Implementation of the BDT Model with Different Volatility Estimators

Abstract

Different volatility estimators have different effects on the pricing of interest rate-sensitive options by the single-factor Black, Derman, and Toy model. The estimators used here include the moving average, such as constantly weighted and exponentially weighted moving average, and time series models, such as generalized autoregressive conditional heteroscedasticity (GARCH) and integrated GARCH (IGARCH), for estimating the volatility of short rates. Empirical results, based on 4,228 estimated prices, indicate that valuation of Eurodollar futures options is sensitive to the volatility model used. The time series models provide a more accurate representation of the underlying time-varying volatility structure than the moving average models.