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An efficient lattice algorithm for the Libor Market Model

An efficient lattice algorithm for the Libor Market Model

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Published by tim_yxiao
The LIBOR Market Model (LMM or BGM) has become one of the most popular
models for pricing interest rate products. It is commonly believed that Monte-Carlo
simulation is the only viable method available for the LIBOR Market Model. In this
article, however, we propose a lattice (or tree) approach to price interest rate
products within the LIBOR Market Model by introducing a shifted forward measure
and several novel fast drift approximation methods. This model should achieve the
best performance without losing much accuracy. Moreover, the calibration is almost
automatic and it is simple and easy to implement. Adding this model to the valuation
toolkit is actually quite useful; especially for risk management or in the case there is
a need for a quick turnaround.
The LIBOR Market Model (LMM or BGM) has become one of the most popular
models for pricing interest rate products. It is commonly believed that Monte-Carlo
simulation is the only viable method available for the LIBOR Market Model. In this
article, however, we propose a lattice (or tree) approach to price interest rate
products within the LIBOR Market Model by introducing a shifted forward measure
and several novel fast drift approximation methods. This model should achieve the
best performance without losing much accuracy. Moreover, the calibration is almost
automatic and it is simple and easy to implement. Adding this model to the valuation
toolkit is actually quite useful; especially for risk management or in the case there is
a need for a quick turnaround.

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Published by: tim_yxiao on Sep 25, 2011
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09/30/2011

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AN EFFICIENT LATTICE ALGORITHM FOR THELIBOR MARKET MODEL
Tim Xiao
1
 
Risk Analytics, Capital Markets Risk Management, CIBC, Toronto, Canada
ABSTRACT
The LIBOR Market Model (LMM or BGM) has become one of the most popularmodels for pricing interest rate products. It is commonly believed that Monte-Carlosimulation is the only viable method available for the LIBOR Market Model. In thisarticle, however, we propose a lattice (or tree) approach to price interest rateproducts within the LIBOR Market Model by introducing a shifted forward measureand several novel fast drift approximation methods. This model should achieve thebest performance without losing much accuracy. Moreover, the calibration is almostautomatic and it is simple and easy to implement. Adding this model to the valuationtoolkit is actually quite useful; especially for risk management or in the case there isa need for a quick turnaround.
Key Words
: LIBOR Market Model (LMM or BGM), lattice model, tree model, shiftedforward measure, drift approximation, risk management, calibration, callable exotics,callable bond, callable capped floater swap, callable inverse floater swap, callablerange accrual swap.
1
The views expressed here are of the author alone and not necessarily of his host institution.Address correspondence to Tim Xiao, Risk Analytics, Capital Markets Risk Management, CIBC,161 Bay Street, 12
th
Floor, Toronto, ON M5J 2S8, Canada; email:Tim.Xiao@CIBC.com 
 
1
The LIBOR Market Model (LMM) is an interest rate model based on evolvingLIBOR market forward rates under a risk-neutral forward probability measure. Incontrast to models that evolve the instantaneous short rates (e.g., Hull-White, Black-Karasinski models) or instantaneous forward rates (e.g., Heath-Jarrow-Morton (HJM)model), which are not directly observable in the market, the objects modeled usingthe LMM are market observable quantities. The explicit modeling of market forwardrates allows for a natural formula for interest rate option volatility that is consistentwith the market practice of using the formula of Black for caps. It is generallyconsidered to have more desirable theoretical calibration properties than short rateor instantaneous forward rate models.In general, it is believed that Monte Carlo simulation is the only viablenumerical method available for the LMM (see Piterbarg [2003]). The Monte Carlosimulation is computationally expensive, slowly converging, and notoriously difficultto use for calculating sensitivities and hedges. Another notable weakness is itsinability to determine how far the solution is from optimality in any given problem.In this paper, we propose a lattice approach within the LMM. The model hassimilar accuracy to the current pricing models in the market, but is much faster.Some other merits of the model are that calibration is almost automatic and theapproach is less complex and easier to implement than other current approaches.We introduce a shifted forward measure that uses a variable substitution toshift the center of a forward rate distribution to zero. This ensures that thedistribution is symmetric and can be represented by a relatively small number of discrete points. The shift transformation is the key to achieve high accuracy inrelatively few discrete finite nodes. In addition, we present several fast and noveldrift approximation approaches. Other concepts used in the model are probabilitydistribution structure exploitation, numerical integration and the long jump technique(we only position nodes at times when decisions need to be made).
 
2
This model is actually quite useful for risk management because normally full-revaluations of an entire portfolio under hundreds of thousands of different futurescenarios are required for a short time window. Without an efficient algorithm, onecannot properly capture and manage the risk exposed by the portfolio.The rest of this paper is organized as follows: The LMM is discussed in SectionI. In Section II, the lattice model is elaborated. The calibration is presented inSection III. The numerical implementation is detailed in Section IV, which willenhance the reader’s understanding of the model and its practical implementation.The conclusions are provided in Section V.
I.
 
LIBOR MARKET MODEL
 
Let (
,
,
0
,
) be a filtered probability space satisfying the usualconditions, where
denotes a sample space,
denotes a
 
-algebra,
denotesa probability measure, and
0
denotes a filtration. Consider an increasingmaturity structure
 N 
...0
10
from which expiry-maturity pairs of dates(
1
,
) for a family of spanning forward rates are taken. For any time
1
, wedefine a right-continuous mapping function
)(
n
by
)(1)(
nn
. The simplycompounded forward rate reset at
t
for forward period (
1
,
) is defined by
    
1),(),(1 ),;(:)(
11
PP
 
(1)where
),(
P
denotes the time
t
price of a zero-coupon bond maturing at time
T
and
),(:
1
  
is the accrual factor or day count fraction for period (
1
,
).Inverting this relationship (1), we can express a zero coupon bond price interms of forward rates as:
n j j jn
PP
)()(
)(11),(),(
 
(2)

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