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

40 Pages Posted: 18 Jun 2009

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)

Danske Bank - Danske Markets ( email )

Holmens Kanal 2-12
DK-1092 Copenhagen K
Denmark

Timur Misirpashaev

Bloomberg LP ( email )

731 Lexington Ave
New York, NY 10022
United States

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