Common Correlation and Calibrating the Lognormal Forward Rate Model

Carol Alexandra ()
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Carol Alexandra: ICMA Centre, University of Reading

ICMA Centre Discussion Papers in Finance from Henley Business School, University of Reading

Abstract: 1997 three papers that introduced very similar lognormal diffusion processes for interest rates appeared virtuously simultaneously. These models, now commonly called the 'LIBOR models' are based on either lognormal diffusions of forward rates as in Brace, Gatarek & Musiela (1997) and Miltersen, Sandermann & Sondermann (1997) or lognormal diffusions of swap rates, as in Jamshidian (1997). The consequent research interest in the calibration of the LIBOR models has engendered a growing empirical literature, including many papers by Brigo and Mercurio, and Riccardo Rebonato (www.fabiomercurio.it and www.damianobrigo.it and www.rebonato.com). The art of model calibration requires a reasonable knowledge of option pricing and a thorough background in statistics - techniques that are quite different to those required to design no-arbitrage pricing models. Researchers will find the book by Brigo and Mercurio (2001) and the forthcoming book by Rebonato (2002) invaluable aids to their understanding.

Pages: 31 pages
Date: 2002-06, Revised 2003-01
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