Efficient and Accurate Log-Levy Approximations of Levy-Driven LIBOR Models

Antonis Papapantoleon, John Schoenmakers, David Skovmand

Research output: Contribution to journalJournal articleResearchpeer-review

Abstract

The LIBOR market model is very popular for pricing interest rate derivatives
but is known to have several pitfalls. In addition, if the model is driven by a
jump process, then the complexity of the drift term grows exponentially fast (as
a function of the tenor length). We consider a Lévy-driven LIBOR model and
aim to develop accurate and efficient log-Lévy approximations for the dynamics
of the rates. The approximations are based on the truncation of the drift term
and on Picard approximation of suitable processes. Numerical experiments for
forward-rate agreements, caps, swaptions and sticky ratchet caps show that the
approximations perform very well. In addition, we also consider the log-Lévy
approximation of annuities, which offers good approximations for high-volatility
regimes.
Original languageEnglish
JournalJournal of Computational Finance
Volume15
Issue number4
Pages (from-to)3-44
ISSN1460-1559
Publication statusPublished - 2012

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