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Time-changed Lévy LIBOR market model: Pricing and joint estimation of the cap surface and swaption cube

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  • Leippold, Markus
  • Strømberg, Jacob

Abstract

We propose a novel time-changed Lévy LIBOR (London Interbank Offered Rate) market model for jointly pricing of caps and swaptions. The time changes are split into three components. The first component allows matching the volatility term structure, the second generates stochastic volatility, and the third accommodates for stochastic skew. The parsimonious model is flexible enough to accommodate the behavior of both caps and swaptions. For the joint estimation we use a comprehensive data set spanning the financial crisis of 2007–2010. We find that, even during this period, neither market is as fragmented as suggested by the previous literature.

Suggested Citation

  • Leippold, Markus & Strømberg, Jacob, 2014. "Time-changed Lévy LIBOR market model: Pricing and joint estimation of the cap surface and swaption cube," Journal of Financial Economics, Elsevier, vol. 111(1), pages 224-250.
  • Handle: RePEc:eee:jfinec:v:111:y:2014:i:1:p:224-250
    DOI: 10.1016/j.jfineco.2013.08.016
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    References listed on IDEAS

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    More about this item

    Keywords

    LIBOR market models; Time-changed Lévy process; Caps volatilities; Swaption cube; Unscented Kalman filter;

    JEL classification:

    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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