Yes, Libor Models Can Capture Interest Rate Derivatives Skew: A Simple Modelling Approach

Abstract

We introduce a simple extension of a shifted geometric Brownian motion for modelling forward LIBOR rates under their canonical measures. The extension is based on a parameter uncertainty modelled through a random variable whose value is drawn at an infinitesimal time after zero. The shift in the proposed model captures the skew commonly seen in the cap market, whereas the uncertain volatility component allows us to obtain more symmetric implied volatility structures.

We show how this model can be calibrated to cap prices. We also propose an analytical approximated formula to price swaptions from the cap calibrated model. Finally, we build the bridge between caps and swaptions market by calibrating the correlation structure to swaption prices, and analyzing some implications of the calibrated model parameters.

Keywords: Libor models, caps, swaptions

JEL Classification: C51, C63