PRICING CMS SPREAD OPTIONS IN A LIBOR MARKET MODEL

Denis Belomestny (), Anastasia Kolodko () and John Schoenmakers ()
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Denis Belomestny: Weierstrass Institute for Applied Analysis and Stochastics, Mohrenstr. 39, 10117, Berlin, Germany
Anastasia Kolodko: Weierstrass Institute for Applied Analysis and Stochastics, Mohrenstr. 39, 10117, Berlin, Germany
John Schoenmakers: Weierstrass Institute for Applied Analysis and Stochastics, Mohrenstr. 39, 10117, Berlin, Germany

International Journal of Theoretical and Applied Finance (IJTAF), 2010, vol. 13, issue 01, 45-62

Abstract: We present two approximation methods for the pricing of CMS spread options in Libor market models. Both approaches are based on approximating the underlying swap rates with lognormal processes under suitable measures. The first method is derived straightforwardly from the Libor market model. The second one uses a convexity adjustment technique under a linear swap model assumption. A numerical study demonstrates that both methods provide satisfactory approximations of spread option prices and can be used for calibration of a Libor market model to the CMS spread option market.

Keywords: CMS spread option; Margrabes formula; Libor market model (search for similar items in EconPapers)
Date: 2010
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DOI: 10.1142/S021902491000567X

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