Yes, Libor Models can capture Interest Rate Derivatives Skew : A Simple Modelling Approach
AbstractWe introduce a simple extension of a shifted geometric Brownian motion for modelling forward LIBOR rates under their canonical measures. The extension is based on a parameter uncertainty modelled through a random variable whose value is drawn at an inÂ¯nitesimal time after zero. The shift in the proposed model captures the skew commonly seen in the cap market, whereas the uncertain volatility component allows us to obtain more symmetric implied volatility structures. We show how this model can be calibrated to cap prices. We also propose an analytical approximated formula to price swaptions from the cap calibrated model. Finally, we build the bridge between caps and swaptions market by calibrating the correlation structure to swaption prices, and analysing some implications of the calibrated model parameters
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Bibliographic InfoPaper provided by Society for Computational Economics in its series Computing in Economics and Finance 2005 with number 192.
Date of creation: 11 Nov 2005
Date of revision:
Libor Models; Volatility Skew; Interest Rate Derivatives;
Find related papers by JEL classification:
- C6 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
This paper has been announced in the following NEP Reports:
- NEP-ALL-2005-11-19 (All new papers)
- NEP-ETS-2005-11-19 (Econometric Time Series)
- NEP-FIN-2005-11-19 (Finance)
- NEP-FMK-2005-11-19 (Financial Markets)
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