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Picard Approximation of Stochastic Differential Equations and Application to Libor Models

Author

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  • Antonis Papapantoleon

    () (Institute of Mathematics, TU Berlin and Quantitative Products Laboratory, Deutsche Bank AG)

  • David Skovmand

    () (Aarhus School of Business and CREATES)

Abstract

The aim of this work is to provide fast and accurate approximation schemes for the Monte Carlo pricing of derivatives in LIBOR market models. Standard methods can be applied to solve the stochastic differential equations of the successive LIBOR rates but the methods are generally slow. Our contribution is twofold. Firstly, we propose an alternative approximation scheme based on Picard iterations. This approach is similar in accuracy to the Euler discretization, but with the feature that each rate is evolved independently of the other rates in the term structure. This enables simultaneous calculation of derivative prices of different maturities using parallel computing. Secondly, the product terms occurring in the drift of a LIBOR market model driven by a jump process grow exponentially as a function of the number of rates, quickly rendering the model intractable. We reduce this growth from exponential to quadratic using truncated expansions of the product terms. We include numerical illustrations of the accuracy and speed of our method pricing caplets, swaptions and forward rate agreements.

Suggested Citation

  • Antonis Papapantoleon & David Skovmand, 2010. "Picard Approximation of Stochastic Differential Equations and Application to Libor Models," CREATES Research Papers 2010-40, Department of Economics and Business Economics, Aarhus University.
  • Handle: RePEc:aah:create:2010-40
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    File URL: ftp://ftp.econ.au.dk/creates/rp/10/rp10_40.pdf
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    References listed on IDEAS

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    1. Alan Brace & Dariusz G¸atarek & Marek Musiela, 1997. "The Market Model of Interest Rate Dynamics," Mathematical Finance, Wiley Blackwell, vol. 7(2), pages 127-155.
    2. repec:wsi:ijtafx:v:04:y:2001:i:04:n:s0219024901001127 is not listed on IDEAS
    3. 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 409-430, March.
    4. Erik Schlögl, 2002. "A multicurrency extension of the lognormal interest rate Market Models," Finance and Stochastics, Springer, vol. 6(2), pages 173-196.
    5. Mark Joshi & Alan Stacey, 2008. "New and robust drift approximations for the LIBOR market model," Quantitative Finance, Taylor & Francis Journals, vol. 8(4), pages 427-434.
    6. Ernst Eberlein & Jean Jacod & Sebastian Raible, 2005. "Lévy term structure models: No-arbitrage and completeness," Finance and Stochastics, Springer, vol. 9(1), pages 67-88, January.
    7. Nicolas Merener & Paul Glasserman, 2003. "Numerical solution of jump-diffusion LIBOR market models," Finance and Stochastics, Springer, vol. 7(1), pages 1-27.
    8. Ernst Eberlein & Fehmi Özkan, 2005. "The Lévy LIBOR model," Finance and Stochastics, Springer, vol. 9(3), pages 327-348, July.
    9. Paul Glasserman & S. G. Kou, 2003. "The Term Structure of Simple Forward Rates with Jump Risk," Mathematical Finance, Wiley Blackwell, vol. 13(3), pages 383-410.
    10. Tim Dun & Geoff Barton & Erik Schlögl, 2001. "Simulated Swaption Delta–Hedging In The Lognormal Forward Libor Model," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 4(04), pages 677-709.
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    Cited by:

    1. Antonis Papapantoleon & John Schoenmakers & David Skovmand, 2011. "Efficient and accurate log-Lévi approximations to Lévi driven LIBOR models," CREATES Research Papers 2011-22, Department of Economics and Business Economics, Aarhus University.

    More about this item

    Keywords

    LIBOR models; Lévy processes; Picard approximation; drift expansion; parallel computing.;

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques

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