Pricing Interest Rate Caps and Floors under the Pearson-Sun Interest Rate Model

Abstract

Interest rate derivatives are largely used to manage interest rate risk. For this reason, the accuracy of their pricing is very important as mispricing can result in huge financial losses. In this study, the Pearson-Sun model, an extension of the CIR model, was used to price interest rate caps and floors. In the pricing process, the prices of zero-coupon bonds and European options on zero-coupon bonds were derived. These were then used to obtain the prices of caps and floors. The parameters of the Pearson-Sun model were estimated using maximum likelihood method on a daily term structure time series data. The results of the study showed that the CIR model is rejected in favour of the Pearson-Sun model. This implies that it would provide a better pricing accuracy as compared to the CIR model and would provide better prices to interest rate derivatives. The prices of caps and floors were simulated using the estimated parameters under the Pearson-Sun model.