On the Presence of Unspanned Volatility in European Interest Rate Options

In a recent paper, Collin-Dufresne and Goldstein (2002) show that the movements of the yield curve and of interest rate derivatives are mostly uncorrelated, advocating the presence of unspanned volatility. This letter shows that their results can be explained in the framework of a Gaussian HJM model with humped term-structure volatility. This implies that hedging interest rate derivatives with interest rate swaps is not ruled out.