An efficient lattice algorithm for the libor market model

Tim, Xiao (2011): An efficient lattice algorithm for the libor market model. Forthcoming in: Journal of Derivatives

Abstract

The LIBOR Market Model (LMM or BGM) has become one of the most popular models for pricing interest rate products. It is commonly believed that Monte-Carlo simulation is the only viable method available for the LIBOR Market Model. In this article, however, we propose a lattice approach to price interest rate products within the LIBOR Market Model by introducing a shifted forward measure and several novel fast drift approximation methods. This model should achieve the best performance without losing much accuracy. Moreover, the calibration is almost automatic and it is simple and easy to implement. Adding this model to the valuation toolkit is actually quite useful; especially for risk management or in the case there is a need for a quick turnaround.

• Item Type: MPRA Paper
• Language: English
• Keywords: LIBOR Market Model, LMM, BGM, lattice model, tree model, shifted forward measure, drift approximation, risk management, calibration, callable exotics, callable bond, callable capped floater swap, callable inverse floater swap, callable range accrual swap
• Subjects: C - Mathematical and Quantitative Methods > C6 - Mathematical Methods ; Programming Models ; Mathematical and Simulation Modeling; D - Microeconomics > D4 - Market Structure, Pricing, and Design; G - Financial Economics > G1 - General Financial Markets > G13 - Contingent Pricing ; Futures Pricing

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