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RFS Advance Access published online on April 28, 2008
Review of Financial Studies, doi:10.1093/rfs/hhn040
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© The Author 2008. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org

A General Stochastic Volatility Model for the Pricing of Interest Rate Derivatives

Anders B. Trolle
Copenhagen Business School

Eduardo S. Schwartz
UCLA Anderson School of Management and NBER

Address correspondence to Anders Trolle, Copenhagen Business School, Solbjerg Plads 3, A5, DK-2000 Frederiksberg, Denmark; telephone: 3815 3058; e-mail: abt.fi{at}cbs.dk.

JEL Classification: E43, G13


  Abstract

We develop a tractable and flexible stochastic volatility multifactor model of the term structure of interest rates. It features unspanned stochastic volatility factors, correlation between innovations to forward rates and their volatilities, quasi-analytical prices of zero-coupon bond options, and dynamics of the forward rate curve, under both the actual and risk-neutral measures, in terms of a finite-dimensional affine state vector. The model has a very good fit to an extensive panel dataset of interest rates, swaptions, and caps. In particular, the model matches the implied cap skews and the dynamics of implied volatilities.

We thank Leif Andersen, Pierre Collin-Dufresne, Bing Han, David Lando, Francis Longstaff, Claus Munk, Kasper Ullegård, and seminar participants at UCLA Anderson School of Management for comments. We are especially grateful for suggestions by Yacine Aït-Sahalia (the editor) and two anonymous referees that have improved the paper significantly. Anders Trolle thanks the Danish Social Science Research Council for financial support.


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