libor-swap rates
tend to lead to unreasonably high estimates for the volatilities of long term bonds and somewhat rugged
correlations. An alternative method to generate reasonable estimates for the bond covariances is to put
some smoothness condition on the shape of the forward rate curve (see, e.g., Driessen, Klaassen and
Melenberg 2003).

14
5 Econometric Method
The econometric exercise in my paper parallels many previous studies that evaluate the
performance of short-rate based term structure models and infer dynamics of the risk
factors driving the short rate using bond prices or swap rates. The focus of my study
is the stochastic covariances of bond yields. I infer dynamics of the risk factors driving
bond covariances and obtain conditional estimates of bond covariances from the swaption
implied volatilities data.12
I adopt the maximum likelihood approach used by Chen and Scott (1993), Pearson
and Sun (1994), Duffie and Singleton (1997), Jagannathan, Kaplin and Sun (2003) and
others. The volatility state variables are unobservable. Thus, they need to be filtered
at the same time as the model is estimated. For a given set of model parameters, the
volatility state variables are inverted from the prices of swaptions that are assumed to
be priced exactly. The percent pricing errors of the other swaptions are assumed to be
i.i.d and jointly normal N (0, Ω). The estimated parameters maximize the sum of the
log-likelihoods of the exactly fitted swaptions and the percent pricing errors of the other
swaptions.
The estimated parameters for the volatility dynamics under the GAN,K model maxi-
mize a log-likelihood function function log L = log L1 + log L2 , where
TX
−1 X
K T
X
log L1 = lnf (νi,t+1 |νi,t ) − ln(Jν,t )
t=1 i=1 t=2
T
(34 − K)(T − 1) T −1 1X 0
log L2 = − ln(2π) − ln|Ω| − et Ω−1 et
2 2 2 t=2

where et is a vector of the percent pricing errors of the non-exactly-fitted swaptions,


Jν,t is the determinant of the matrix of first order partial derivatives of K exactly-fitted
swaptions with respect to each of the K volatility factors, and f (νi,t+1 |νi,t ) is the transition
density of the ith volatility factor (assumed to follow independent CIR process). Omitting
the subscript i,
µ ¶q/2
−u−w w

f (νt+1 |νt ) = 2ce Iq (2 uw)
u
with
2κ̂ 2κ̂θ̂
c= 2 −κ̂(T −t)
, u = cνt e−κ̂(T −t) , w = cνT , q = 2 − 1,
σ (1 − e ) σ
and Iq is a qth order modified Bessel function of the first kind. Since the data are sampled
12
Collin-Dufresne, Goldstein and Jones (2004) find that interest rate volatility can not be extracted
from the cross-section of bond prices.

15
weekly, the above formula is applied with T − t = 1/52 year.
To implement the maximum likelihood approach above, I have to choose the swaptions
that are to be fitted exactly. Each swaption provides information about the covariances
of a segment of the yield curve and there are no good reasons to choose one swaption
over another to be fitted exactly.13 For all results reported in this paper, I invert the
K volatility state variables under the GAN,K model by assuming that K portfolios of
swaptions (corresponding to the first K principal components of the swaption implied
volatilities) are fitted exactly, and measurement errors apply to other principal compo-
nents.14 This approach not only circumvents the arbitrariness of standard approach of
fitting specific instruments exactly, it also approximately orthogonalizes the matrix of
measurement errors.

6 Empirical Results
The empirical results presented below answer, among other things, the following questions:
1) how many yield factors and how many covariance factors are needed to explain the
swaptions data? 2) can my model explain the relative valuation of swaptions and interest
rate caps? 3) how do the covariances of bond yields implied from the swaptions compare
to the historical estimates based on bond prices alone?

6.1 Number of Factors Underlying the Swaptions Data


Recall that my GAN,K model have N yield factors, and the first K yield factors have
stochastic volatilities. When K = 0, my model specifies a constant covariance matrix
for bonds with fixed time-to-maturity. There are only N parameters under the GAN,0
model, which are the constant variances of the N yield factors. They can be estimated
via the General Methods of Moments approach. The pricing error of each swaption
provides a moment condition. The test statistic for over-identifying moment restrictions
is asymptotically distributed as χ234−N .
The constant covariance model could not fit the swaptions data well. Even when there
13
For my model with only one volatility factor, I find that the parameter estimates and the implied
volatility state variable can differ significantly depending on the choice of the swaption to be fitted exactly.
This reflects the fact that my model with only one volatility factor is unable to fit simultaneously both
short-maturity options on short-tenor swaps and long-maturity options on long-tenor swaps. My model
with multiple factors driving the volatilities and correlations of bond yields fits the data much better and
the estimation results are not sensitive to the choices of swaptions to be fitted exactly.
14
Collin-Dufresne, Goldstein and Jones (2004) has applied a similar approach in estimating various
affine model using bond prices.

