An N-Dimensional Markov-Functional Interest Rate Model
Journal of Computational Finance, Vol.17, Issue 1, 2013
44 Pages Posted: 9 Jan 2008 Last revised: 17 Nov 2019
Date Written: July 17, 2011
This paper develops an n-dimensional Markov-functional interest rate model, i.e. a model driven by an n-dimensional state process and constructed using Markov-functional techniques. It is shown that this model is very similar to an n-factor LIBOR market model hence allowing intuition from the LIBOR market model to be transferred to the Markov-functional model. This generalises the results of Bennett & Kennedy (2005) from one-dimensional to n-dimensional driving state processes. The model is suitable for pricing certain type of exotic interest rate derivative products such as TARNs on LIBORs or CMS spreads. For these products, the n-dimensional Markov-functional model may be used as a benchmark model allowing for powerful and flexible control of both correlations between different rates as well as skews/smiles in implied volatilities.
Keywords: Interest rate derivatives, Markov-functional models, LIBOR market models, Multi-dimensional
JEL Classification: G13
Suggested Citation: Suggested Citation