This study evaluates two one-factor, two two-factor, and two three-factor implied volatility functions in the HJM class, with the use of eurodollar futures options across both strike prices and maturities. The primary contributions of this article are (a) to propose and test three implied volatility multifactor functions not considered by K. I. Amin and A. J. Morton (1994), (b) to evaluate models using the AIC criteria as well as other standard criteria neglected by S. Y. M. Zeto (2002), and (c) to find that multifactor models incorporating the exponential decaying implied volatility functions generally outperform other models in fitting and prediction, in sharp contrast to K. I. Amin and A. J. Morton, who find the constantvolatility model superior. Correctly specified and calibrated simple constant and square-root factor models may be superior to inappropriate multifactor models in option trading and hedging strategies.

This study proposes the implied deterministic volatility function (IDVF) for the volatility as the function of moneyness and time in the Heath, Jarrow, and Morton (1992) model to price and hedge Euribor options across moneyness and maturities from 1 January 2003 to 31 December 2005. The IDVF models are extended to two-and three-factor models, indicating that they are potential candidates for interest rate risk management. Based on the criteria of in-sample fitting, prediction, and hedging, it is found that two-factor IDVF models provide the best in-sample and prediction performance, whereas three-factor IDVF models yield the best results for hedging. Correctly specified multifactor models with the volatility as the function of moneyness and time can replace inappropriate onefactor models.

Jump-diffusion models, HJM models, Volatility smile, Euribor options, G12, G13,

No abstract

Campbell and Shiller (1991) find the presence of term structure anomaly, in which the slope of the term structure predicts inconsistently to the change in yield of longer term bonds over the life of shorter term bonds during 1952–1987. Focusing on the post Campbell and Shiller period, our findings suggest that the anomaly is not only attributed to term premia but also relates to expectation errors. We found that macroeconomic surprises and irrationality from investors' behaviour are important determinants of time‐varying expectation errors. These factors are capable of explaining the rejection of the expectation hypothesis and the U.S. term structure anomaly in long‐term securities.