Systematic Generation of Parametric Correlation Structures for the LIBOR Market Model

John Schoenmakers () and Brian Coffey
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John Schoenmakers: Weierstrass Institute, Mohrenstrasse 39, D-10117 Berlin, Germany;
Brian Coffey: Merrill Lynch, Ropemaker Place, 25 Ropemaker Street, London EC2Y 9LY, UK

International Journal of Theoretical and Applied Finance (IJTAF), 2003, vol. 06, issue 05, 507-519

Abstract: We present a conceptual approach of deriving parsimonious correlation structures suitable for implementation in the LIBOR market model. By imposing additional constraints on a known ratio correlation structure, motivated by economically sensible assumptions concerning forward LIBOR correlations, we yield a semi-parametric framework of non-degenerate correlation structures with realistic properties. Within this framework we derive systematically low parametric structures with, in principal, any desired number of parameters. As illustrated, such structures may be used for smoothing a matrix of historically estimated LIBOR return correlations. In combination with a suitably parametrized deterministic LIBOR volatility norm we so obtain a parsimonious multi-factor market model which allows for joint calibration to caps and swaptions. See Schoenmakers [14] for a stable full implied calibration procedure based on the correlation structures developed in this paper.

Keywords: LIBOR models; correlation structures; calibration (search for similar items in EconPapers)
Date: 2003
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Citations: View citations in EconPapers (10)

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DOI: 10.1142/S0219024903002055

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