An Empirical Comparison of Forward-Rate and Spot-Rate Models for Valuing Interest-Rate Options


  • Bühler and Uhrig-Homburg are from the University of Mannheim, Germany. Walter is at Deutsche Genossenschaftsbank, Germany. Weber is at Infinity Financial Technology, London. We thank Michael Dempster, Darrell Duffie, Stewart Hodges, Wolfgang Schmidt, and Dieter Sondermann. We are especially grateful for the comments by Stephen Figlewski, Olaf Korn, and Stuart Turnbull. The paper has also greatly benefited from comments made at the Warwick Option Conference 1995, the European Financial Management Association Conference 1997, and the Finance seminars at Ecole Supérieure des Sciences Economiques et Commerciales, Paris; Eidgenössische Hochschule, Zürich; and Erasmus University, Rotterdam. Additional thanks go to an anonymous referee and René Stulz for helping us to sharpen our focus.


Our main goal is to investigate the question of which interest-rate options valuation models are better suited to support the management of interest-rate risk. We use the German market to test seven spot-rate and forward-rate models with one and two factors for interest-rate warrants for the period from 1990 to 1993. We identify a one-factor forward-rate model and two spot-rate models with two factors that are not significantly outperformed by any of the other four models. Further rankings are possible if additional criteria are applied.