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Projection on a Quadratic Model by Asymptotic Expansion with an Application to LMM Swaption

40 Pages Posted: 18 Jun 2009  

Alexandre Antonov

Numerix

Timur Misirpashaev

Merrill Lynch & Co.

Date Written: June 16, 2009

Abstract

We develop a technique of parameter averaging and Markovian projection on a quadratic volatility model based on a term-by-term matching of the asymptotic expansions of option prices in volatilities.

In doing so, we revisit the procedure of asymptotic expansion and show that the use of the product formula for iterated Ito integrals leads to a considerable simplification in comparison with the approach currently prevalent in the literature.

Results are applied to the classic problem of LIBOR Market Model (LMM) swaption pricing. We confirm numerically that the retention of the quadratic term gives a marked improvement over the standard approximation based on the projection on a displaced diffusion.

Keywords: asymptotic expansion, Markovian projection, skew averaging, quadratic volatility model, LIBOR Market Model, swaption, Wiener chaos

JEL Classification: C1, C3, C5, C6

Suggested Citation

Antonov, Alexandre and Misirpashaev, Timur, Projection on a Quadratic Model by Asymptotic Expansion with an Application to LMM Swaption (June 16, 2009). Available at SSRN: https://ssrn.com/abstract=1421139 or http://dx.doi.org/10.2139/ssrn.1421139

Alexandre Antonov (Contact Author)

Numerix ( email )

58 bis rue de la Chaussee d'Antin
Paris, 75009
France

Timur Misirpashaev

Merrill Lynch & Co. ( email )

4 World Financial Center
New York, NY 10080
United States

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