AbstractInterest rate derivatives are used for interest rate risk management. Euribor futuresand options are derivatives used for hedging short-term Euro-denominated interest raterisk. The accuracy of hedging interest rate risk is determined by how interest rateoptions are valued and how volatility is estimated. This paper proposes severaldeterministic volatility function models under Heath, Jarrow, and Morton model (HJM,1992) using intraday observations of Euribor futures and options from 1 January 2003to 31 December 2005.This paper compares models’ pricing and hedging performance for severalsingle-factor model and multifactor DVF models which have not evaluated by previousliteratures. The DVF models are models incorporating moneyness and time that intendsto capture the smile pattern observed in Euribor options across moneyness and time andthe negative relationship between option implied volatility and futures price movements.We also include multifactor models because recent literature indicated that single factormodels are outperformed by multifactor models.Three criteria, namely in-sample estimation and out-of-sample prediction are used toevaluate the performance of DVF models. If the estimated volatility function is stableacross all criteria, the result supports the DVF approach that can well describe thereported option prices. The DVF models can be used to price and hedge Euribor optionsparticularly and other interest rate contingent claims in general. On the other hand, if theestimated function is not stable, the DVF models are unreliable and other explanationsfor the HJM implied volatility patterns must be sought.
