Consistent calibration of HJM models to cap implied volatilities

Abstract

This article proposes a calibration algorithm that fits multifactor Gaussian models to the implied volatilities of caps with the use of the respective minimal consistent family to infer the forward-rate curve. The algorithm is applied to three forward-rate volatility structures and their combination to form two-factor models. The efficiency of the consistent calibration is evaluated through comparisons with nonconsistent methods. The selection of the number of factors and of the volatility functions is supported by a principal-component analysis. Models are evaluated in terms of in-sample and out-of-sample data fitting as well as stability of parameter estimates. The results are analyzed mainly by focusing on the capability of fitting the market-implied volatility curve and, in particular, reproducing its characteristic humped shape. © 2005 Wiley Periodicals, Inc. Jrl Fut Mark 25:1093–1120, 2005

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