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Yes, Libor Models can capture Interest Rate Derivatives Skew : A Simple Modelling Approach

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Author Info
Eymen Errais () (Managment Science and Engineering Stanford University)
Fabio Mercurio
Abstract

We 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 in¯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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Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2005 with number 192.

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Date of creation: 11 Nov 2005
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Handle: RePEc:sce:scecf5:192

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Related research
Keywords: Libor Models; Volatility Skew; Interest Rate Derivatives;

Find related papers by JEL classification:
C6 - Mathematical and Quantitative Methods - - Mathematical Methods and Programming
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Black, Fischer, 1976. "The pricing of commodity contracts," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 167-179. [Downloadable!] (restricted)
  2. Goldstein, Robert S, 2000. "The Term Structure of Interest Rates as a Random Field," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 13(2), pages 365-84.
  3. Farshid Jamshidian, 1997. "LIBOR and swap market models and measures (*)," Finance and Stochastics, Springer, vol. 1(4), pages 293-330. [Downloadable!] (restricted)
  4. Leif Andersen, Jesper Andreasen, 2000. "Volatility skews and extensions of the Libor market model," Applied Mathematical Finance, Taylor and Francis Journals, vol. 7(1), pages 1-32, March. [Downloadable!] (restricted)
  5. Miltersen, Kristian R & Sandmann, Klaus & Sondermann, Dieter, 1997. " Closed Form Solutions for Term Structure Derivatives with Log-Normal Interest Rates," Journal of Finance, American Finance Association, vol. 52(1), pages 409-30, March. [Downloadable!] (restricted)
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  6. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June. [Downloadable!] (restricted)
  7. Santa-Clara, Pedro & Sornette, Didier, 2001. "The Dynamics of the Forward Interest Rate Curve with Stochastic String Shocks," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 14(1), pages 149-85.
  8. Feng Zhao & Robert Jarrow & Haitao Li, 2004. "Interest Rate Caps Smile Too! But Can the LIBOR Market Models Capture It?," Econometric Society 2004 North American Winter Meetings 431, Econometric Society. [Downloadable!]
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(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Marc Henrard, 2005. "Libor Market Model and Gaussian HJM explicit approaches to option on composition," Finance 0511016, EconWPA, revised 07 Dec 2005. [Downloadable!]
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