16
are 4 factors driving the innovations in the yield curve, the mean absolute pricing error
is 9.86%, and the average RMSE for the swaptions is 10.21%. The constant covariance
model tends to underprice swaptions. The test statistics for over-identifying moment
restrictions is 129.18. Since the 99% critical value for χ230 is 50.89, I can reject the
GAN,0 model. Constant covariance model with fewer yield factors performs even worse.
Increasing the number of yield factors to N > 4 does not significantly improve model fit.
Allowing stochastic covariances greatly improves model’s fitting performance for swap-
tions. Table 2 shows that under the GA4,1 model, the overall mean absolute swaption
pricing error is reduced to 3.28%, and the average (median) RMSE for the swaptions
is 3.97% (3.53%). The swaption RMSE under GA4,1 is always smaller than that under
GA4,0 . The difference is especially big in the months leading up to the Long Term Capital
Management (LTCM) crisis in the fall of 1998. Between January 1998 to the end of Au-
gust 1998, the swaption RMSE under the constant covariance GA4,0 model raises steadily
from around 10% to over 30%, but it stays around 2.5% under the GA4,1 model.
However, the GA4,1 model, with only one factor driving the stochastic covariances
of bond yields, has difficulty fitting simultaneously both short and long dated swaptions,
especially during the LTCM crisis. As can be seen from Figure 1, the implied volatility for
the 0.5 into 1 swaption jumps from just above 10% before the LTCM crisis to more than
24% during the crisis, while the implied volatility for the 5 into 1 swaption only increases
from about 13% to 17%. In order to generate this feature of the data using models with
one volatility factor, the mean reversion speed κ1 must be high. A large κ1 implies fast
reversion to the mean. Thus, a volatility shock is expected to die out quickly, which
implies much smaller changes in the implied volatilities for the long-dated swaptions than
short-dated swaptions. Yet a high κ1 would produce large swaption pricing errors during
normal market when implied volatilities for short dated and long dated swaptions tend
to move by about the same amount.
My model with multiple covariance factors solves the problem above. The mean
absolute pricing error for the swaptions is 2.17% under the GA4,2 model. The median
swaption RMSE is 2.61% and the maximum is 8.00%. The GA4,3 model performs even
better. It implies a mean absolute pricing error of 2.06%. Panel A of Figure 2 shows that
the swaption RMSE under GA4,3 is lower than 4% except during the LTCM crisis. On
161 of the 220 weeks, the RMSE is lower than 3% (about half of the bid-ask spread).15
In addition to having multiple factors driving the bond covariances, it is also important
to have a sufficient number of yield factors. For example, although GA2,2 has more
15
Note that the bid-ask spread for the swaption implied volatility is usually 1 volatility point (i.e., 1%)
during my sample period. For a typical implied volatility of 16% for at-the-money-forward swaption, this
translates into a bid-ask spread of about 6% bid-ask spread for the swaption price, since price of swaption
at-the-money-forward is almost linear in its Black implied volatility.

17
volatility factors than GA4,1 , it often produces larger pricing errors. The GA4,2 model
significantly dominates both GA4,1 and GA2,2 , as formal statistical tests presented below
also shows.
The swaption pricing errors obtained in the previous studies are substantially higher
than ours, even when the models are frequently recalibrated in these studies in order to
fit the data better. For example, De Jong, Driessen and Pelsser (1999) find that for a
variety of Libor and swap market model specifications, the mean absolute pricing error
ranges from 0.87 to 2.28 volatility points, or about 5% to 14% assuming an average im-
plied volatility of 16%. Driessen, Klaassen and Melenberg (2003) report average absolute
swaption pricing error between 7.23% and 9.50% for several HJM type models. Jagan-
nathan, Kaplin and Sun (2003) report swaption pricing errors that are larger than the
bid-ask spread. For example, under the two-factor CIR model, the mean absolute pricing
error is about 8% for 3-month into 2-year swaption, and 31.39% for 2-year into 5-year
swaption.16
The best prior fitting performance for the swaptions data comes from the four-factor
string-market model of Longstaff, Santa-Clara and Schwartz (2001). The median swaption
RMSE is 3.10%, but it becomes over 15% during the LTCM crisis. Just like my GA4,0
model, their model assumes constant covariances of bond yields (with constant time-to-
maturities). The difference is that they recalibrate their model each date which implicitly
allows four factors to drive the covariances of bond yields. In contrast, I explicitly model
the dynamics of the risk factors that drive the covariances of bond yields. As a result,
my GA4,2 model, with only two factors driving the covariances of bond yields, is able
to fit the swaption data better, both under normal market condition and during market
crises.17
Table 3 reports the Diebold and Mariano (1995) test statistics for pairwise comparisons
of alternative specifications of my model. Each model specification implies a time series
of mean squared swaption pricing errors SSE(t) corresponding to the optimized model
1 P34 2
parameters: SSE(t) = 34 i=1 ²i,t , where ²i,t is the percent pricing error for the ith
swaption on date t. Consider two models that give rise to {SSE1 (t)}Tt=1 and {SSE2 (t)}Tt=1
respectively (T = 220 in my case). The null hypothesis that the two models have the
same pricing accuracy is equivalent to the null hypothesis that the population mean (µ)
16
Umantsev (2001) shows that the three-factor affine model A1 (3) of Dai and Singleton (2000) fits
the swaption volatilities better than the multi-factor CIR model, especially when the swaptions data are
included in the estimation procedure. However, the pricing errors for swaptions with long option or swap
maturity are still quite large.
17
As reported earlier, over the entire sample of 220 weekly observations, the median swaption RMSE
under the GA4,2 model is 2.61% and the maximum is 8.00%. The sample in Longstaff, Santa-Clara and
Schwartz (2001) is the first 128 weeks of mine. Over this subsample, the median RMSE of my GA4,2
model is 2.43%.

