Theory and Calibration of Swap Market Models

FAME Working Paper No. 107

42 Pages Posted: 27 Feb 2005

See all articles by Stefano Galluccio

Stefano Galluccio

BNP Paribas Fixed Income

O. Scaillet

Swiss Finance Institute - University of Geneva

Zhijiang Huang

JP Morgan

Jean-Michel Ly

BNP Paribas Fixed Income

Multiple version iconThere are 2 versions of this paper

Date Written: June 2005

Abstract

This paper introduces a general framework for market models, named Market Model Approach, through the concept of admissible sets of for-ward swap rates spanning a given tenor structure. We relate this concept to results in graph theory by showing that a set is admissible if and only if the associated graph is a tree. This connection enables us to enumerate all admissible models for a given tenor structure. Three main classes are identified within this framework, and correspond to the co-terminal, co-initial, and co-sliding model. We prove that the LIBOR market model is the only admissible model of a co-sliding type. By focusing on the co-terminal model in a lognormal setting, we develop and compare several approximating analytical formulae for caplets, while swaptions can be priced by a simple Black-type formula. A novel calibration technique is introduced to allow simultaneous calibration to caplet and swaption prices. Empirical calibration of the co-terminal model is shown to be faster, more robust and more efficient than the same procedure applied to the LIBOR market model. We then argue that the co-terminal approach is the simplest and most convenient market model for pricing and hedging a large variety of exotic interest-rate derivatives.

Keywords: Swap market model, cap, swaption, calibration

JEL Classification: G12, G13

Suggested Citation

Galluccio, Stefano and Scaillet, Olivier and Huang, Zhijiang and Ly, Jean-Michel, Theory and Calibration of Swap Market Models (June 2005). FAME Working Paper No. 107, Available at SSRN: https://ssrn.com/abstract=533136 or http://dx.doi.org/10.2139/ssrn.533136

Stefano Galluccio (Contact Author)

BNP Paribas Fixed Income ( email )

10, Harewood Avenue
NW1 6AA London
United Kingdom

Olivier Scaillet

Swiss Finance Institute - University of Geneva ( email )

Geneva
Switzerland

Zhijiang Huang

JP Morgan

London
United Kingdom

Jean-Michel Ly

BNP Paribas Fixed Income ( email )

10 Harewood Avenue
NW1 6AA London
United Kingdom

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