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Variance Optimal Cap Pricing Models

Author

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  • Laurent, J.P.

    (CREST)

  • Scaillet, O.

    (UNIVERSITE CATHOLIQUE DE LOUVAIN, Institut de Recherches Economiques et Sociales (IRES); UNIVERSITE CATHOLIQUE DE LOUVAIN, Institut d’Administration et de Gestion (IAG))

Abstract

We propose new closed-form pricing formulas for interest rate options which guarantee perfect compatibility with volatility smiles. These cap pricing formulas are computed under variance optimal measures in the framework of the market model or the Gaussian model and achieve an exact calibration of observed market prices. They are presented in a general setting allowing to study model and numéraire choice effects on the computed prices. Numéraire dependence is particularly emphasized. A numerical example and an empirical application on market data are given to illustrate the practical use of the calibration procedure.

Suggested Citation

  • Laurent, J.P. & Scaillet, O., 1997. "Variance Optimal Cap Pricing Models," LIDAM Discussion Papers IRES 1999002, Université catholique de Louvain, Institut de Recherches Economiques et Sociales (IRES), revised 01 Jan 1999.
    • Handle: RePEc:ctl:louvir:1999002
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    File URL: http://sites.uclouvain.be/econ/DP/IRES/9902.pdf
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    Cited by:

    1. Prigent, Jean-Luc & Renault, Olivier & Scaillet, Olivier, 2004. "Option pricing with discrete rebalancing," Journal of Empirical Finance, Elsevier, vol. 11(1), pages 133-161, January.

    More about this item

    Keywords

    Discount bond option; cap pricing formula; volatility smile; variance optimal measure; implied pricing model;
    All these keywords.

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • C4 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics

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