18
of the difference in pricing errors (dt ) is zero, where dt = SSE1 (t) − SSE2 (t). Diebold
and Mariano (1995) show that if {dt }Tt=1 is covariance stationary and short memory, then
P
the asymptotic distribution of the sample mean of pricing error difference d¯ = T1 Tt=1 dt
is normally distributed as √
T (d¯ − µ) ∼ N (0, 2πfd (0))
where fd (0) is the spectral density of the pricing error difference at frequency:

1 X
fd (0) = rd (τ ) where rd (τ ) = E[(dt − µ)(dt−τ − µ)]
2π τ =−∞

The formula for fd (0) shows correction for serial correlation in dt . Diebold and Mariano
(1995) obtain a consistent estimate of 2πfd (0) by the sum of available autocovariances up
to a certain truncation lag q:18
q
X T
X
1
2π fdˆ(0) = rˆd (τ ), where rˆd (τ ) = ¯ t−|τ | − d)
(dt − d)(d ¯
τ =−q T t=|τ |+1

Thus, under the null hypothesis of equal pricing accuracy across the two models, the
following statistic √
T d¯
S=q
2π fdˆ(0)
is distributed asymptotically as standard normal N (0, 1).
Table 3 confirms my earlier results on the comparison of model fitting performance.
Models with more yield factors and volatility factors usually fit the swaptions data signifi-
cantly better. The largest improvement comes from increasing the number of yield factors
from one to two, or from two to three, and from increasing the number of volatility factors
from one to two. In each pair of such comparisons, models with more yield or volatility
factors imply at least 1% lower swaption RMSE on at least 200 weeks out of a total of 220
weeks. These cases also give the largest Diebold and Mariano (1995) statistics. Overall,
the GA4,3 model with four yield factors and three separate volatility factors best fit the
swaptions data. The GA4,2 model and the GA3,3 model also provides excellent fit to the
swaptions data.
Results in Table 3 are also consistent with Heidari and Wu (2001) who find by princi-
pal component analysis that one needs three volatility factors that are independent of the
underlying yield curve to capture the movement of the swaption implied volatility surface.
However, the principal component analysis is unconditional, and completely ignores the
18
In Table 3, lag order q = 52. I verify that my results are robust to alternative lag order q such as 5,
10, 26, and 102.

19
rich information contained in the cross-section of swaptions that my stochastic-covariance
model tries to capture. Through rigorous modeling and econometric estimation, I obtain
estimates of conditional covariances of bond yields and infer information about the dy-
namics of the factors that drive bond covariances. I can also address issues such as the
relative valuation of swaptions and interest rate caps. These are impossible to achieve
with principal component analysis.

6.2 Relative Valuation of Swaptions and Caps


The relative valuation of swaptions and interest rate caps crucially depends on the co-
variances of bond yields, and thus provides a diagnostic test for my model. This is an
out-of-sample test in the sense that I first estimate my model with the swaptions data,
then compare the model implied no-arbitrage values for the interest rate caps given by
equation (17) to their market prices. The differences are referred to as cap pricing errors.
Table 4 reports the mean and mean absolute pricing errors of interest rate caps. The
constant-covariance model, even with as many as four yield factors, still implies large
mean absolute pricing error (10.36%). Just like the case for the swaptions, introducing
stochastic covariances substantially improves model fit to the caps. The mean absolute
cap pricing error is 5.41% under GA4,1 , 4.88% under GA4,2 , and 4.54% under the GA4,3
model. The average pricing error is 0.62% under the GA4,2 model and only 0.03% under
the GA4,3 model. Only the 2-year cap shows some systematic overvaluation by the GA4,2
model. The GA4,3 model, which is favored by the statistical tests based on models’ fit
to the swaptions, also implies the smallest pricing errors for the interest rate caps. Its
improvement over the GA4,2 model is mainly reducing the pricing error of the 2-year cap.
Panel B of Figure 2 shows that differences between the market prices of interest rate
caps and their no-arbitrage values implied from the swaptions according to my GA4,3
model are typically lower than 6% (about the bid-ask spread). There are only two periods
when the cap RMSE is higher than 6%. The first occurs during the LTCM crisis. For
example, the cap RMSE jumps to 19.9% on August 28, 1998 and 30.4% on September
4, 1998, right after The Times headlined “Meriwether fund plummets by 44%.” For the
next 4 weeks, the average cap pricing error stays below 6% until it shoots up again to
25.8% on October 2, 1998. During that week, many banks revealed huge exposure to or
investment in the hedge-fund which led to a 3.5 billion bail out of LTCM.
The second period of relatively large cap pricing errors starts at the beginning of
August 1999, when, according to my GA4,3 model, the no-arbitrage prices of individual
interest rate caps implied from the swaptions are lower than the market prices of caps by
about 8%. Supporting the view that caps are overvalued relative to swaptions during this

20
period, various news reports indicate that proprietary desks are short cap volatility and
long swaption volatility.19 The cap pricing errors revert to around 3% (about half of the
bid-ask spread) by the end of 1999.
Under my GA4,3 model, the market prices of interest rate caps do not deviate signif-
icantly from their no-arbitrage values implied from the swaptions. In contrast, using a
four-factor constant-covariance model, Longstaff, Santa-Clara and Schwartz (2001) find
periodically large and somewhat bimodally distributed pricing errors for interest rate
caps. The average cap pricing error is 10.38%, and the mean absolute cap pricing error is
14.19%. Note that their model and my model both have four factors driving the innova-
tions in the yield curve. The difference is that my model also has separate factors driving
the covariances of bond yields. My model seems to realistically capture the dynamics
of bond covariances and largely eliminates the large and systematic mispricing between
swaptions and caps found by Longstaff, Santa-Clara and Schwartz (2001) and several
other studies.20
As an additional test of goodness-of-fit for my stochastic covariance model, I regress
changes in the market prices of interest rate derivatives on the changes in the fitted prices
under the GA4,3 model. The regression is run individually for each swaption and interest
rate cap. If my model describes the data well, then the estimated intercept should be
very close to 0, and the slope coefficient to be indistinguishable from 1, as well as a high
R2 for the regression. This is what I find. None of the intercept is even close to being
statistically different from 0. The average estimated slope coefficient is not significantly
different from 1. The average R2 is 0.92 (0.78) across all the regressions corresponding to
the swaptions (interest rate caps).

