Efficient and accurate log-L\'evy approximations to L\'evy driven LIBOR models
AbstractThe LIBOR market model is very popular for pricing interest rate derivatives, but is known to have several pitfalls. In addition, if the model is driven by a jump process, then the complexity of the drift term is growing exponentially fast (as a function of the tenor length). In this work, we consider a L\'evy-driven LIBOR model and aim at developing accurate and efficient log-L\'evy approximations for the dynamics of the rates. The approximations are based on truncation of the drift term and Picard approximation of suitable processes. Numerical experiments for FRAs, caps, swaptions and sticky ratchet caps show that the approximations perform very well. In addition, we also consider the log-L\'evy approximation of annuities, which offers good approximations for high volatility regimes.
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Bibliographic InfoPaper provided by arXiv.org in its series Papers with number 1106.0866.
Date of creation: Jun 2011
Date of revision: Jan 2012
Publication status: Published in Journal of Computational Finance 2012, Vol. 15, No. 4, 3-44
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