This research is designed to analyze Korean interest rate derivatives, especially caps, swaptions and their relationships using the string market model framework introduced by Longstaff, Santa-Clara and Schwartz(2001). Even though caps and swaptions are traded as separate products and valued by different models, they have to satisfy Merton(1973)’s no-arbitrage relationship because they are fundamentally evaluated by the correlation of the forward rates. According to empirical results, the number of significant factors is two and swaptions whose options have longer maturities appear mispriced. Market price of swaptions is generally overvalued compared to the model prices. Cap prices calculated by the model are lower than market prices and Merton’s no-arbitrage relationship between the cap prices and swaption prices holds. However, empirical results provide that the string market model has a problem explaining the complex covariance of a change of Korean forward rates. Moreover a time-varying covariance structure is also necessary to analyze Korean interest rate derivatives accurately.