6.3 The Volatility Factors and Implied Covariances


Through the model estimation, I also extract market’s view about the dynamics of the
volatility factors and obtain implied bond covariances. Here I compare the implied volatil-
ities and correlations of bond yields to their historical estimates (both unconditional and
conditional). All results below are based on the estimated GA4,3 model.
19
However, this position is risky. On August 5, 1999, Dow Jones Newswire reports that two major US
investment banks lose millions of dollars when they had to unwind big swaption positions and cover short
cap positions. Interestingly, this correlation play on the forward rates was reported to be put back on
just three weeks later.
20
For example, the smallest mean absolute pricing error for caplets among all the Libor and swap
market models tested in De Jong, Driessen and Pelsser (1999) is about 20%. Driessen, Klaassen and
Melenberg (2003) find that the average absolute pricing errors for several multi-factor HJM models are
all bigger than 10%. Jagannathan, Kaplin and Sun(2003) find smallest mean absolute pricing error for
caps under one, two, or three-factor CIR models are still much larger than the bid-ask spreads.

21
Recall that instantaneous covariances of bond yields under the GA4,3 model are linear
in the variances of four yield factors. Plots of the factor loadings obtained from the
principal component analysis confirm that the first three yield factors approximately
represent the level, slope and curvature of the term structure. The fourth factor only
affects the short end of the yield curve (less than 2-year maturity).
The first volatility factor, or the variance of the level yield factor, is quite persistent.
On the other hand, the second and the third volatility factor, or the variance of the slope
and the curvature yield factor mean revert very fast. The “half-life,” defined as logκ 2 ,
where κ is the mean reversion speed, measures the time when a mean-reverting variable is
expected to reach a value halfway between the current level and its long-run mean. Based
on the model parameter estimates presented in Table 5 Panel A, the half life of the first
volatility factor is about 6 years under the physical measure, while it is only about 3 to
4 months for the second and the third volatility factor.
Several implications follow from the weights of the yield factors and the mean reversion
speeds of their stochastic volatility. First, the long-dated swaptions are mainly influenced
by the first volatility factor. Second, swaptions of different maturities and tenors are about
equally sensitive to innovations in the first volatility factor. Therefore, the first volatility
factor proxies for the average level of the surface of swaption implied volatilities. Third,
the second volatility factor proxies for the spread between the implied volatilities of short
and long dated swaptions of the same tenor.21 Finally, only short-dated swaptions on
one-year and two-year swaps are sensitive to the third volatility factor. I have confirmed
these implications with numerical analysis.
Panel B of Table 5 reports the sample correlations between the yield factors and the
volatility factors under the GA4,3 model. It strongly supports my model’s assumption
that shocks to the yield factors are uncorrelated with their stochastic volatilities. Panel C
of Table 5 shows that the time series average of the implied variances of the yield factors
are very close to the unconditional variances of the yield factors. Figure 3 shows that
the average implied covariances of bond yields are also very close to their unconditional
historical estimates.22
Finally, Figure 4 compares the implied covariances of forward bonds to the conditional
covariances obtained from the Dynamic Conditional Correlation (DCC) model, a new class
of multivariate GARCH models proposed by Engle (2002). He shows that this model
provides a very good approximation to a variety of time varying correlation process, yet it
21
The sample correlations between implied ν2 and the difference between the Black implied volatilities
for 0.5 into T and 5 into T year swaptions are all about 0.95, for T = 1, . . . , 5.
22
The only noticeable difference occurs for the correlations of bonds with maturity below 3 years where
the implied correlations are lower than the historical correlations. But most of the differences are smaller
than 0.05. The maximum difference is 0.08.

22
still has the flexibility of univariate GARCH model. I apply this model to changes in the
logarithm of six-month forward bonds. Conditional covariances are estimated following a
two-step procedure as described in detail by Engle and Sheppard (2001).
Several interesting results can be observed from Figure 4. The instantaneous volatility
of six-month forward rate implied from the swaptions closely tracks the GARCH(1,1)
estimate. For example, in the case of six-month forward rate with two year maturity
plotted in the top panel of Figure 4, the correlation between the two conditional volatility
estimates is 0.62. There is no systematic difference between the two conditional volatility
estimate. The bottom panel in Figure 4 plots estimates for the correlation between the
two and five year maturity six-month forward rates. The correlation implied from the
swaptions is more volatile than that estimated from the bond prices under the DCC
model. The sample correlation between the two correlation series is only 0.15. During
periods of market crises, the implied correlation drops precipitously but this is not reflected
in the DCC estimate. The comparison of implied correlations and historical correlations
deserves further investigation in future studies.

