Using 3 years of interest rate caps price data, we provide a comprehensive documentation of volatility smiles in the caps market. To capture the volatility smiles, we develop a multifactor term structure model with stochastic volatility and jumps that yields a closed-form formula for cap prices. We show that although a three-factor stochastic volatility model can price at-the-money caps well, significant negative jumps in interest rates are needed to capture the smile. The volatility smile contains information that is not available using only at-the-money caps, and this information is important for understanding term structure models. THE EXTENSIVE LITERATURE ON MULTIFACTOR DYNAMIC term structure models (hereafter, DTSMs) of the last decade mainly focuses on explaining bond yields and swap rates (see Dai and Singleton (2003) and Piazzesi (2003) for surveys of the literature). The pricing and hedging of over-the-counter interest rate derivatives such as caps and swaptions has attracted attention only recently. World-wide, caps and swaptions are among the most widely traded interest rate derivatives. According to the Bank for International Settlements, in recent years, their combined notional value exceeds 10 trillion dollars, which is many times larger than that of exchange-traded options. The accurate and efficient pricing and hedging of caps and swaptions is therefore of enormous practical importance. Moreover, because cap and swaption prices may contain information on term structure dynamics not contained in bond yields or swap rates (see Jagannathan, Kaplin, and Sun (2003) for a related discussion), Dai and Singleton (2003 p. 670) argue that there is an "enormous potential for new insights from using (interest rate) derivatives data in model estimations."The extant literature on interest rate derivatives primarily focuses on two issues (see Section 5 of Dai and Singleton (
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