An Efficient Lattice Algorithm for the Libor Market Model
CIBC World Markets - Risk Quant, Capital Markets, CIBC
June 18, 2011
Journal of Derivatives, Forthcoming
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 (or tree) 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.
Number of Pages in PDF File: 31
Keywords: LIBOR Market Model, LMM lattice or tree, BGM lattice or tree, shifted forward measure, drift approximation, risk management, calibration, callable exotics, callable bond, callable capped floater swap, callable inverse floater swap, callable range accrual swap
JEL Classification: G1, C5, C6, F1Accepted Paper Series
Date posted: August 26, 2011 ; Last revised: September 25, 2011
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