7 Conclusion
Recent studies find that it is difficult for many popular term-structure models to explain
the valuation of swaptions and interest rate caps, although these models can price the
underlying bonds very well or even fit them exactly by design. A potential limitation of
these models is that the covariances of bond yields are either deterministic, or can be com-
pletely hedged by the underlying bonds. Collin-Dufresne and Goldstein (2003), Dai and
Singleton (2003) and Jagannathan, Kaplin and Sun (2003) conjecture that the resolution
of the swaptions and caps valuation puzzle may require models that can accommodate
more general forms of stochastic volatility and time varying correlations, such as having
volatility factors that do not affect bond prices.
In this paper, I develop and evaluate a term-structure model that has separate factors
driving innovations in bond yields and their stochastic volatilities and correlations. The
covariances of bond yields are affine in a set of volatility state variables that are not
spanned by bonds. Empirically, my model explains the cross-section and the time-series
variation of the swaption implied volatilities very well, and reconciles the relative valuation
of swaptions and interest rate caps. These results support the conjectures by Collin-
Dufresne and Goldstein (2003), Dai and Singleton (2003) and Jagannathan, Kaplin and
Sun (2003).
The modelling of factors driving stochastic covariances of bond yields and the econo-
metric estimation using interest rate derivative prices in my study are parallel to a large

23
literature that studies short-rate based term-structure models using bond prices. More
empirical research is needed to better understand the rich dynamics of interest rates
volatilities and correlations as well as the valuation of interest rate derivatives, and to
evaluate the class of models proposed in this paper as well as in Collin-Dufresne and
Goldstein (2003) and Kimmel (2004).

24
Table 1: Descriptive Statistics of European Swaption Volatilities
This table presents descriptive statistics for the mid-market Black implied volatilities for 34 at-the-
money-forward European swaptions analyzed in the paper. The data are Friday close collected from the
Bloomberg, from January 24, 1997 to April 6, 2001. “Expiration” refers to the number of years till option
expiration and “Tenor” refers to the maturity of the underlying swap. The last column reports the first
order serial correlation of each swaption implied volatility series. The swaption implied volatilities are
annualized and expressed in percentage points.

Expiration Tenor Mean Median Standard Min Max Serial


Deviation Correlation
0.5 1 14.77 13.85 3.29 9.70 27.00 0.93
1 1 16.12 15.45 2.79 11.80 26.00 0.95
2 1 16.85 16.50 2.11 13.10 23.20 0.94
3 1 16.66 16.40 1.87 13.00 21.80 0.93
4 1 16.35 16.10 1.69 13.00 20.70 0.92
5 1 16.05 15.90 1.50 12.90 20.25 0.93

0.5 2 15.50 14.55 3.02 10.40 27.00 0.94


1 2 16.10 15.50 2.48 12.20 24.00 0.94
2 2 16.37 16.05 1.95 13.00 22.50 0.93
3 2 16.12 15.90 1.70 12.90 21.00 0.93
4 2 15.82 15.73 1.51 12.80 20.10 0.92
5 2 15.51 15.50 1.37 12.70 19.75 0.92

0.5 3 15.48 14.58 2.89 10.60 27.00 0.93


1 3 15.87 15.30 2.28 12.20 23.00 0.94
2 3 16.04 15.70 1.81 12.90 21.50 0.93
3 3 15.79 15.70 1.57 12.80 20.20 0.93
4 3 15.50 15.50 1.41 12.70 19.85 0.92
5 3 15.18 15.20 1.29 12.60 19.50 0.91

0.5 4 15.42 14.60 2.73 10.80 26.50 0.93


1 4 15.65 15.30 2.12 12.10 22.50 0.93
2 4 15.74 15.55 1.67 12.80 20.30 0.93
3 4 15.50 15.40 1.48 12.70 19.95 0.93
4 4 15.20 15.20 1.33 12.60 19.50 0.91
5 4 14.85 14.90 1.22 12.40 19.05 0.91

0.5 5 15.36 14.60 2.60 11.00 26.50 0.92


1 5 15.40 15.10 2.00 11.30 21.50 0.93
2 5 15.46 15.30 1.57 12.70 19.80 0.92
3 5 15.22 15.18 1.40 12.60 19.55 0.92
4 5 14.89 14.90 1.27 12.50 19.10 0.91
5 5 14.50 14.53 1.15 12.10 18.55 0.90

0.5 7 15.18 14.50 2.45 11.00 26.00 0.92


1 7 15.12 14.80 1.80 12.00 20.50 0.92
2 7 15.07 14.90 1.49 12.40 19.45 0.92
3 7 14.82 14.70 1.35 12.30 19.20 0.91

25
Table 2: Swaption Pricing Errors
This table reports the mean absolute value of the percent pricing errors of 34 at-the-money-forward
European swaptions under various model specifications. For the model corresponding to the column
labelled by (N, K), there are N factors driving the evolution of yield curve, and the first K yield factors
have unspanned stochastic volatility. All models are estimated using a panel dataset consisting of 220
weekly observations on 34 swaptions from January 24, 1997 to April 6, 2001. The percent pricing error for
a swaption is the difference between its fitted model price and its market price expressed as a percentage
of market price.

Expiration Tenor Model


(4,0) (4,1) (2,2) (4,2) (3,3) (4,3)
0.5 1 13.36 7.78 12.45 4.23 3.43 3.31
1 1 10.56 4.22 7.46 3.32 2.74 2.84
2 1 9.78 3.13 3.57 3.08 3.14 3.14
3 1 9.63 3.14 3.39 2.93 2.91 2.79
4 1 9.58 3.84 4.11 3.37 3.15 3.18
5 1 9.44 4.48 3.80 3.03 2.94 3.01

0.5 2 13.19 5.16 2.69 2.12 3.28 1.85


1 2 10.76 2.41 3.34 2.59 3.15 2.57
2 2 9.71 1.50 2.48 1.50 1.49 1.61
3 2 9.44 1.77 1.49 1.41 1.36 1.30
4 2 9.11 2.42 1.39 1.47 1.19 1.30
5 2 9.22 3.18 1.18 1.27 1.35 1.31

0.5 3 13.26 4.20 6.65 2.85 2.64 2.28


1 3 10.62 1.70 4.91 2.17 1.87 1.99
2 3 9.33 1.56 2.12 0.99 1.13 1.00
3 3 8.97 1.97 0.91 1.17 1.08 1.02
4 3 8.82 2.59 0.79 1.05 0.95 1.00
5 3 9.08 3.24 1.26 1.36 1.46 1.35

