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Multifactor implied volatility functions for HJM models

✍ Scribed by I-Doun Kuo; Dean A. Paxson

Publisher: John Wiley and Sons
Year: 2006
Tongue: English
Weight: 489 KB
Volume: 26
Category: Article
ISSN: 0270-7314
DOI: 10.1002/fut.20215

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✦ Synopsis

This study evaluates two one-factor, two two-factor, and two three-factor implied volatility functions in the HJM class, with the use of eurodollar futures options across both strike prices and maturities. The primary contributions of this article are (a) to propose and test three implied volatility multifactor functions not considered by K. I. Amin and A. J. Morton (1994), (b) to evaluate models using the AIC criteria as well as other standard criteria neglected by S. Y. M. Zeto (2002), and (c) to find that multifactor models incorporating the exponential decaying implied volatility functions generally outperform other models in fitting and prediction, in sharp contrast to K. I. Amin and A. J. Morton, who find the constantvolatility model superior. Correctly specified and calibrated simple constant and square-root factor models may be superior to inappropriate multifactor models in option trading and hedging strategies.

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