CRIF Working Paper No. 02015

Are Interest Rate Derivatives Spanned by the Term Structure of Interest Rates?

Title: Are Interest Rate Derivatives Spanned by the Term Structure of Interest Rates?

Authors: Massoud Heidari (Caspian Capital Management, L.L.C.) 

              Liuren Wu (Fordham University)

Contact: wu@fordham.edu

Keywords: Factors, principal component, LIBOR, swaps, swaptions, yield curve, implied volatility surface.

JEL Classification: E43, G12

Abstract: We investigate whether the same finite dimensional dynamic system spans both interest rates (the yield curve) and interest rate options (the implied volatility surface). We find that the options market exhibits factors independent of the underlying yield curve. While three common factors are adequate to capture the systematic movement of the yield curve, we need three additional factors to capture the movement of the implied volatility surface.

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