The performance of multi-factor term structure models for pricing and hedging caps and swaptions

We empirically compare a wide range of term structure models used in the pricing and, in particular, hedging of caps and swaptions. We analyze the influence of the number of factors on the hedging, and pricing results, and investigate the type of data-interest rate or derivative price-in combination with the estimation technique that should be used to obtain the best hedging and pricing results. We use data on interest rates, and cap and swaption prices from 1995-1999. The empirical results show that, if the number of hedge instruments is equal to the number of factors, multi-factor models outperform one-factor models in hedging caps and swaptions. However, if one uses a large set of hedge instruments, one-factor models perform as well as multi-factor models. We find that models with two or three factors imply better out-of-sample predictions of cap and swaption prices than one-factor models. Estimation on the basis of current derivative prices leads to more accurate out-of-sample prediction of cap and swaption prices than estimation on the basis of interest rate data.