An Assessment of the BGM-model Swap Option Pricing Performance in the Swedish Interest Rate Market

Abstract: In this thesis the ability of a full-factor and a two-factor BGM-model to determine current and predict future plain-vanilla swaption prices issued on the Stockholm Interbank Offered Rate (STIBOR) is assessed. The study is conducted on daily data from January 4 to December 30, 2005. The assessment is based on a simultaneous calibration of the BGM-model to market implied cap and swaption volatilities. The calibration is made with a parametric volatility structure and an instantaneous correlation calibration within both a full-factor and a two-factor framework. The calibrated model is used to determine current and predict future plain-vanilla swaption prices using Rebonato’s approximative formula for swaption prices. The BGM-model is found to accurately recover prices of plain-vanilla swaptions in-sample and out-of-sample on the date of calibration. The full-factor model is found to slightly outperform the two-factor BGM-model in both accurately pricing current date swaptions and predicting future swaption prices. For both model specifications, the average pricing error is found to be in an acceptable range, both for the pricing of current date swaptions and the prediction of future date swaption prices. The ability of the BGM-model to predict future plain-vanilla swaption prices is also found to decay as the prediction horizon is increased.