On Stochastic Volatility in Interest Rate Dynamics

iii In this Master Thesis we investigate the presence of stochastic volatility in interest rate dynamics and its effect on pricing interest rate derivatives. Different stochastic volatility models are compared to each other and to models where the volatility is constant. The models are calibrated to the short rate with the EMM procedure. The models are also calibrated to market data like the yield curve and swaption prices with the Kalman fil-ter method and by minimizing the sum of squares. We find that stochastic volatility is very much present in interest rate dynamics, and that models are improved by adding a stochastic volatility process. The pricing capabilities of the models are on the other hand not improved by adding a stochastic volatility factor but instead make the models considerably slower. v Acknowledgements We would like to thank our supervisor Patrik Albin for his help and encouragement, a