Markovian Projection Onto a Displaced Diffusion: Generic Formulas with Applications
18 Pages Posted: 17 Oct 2006
Date Written: October 9, 2006
We develop a systematic approach to Markovian projection onto an effective displaced diffusion, and work out a set of computationally efficient formulas valid for a large class of non-Markovian underlying processes. The generic derivation is followed by applications, including the calculation of FX options in cross-currency models and swaption pricing in LIBOR Market Models, where we are able to recover in an unambiguous way many known analytical approximations and derive several new ones.
Keywords: Markovian projection, displaced diffusion, Cross Currency Libor Market Models with Skew, FX volatility skew, LMM swaption formula
JEL Classification: C3, C5, C6
Suggested Citation: Suggested Citation