Implied volatility of interest rate options: An empirical investigation of the market model

We analyze the empirical properties of the volatility implied in options on the 13-week US Treasury bill rate. These options have not been studied previously. It is shown that a European style put option on the interest rate is equivalent to a call option on a zero-coupon bond. We apply the LIBOR market model and conduct a battery of validity tests to compare three different volatility specifications: constant, affine, and exponential volatility. It appears that the additional parameter in the affine and the exponential volatility function is not justified. Overall, the LIBOR market model fares well in describing these options. © 2002 Kluwer Academic Publishers.