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Time-Changed Lévy LIBOR Market Model: Pricing and Joint Estimation of the Cap Surface and Swaption CubeMarkus LeippoldUniversity of Zurich - Department of Banking and Finance; Swiss Finance Institute; University of Zurich - Faculty of Economics, Business Administration and Information Technology Jacob StrombergSwiss Finance Institute May 18, 2012 Swiss Finance Institute Research Paper No. 12-23 Abstract: We propose a novel time-changed Lévy LIBOR market model for the joint pricing of caps and swaptions. The time changes are split into three components. The first component allows us to match the volatility term structure, the second generates stochastic volatility, and the third one accommodates for stochastic skew. The model is parsimonious, yet flexible enough to accommodate the behavior of both caps and swaptions well. For the joint estimation we use a comprehensive dataset spanning the recent financial crisis. We fi nd that, even during the recent fi nancial crisis, neither market is as fragmented as suggested by the previous literature.
Number of Pages in PDF File: 68 Keywords: LIBOR market models, time-changed Lévy process, caps volatilities, swaption cube, unscented Kalman filter JEL Classification: C51, E43, G13 working papers seriesDate posted: May 24, 2012 ; Last revised: May 17, 2013Suggested CitationContact Information
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