Stochastics Volatility Corrections for Interest Rate Models

Abstract

This paper is mainly focused on how to price the interest rate derivatives by stochastic volatility models. We will use CIR model and introduce a new Ito process to the model with fast mean-reverting stochastic volatility to compute the corrections of interest rate derivatives. There is a significant difference of the shape of yield curves between the corrected model and original CIR model. It can also be used to price interest rate derivatives such as bond options.