Average Interest Rate Caps
Posted: 3 May 1998
Date Written: June 1996
There exist a number of approximation methods for the price of average rate options, when the underlying asset is a currency or equity. Realistic pricing models for average interest rate caps based on interbank offered rates have not yet been published. In this paper, we propose to adapt the methods of Levy (1992), Vorst (1992) and Rogers and Shi (1995) for average rate options to price average interest rate caps and compare their computational efficiencies. All three methods are very fast, compared to the Monte Carlo simulation. Two of them are fast enough for on-the-fly calculations. The underlying interest rate model we use is consistent with the observed term structure of interest rate. Hence, the models developed here are suitable for practical implementation.
JEL Classification: G13
Suggested Citation: Suggested Citation