Most previous empirical studies using the Heath–Jarrow–Morton model (hereafter referred to as the HJM model) have focused on the one-factor model. In contrast, this study implements the Das (1999) two-factor Poisson–Gaussian version of the HJM model that incorporates a jump component as the second-state variable. This study aims at examining the performance of the two-factor model through comparing it with the one-factor model in pricing and hedging the Eurodollar futures option.
The degree of impact arising from the jump factor also is examined. In addition, three new volatility specifications are constructed to enhance further the pricing performance of the model. Their performances are compared according to three performance yardsticks—in-sample fitting, out-of-sample pricing, and the hedging test. The result indicates that
the two-factor model outperforms the one-factor model in both the in-sample and out-sample price fitting, but the one-factor model performs better in the hedging test. In addition, the HJM model, coupled with the proposed volatility specification, leads to good fitting results that will be of considerable use to practitioners and academics in guiding
model choice for interest-rate derivatives.