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

See all articles by Linus Kaisajuntti

Linus Kaisajuntti

Stockholm School of Economics - Department of Finance

Joanne Kennedy

University of Warwick - Department of Statistics

Date Written: July 17, 2011

Abstract

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

Kaisajuntti, Linus and Kennedy, Joanne E., An N-Dimensional Markov-Functional Interest Rate Model (July 17, 2011). Journal of Computational Finance, Vol.17, Issue 1, 2013. Available at SSRN: https://ssrn.com/abstract=1081337 or http://dx.doi.org/10.2139/ssrn.1081337

Linus Kaisajuntti (Contact Author)

Stockholm School of Economics - Department of Finance ( email )

SE-113 83 Stockholm
Sweden

Joanne E. Kennedy

University of Warwick - Department of Statistics ( email )

Coventry CV4 7AL
United Kingdom

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