0.5 4 12.55 3.66 5.51 2.50 2.13 2.25


1 4 10.11 1.76 3.46 1.55 1.43 1.51
2 4 8.84 2.28 0.94 1.20 1.43 1.18
3 4 8.58 2.70 1.02 1.33 1.32 1.29
4 4 8.59 3.13 1.15 1.29 1.33 1.28
5 4 9.18 3.78 2.22 2.26 2.23 2.14

0.5 5 11.71 3.72 3.49 2.84 2.86 2.93


1 5 9.97 2.31 2.15 1.76 1.81 1.76
2 5 8.54 3.06 1.27 1.44 1.55 1.47
3 5 8.42 3.47 1.48 1.45 1.54 1.51
4 5 8.66 3.92 1.89 2.01 2.10 1.97
5 5 9.76 4.37 3.52 3.42 3.15 3.13

0.5 7 11.04 4.26 4.69 4.52 4.54 4.65


1 7 9.03 2.99 2.72 2.38 2.37 2.40
2 7 8.24 3.80 2.16 1.81 1.86 1.86
3 7 8.28 4.15 2.00 1.97 2.06 1.96

Average 9.86 3.28 3.05 2.17 2.15 2.06


26
Table 3: Tests of Alternative Model Specifications
This table reports pairwise comparisons of pricing accuracy of alternative specifications of my model. All
models are estimated using a panel dataset consisting of 220 weekly observations on 34 swaptions from
January 24, 1997 to April 6, 2001. For the model labelled by (N, K), there are N factors driving the
evolution of the term structure of bond yields. The first K factors have unspanned stochastic volatility,
and the other N −K factors have constant volatility. The “DM” column reports the Diebold and Mariano
(1995) statistic that tests the null hypothesis that the models in the first two columns have the same
pricing accuracy for swaptions. Under the null hypothesis, the Diebold and Mariano statistic is distributed
asymptotically as standard normal N (0, 1). Column four reports the number of weeks (out of a total
of 220 weeks) that Model 1 implies a higher root-mean-squared percent pricing error (RMSE) for the
cross-section of swaptions, and column five reports the average reduction in swaption RMSE (reported
in percent) implied by Model 2 during these weeks. Similarly, the sixth column reports the number of
weeks that Model 2 implies a higher swaption RMSE, and the last column reports the average reduction
in swaption RMSE (reported in percent) implied by Model 1 during these weeks.

Model 1 Model 2 DM RM SE2 < RM SE1 RM SE2 > RM SE1


Statistic Frequency Mean Difference Frequency Mean Difference
(1,1) (2,1) 6.46 211 1.88 9 0.47

(2,1) (3,1) 9.59 213 1.29 7 0.31

(3,1) (4,1) 0.26 119 0.17 101 0.16

(2,1) (2,2) 2.87 218 1.02 2 0.11

(2,2) (3,2) 6.68 211 1.36 9 0.48

(3,2) (4,2) 2.18 178 0.19 42 0.08

(3,1) (3,2) 3.61 200 1.17 20 0.21

(3,2) (3,3) 3.55 166 0.32 54 0.21

(3,3) (4,3) 2.50 161 0.16 59 0.10

(4,0) (4,1) 2.38 209 7.17 11 0.62

(4,1) (4,2) 2.83 214 1.21 6 0.18

(4,2) (4,3) 2.10 149 0.31 71 0.21

(4,3) (4,4) 0.52 127 0.21 93 0.20

27
Table 4: Interest Rate Caps Pricing Errors
This table reports the average and mean absolute pricing errors for the interest rate caps of maturity
two, three, four, five, seven and ten years under various model specifications. For the model labelled by
(N, K), there are N factors driving the evolution of the term structure of bond yields. The first K factors
have unspanned stochastic volatility, and the other N − K factors have constant volatility. The pricing
error for an interest rate cap is defined as the difference between its no-arbitrage model price implied
from the swaptions and its market price expressed as a percentage of the market price. The model price is
obtained from equation (17) using the model parameters (and implied volatility state variables) estimated
from the swaptions data. The dataset consists of 220 weekly observations on each series from January
24, 1997 to April 6, 2001.

Maturity Mean Percent Pricing Errors Mean Absolute Percent Errors


(4,0) (4,1) (4,2) (3,3) (4,3) (4,0) (4,1) (4,2) (3,3) (4,3)
2 -3.04 0.21 6.07 -2.82 4.52 10.96 6.27 7.26 4.52 5.94
3 -3.71 -3.26 0.91 -4.57 0.04 10.45 5.12 4.72 5.25 4.25
4 -3.37 -3.10 0.04 -3.92 -0.47 10.67 5.06 4.58 5.12 4.36
5 -3.35 -3.92 -1.51 -4.43 -1.77 10.53 5.35 4.51 5.33 4.45
7 -1.69 -3.33 -1.51 -3.44 -1.64 10.16 5.44 4.34 4.86 4.35
10 0.81 -2.07 -0.28 -1.88 -0.49 9.43 5.24 3.86 4.14 3.92
Average -2.39 -2.58 0.62 -3.51 0.03 10.36 5.41 4.88 4.87 4.54

28
Table 5: Maximum Likelihood Estimation of the GA4,3 Model
This table reports the results of maximum likelihood estimation of the GA4,3 model. There are four factors
driving the innovation of bond yields. The first three factors display unspanned stochastic volatility, and
the fourth factor has constant volatility. The model is estimated with a panel dataset of 220 weekly
observations on 34 at-the-money-forward European swaptions from January 24, 1997 to April 6, 2001.
Panel A reports the estimates for κi , θi and σi (i = 1, 2, 3) that govern the risk-neutral dynamics of
the volatility state variables. The λi ’s are the market prices of volatility risk. The standard errors of
parameter estimates reported in the parentheses are obtained by calculating the inverse of the information
matrix based on the Hessian of the likelihood function. Panel B reports the sample correlations between
the yield factors and each volatility state variable, as well as the correlations between the implied volatility
state variables. Panel C reports the sample mean of the implied variances of the first three yield factors
and their unconditional variances.

