An Empirical Analysis of the Pricing of Interest Rate Caps

An Empirical Analysis of the Pricing of Interest Rate Caps
Author(s): Jegadeesh, Narasimhan
Year: 1999
Paper Number: GBS-FIN-1999-003
Goizueta Department: Finance

Abstract

This paper evaluates the empirical performance of the Vasicek (1977) model and the extended-Vasicek model proposed by Hull and White (1990) for pricing interest rate caps and hedging their interest rate risks. I find that the Vasicek model cap prices are significantly smaller than the market prices. An important reason for this bias is that this model does not fit the term structure of futures rates particularly well. It is found that the extended-Vasicek model cap prices are closer to the market prices than the original Vasicek model. A strategy to hedge the interest rate risks of caps constructed on the bias of the extended- Vasicek model reduces over 90 percent of the cash flow variance for at-the-money caps with less than one year maturity. The effectiveness of the hedge strategy declines with the time to maturity of the caps and for three year at- the-money caps the hedge strategy reduces cash flow variance by about 63 percent.