Time-Changed Lévy LIBOR Market Model: Pricing and Joint Estimation of the Cap Surface and Swaption Cube
68 Pages Posted: 24 May 2012 Last revised: 22 May 2013
Date Written: May 1, 2013
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 find that, even during the recent financial crisis, neither market is as fragmented as suggested by the previous literature.
Keywords: LIBOR market models, time-changed Lévy process, caps volatilities, swaption cube, unscented Kalman filter
JEL Classification: C51, E43, G13
Suggested Citation: Suggested Citation