Panel A: Parameter Estimates

κ 100 θ σ λ
ν1 0.0509 0.0354 0.0081 -0.0582
(0.0016) (0.0091) (0.0033) (0.1811)
ν2 1.9703 0.0041 0.0138 -0.1479
(0.0329) (0.0001) (0.0056) (0.4186)
ν3 2.6144 0.0018 0.0079 -0.2007
(0.3945) (0.0003) (0.0032) (0.2936)
ν4 - 0.0026 - -
- (0.0002) - -

Panel B: Correlations between Yield Factors and Volatility Factors

Factor Yield Factors Volatility Factors


z1 z2 z3 z4 ν1 ν2 ν3
z1 1
z2 -0.0000 1
z3 -0.0000 0.0000 1
z4 -0.0000 -0.0000 0.0000 1
ν1 -0.0302 0.0084 -0.0162 -0.0579 1
ν2 0.0028 -0.0362 0.0613 0.0714 0.0955 1
ν3 -0.0291 -0.0434 -0.0791 -0.1288 0.3488 0.1473 1

Panel C: Unconditional and Average Implied Factor Variance

103 ν1 103 ν2 103 ν3


Historical 0.4584 0.0617 0.0159
Avergae Implied 0.4428 0.0761 0.0178

29
Figure 1: Time Series of Swaption Implied Volatilities
This figure plots the time series of implied volatilities for 4 at-the-money-forward European-style swap-
tions. The data are mid-market quotes of annualized implied volatilities measured in percentage. The
sample is weekly from January 24, 1997 to April 6, 2001.

28
0.5 into 1
5 into 1
0.5 into 5
26
5 into 5

24

22
Swaption Implied Volatility

20

18

16

14

12

10

8
01/24/97 07/25/97 01/23/98 07/24/98 01/22/99 07/23/99 01/21/00 07/22/00 01/20/01
Date

30
Figure 2: Time Series of Pricing Errors for Swaptions and Interest Rate Caps
This graph plots the time series of root mean squared pricing errors (RMSE) for swaptions and interest
rate caps under the GA4,3 model. The model is estimated via maximum likelihood using 34 at-the-
money-forward European swaptions. Panel A plots the RMSE of these 34 swaptions. Panel B plots the
RMSE for interest rate caps with maturity two, three, four, five, seven and ten years. For each interest
rate cap, the pricing error is calculated as the difference between its no-arbitrage value implied from the
swaptions according to the GA4,3 model and its market price, expressed as a percentage of the market
price. The dataset consists of 220 weekly observations on each series from January 24, 1997 to April 6,
2001.

Swaptions
Root Mean Squared Percent Error

0
01/24/97 11/24/97 09/24/98 07/25/99 05/24/00 03/24/01
Date
Interest Rate Caps
Root Mean Squared Percent Error

40

30

20

10

0
01/24/97 11/24/97 09/24/98 07/25/99 05/24/00 03/24/01
Date

31
Figure 3: Average Implied Covariances versus Unconditional Covariances
This graph compares the time series average of the option-implied conditional covariances of the six-month
forward rates (up to 10 years in maturity) under the GA4,3 model to the their unconditional estimates.
Panel A plots the average implied volatility and the sample standard deviation of the six-month forward
rates (both annualized). Panel B plots the difference between the average implied correlations and the
sample correlations based on weekly data from January 24, 1997 to April 6, 2001. The implied volatilities
and implied correlations are calculated according to the covariance structure specified in equation (12)
under the estimated GA4,3 model.

Volatility of Six−Month Forward Rates


0.014
Average Implied
0.013 Unconditional

0.012

0.011

0.01

0.009

0.008
1 2 3 4 5 6 7 8 9 10
Maturity
Difference Between Average Implied and Unconditional Correlations

0.1

0.05

−0.05

−0.1
9 8 7 6 8 9
5 6 7
4 3 4 5
2 2 3
1 1
Maturity Maturity

32
Figure 4: Conditional Covariances: GARCH versus Option-Implied
This graph compares the conditional volatilities and correlations of the six-month Libor forward rates
implied from the swaptions according to my GA4,3 model to those estimated from the historical bond
prices according to Engle (2002)’s GARCH model with dynamic conditional correlations. Panel A illus-
trates two estimates of the volatility of the six-month forward rate with two-year maturity. Panel B plots
two estimates of the correlation between the two-year maturity and five-year maturity six-month forward
rates. In both panels, the horizonal line marks the unconditional estimate. The data sample is weekly
from January 24, 1997 to April 6, 2001.

