MARKOV MARKET MODEL CONSISTENT WITH CAP SMILE

P. Balland () and L. P. Hughston ()
Additional contact information
P. Balland: Merrill Lynch International, 25 Ropemaker Street, London EC2Y 9LY, UK
L. P. Hughston: Department of Mathematics, King's College London, The Strand, London WC2R 2LS, UK

International Journal of Theoretical and Applied Finance (IJTAF), 2000, vol. 03, issue 02, 161-181

Abstract: New interest rate models have emerged recently in which distributional assumptions are made directly on financial observables. In these "Market Models" the Libor rates have a log-normal distribution in the corresponding forward measure, and caps are priced according to the Black–Scholes formula. These models present two disadvantages. First, Libor rates do not in reality have a log-normal distribution since the implied volatility of a cap depends typically on the strike. Second, these models are difficult to use for pricing derivatives other than caps. In this paper, we extend these models to allow for a broader class of Libor rate distributions. In particular, we construct multi-factor Market Models that are consistent with an initial cap smile surface, and have the useful feature of exhibiting Markovian Libor rates. We show that these Markov Market Models can be used relatively easily to price complex Libor derivatives, such as Bermudan swaptions, captions or flexi-caps, by construction of a tree of Libor rates.

Keywords: Interest rate term structure; HJM theory; market models; BGM models; implied libor trees (search for similar items in EconPapers)
Date: 2000
References: Add references at CitEc
Citations: View citations in EconPapers (5)

Downloads: (external link)
http://www.worldscientific.com/doi/abs/10.1142/S0219024900000085
Access to full text is restricted to subscribers

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:wsi:ijtafx:v:03:y:2000:i:02:n:s0219024900000085

Ordering information: This journal article can be ordered from

DOI: 10.1142/S0219024900000085

Access Statistics for this article

International Journal of Theoretical and Applied Finance (IJTAF) is currently edited by L P Hughston

More articles in International Journal of Theoretical and Applied Finance (IJTAF) from World Scientific Publishing Co. Pte. Ltd.
Bibliographic data for series maintained by Tai Tone Lim ().