IMPLIED DETERMINISTIC VOLATILITY FUNCTIONS: AN EMPIRICAL TEST FOR EURIBOR OPTIONS

This study proposes the implied deterministic volatility function (IDVF) for the volatility as the function of moneyness and time in the Heath, Jarrow, and Morton (1992) model to price and hedge Euribor options across moneyness and maturities from I January 2003 to 31 December 2005. The IDVF models are extended to two- and three-factor models, indicating that they are potential candidates for interest rate risk management. Based on the criteria of in-sample fitting, prediction, and hedging, it is found that two-factor IDVF models provide the best in-sample and prediction performance, whereas three-factor IDVF models yield the best results for hedging. Correctly specified multifactor models with the volatility as the function of moneyness and time can replace inappropriate one-factor models. (C) 2009 Wiley Periodicals, Inc. Jrl Fut Mark 29:319-347, 2009