0.02

0.015
Volatility

0.01

GARCH(1,1)
Option−Implied
0.005
01/24/97 11/24/97 09/24/98 07/25/99 05/24/00 03/24/01
Date

0.9

0.8
Correlation

0.7

0.6

0.5 Bivariate GARCH


Option−Implied
0.4
01/24/97 11/24/97 09/24/98 07/25/99 05/24/00 03/24/01
Date

33
Appendix

Proof of Proposition 1:
Under the forward risk-neutral measure Qτ , Sj (t) is a martingale, since it differs from
D(t, τ, τj ) only by a constant, for all j = 1, · · · , 2(T −τ ). Moreover, the covariances among
{d log D(t, τ, τj )}j and {d log Sj }j are the same. Let S(t) be a vector of length 2(T − τ )
that stacks all Sj (t). Denote Σt as the instantaneous covariance matrix of d log S and Rt
0
as the Cholesky decomposition of Σt so that Rt Rt = Σ. Using equations (12) and (13),
Σt can be expressed explicitly in terms of U and νk (t), k = 1, · · · , n, as follows: for any
time t < τ = i/2, let integer m be such that m/2 ≤ t < (m + 1)/2, then
0 0 0 0
Σt = (1 − 2(t − m/2)) A1 U Λt U A1 + 2(t − m/2) A2 U Λt U A2

where A1 and A2 are both 2(T − τ ) by 20 matrix. All elements of A1 (resp. A2 ) are zero,
except that the 2(T − τ ) by 2(T − τ ) submatrix consisting of i − m + 1th to i − m + jth
column (resp. from i − mth to i + j − 1 − mth column) is a lower triangular matrix whose
elements on and below diagonal are 1. It follows each variance and covariance term in Σt
is linear in the volatility state variables νk (t), k = 1, · · · , N .
Let dZt be 2(T − τ ) dimension standard Brownian motions, then under Qτ ,

dS(t)
= Rt dZt
S(t)

By Ito’s lemma and definition of G, this implies that


2(T −τ )
X 1 0 0
d log G̃ = ω̃j d log Sj = − ω̃ diag(Σ)dt + ω̃ Rt dZt
j=1 2

where diag is an operator that takes the diagonal of a matrix. Note that if νk (t) is
deterministic instead of following process (7), then G̃(τ ) is lognormal.
Now I calculate the expectation in equation (14) via the law of iterated expectation
by first conditioning on a vector V̄ which stacks the average values of νk (t) over time
interval [0, τ ], for k = 1, · · · , n. Based on the assumption that the volatility state vari-
ables are instantaneously uncorrelated with innovations in the yield curve, and following
an argument of Hull-White (1987) (see their lemma on P284-285), G̃(τ ) is lognormally
distributed conditional on V̄ :
G̃(τ ) = exp(ετ − µτ ) (21)
0
where µ = − 12 ω̃ diag(Σ̄) and ετ is a normal mean zero random variable whose variance
0
is (ω̃ Σ̄ω̃)τ . Σ̄ is the average covariance matrix of S over [0, τ ] corresponding to V̄ . To
calculate the expectation in (14), I use the following simple lemma:

Lemma 1 Let ξ be a Gaussian random variable with zero mean and the variance σ 2 . For

34
any strictly positive numbers a and b, I have
³ 2
´
E max(aeξ−0.5σ − b, 0) = aN (h) − bN (h − σ)

where h = σ −1 ln(a/b) + 0.5σ.


τ
Note that EQ [Ãτ ] = 1 since each Sj is a martingale under Qτ and Sj (0) = 1. Hence
τ
g = EQ [G̃(τ )]. Apply lemma 1 to G̃(τ ) as in (21), it follows that the price of a τ by T
at-the-money-forward swaption is approximately
τ
³ h ³ ´ i´
P = D(0, τ ) EQ

E M ax G̃τ − g, 0 |V̄
· ¸
Qτ 1√ 0 1√ 0
= D(0, τ ) EV̄ N ( ω̃ Σ̄ω̃τ ) − N (− ω̃ Σ̄ω̃τ )
2 2
· µ q ¶ ¸
1 τ
= D(0, τ ) 2N ω̃ 0 EQ V̄
[Σ̄] ω̃τ − 1)
2
Here I use the well known fact at-the-money option is almost linear in the Black volatility
which follows from the property of the normal cumulative density function N (·) and the
fact that expectation operator is linear.
To finish the evaluation of the expectation above, I just need to compute the average
expected value of the ν’s from time 0 to τ and hence the average expected covariance
matrix of the forward bonds involved in pricing τ by T swaption. This can be done with
simple but tedious algebra, using the conditional expectation of a mean reverting process:

E0 [νj (t)] = e−κj t νj (0) + (1 − e−κj t )θj

Proof of Proposition 2: A cap on six-month Libor rate of final maturity T year with
cap rate R consists of 2 ∗ T − 1 caplets Ci , i = 1, . . . , 2T − 1. Let τi = 2i and D(t, τi , τi+1
be the forward Libor bond price. Each caplet Ci protects the six-month Libor rate Li
applicable between time [τi , τi+1 ] year from rising above R. Its pays off 21 max(Li − R, 0)
per unit dollar of principal at time τi+1 . Since Li = 2( D(τi ,τ1i ,τi+1 ) − 1), the payoff of caplet
Ci discounted to time τi can be rewritten as
1 1 1 1
max(Li − R, 0) = (1 + 0.5R)max( − , 0)
1 + 0.5Li 2 1 + 0.5R 1 + 0.5Li
1
= (1 + 0.5R)max( − D(τi , τi , τi+1 ), 0)
1 + 0.5R
Hence each caplet Ci is a European put option on forward Libor bond D(t, τi , τi ), with
1
a strike price 1+0.5R and maturing at τi . A cap can be also viewed as a portfolio of put
options on forward Libor bond. I can price each caplet Ci using the corresponding forward
measure Qτi . The key quantity is the average expected variance of each forward Libor
bond (of fixed maturity), which can be calculated from equations (12), (7) and (13).

35
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