Modeling interest rate dynamics: A New Zealand approach

Abstract

Term structure models use interest rate derivative products to depict the evolution of spot and forward interest rates. This study investigates the pricing performance of no-arbitrage interest rate option models using New Zealand derivatives data. One spot rate model and one forward rate model are calibrated to daily options data from 1997-2001, and model prices are estimated for each option's market price over this period. The models are tested for parameter stability, in-sample pricing errors, and systematic biases. The models are similar with regard to parameter stability, but the spot rate model outperforms the forward rate model in terms of percentage pricing errors. Both the spot rate and forward rate models have a tendency to underprice options, and they display systematic relationships with option variables (e.g. time-to-maturity) that are consistent with standard options theory.