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THE AFFINE LIBOR MODELS

Authors


  • All authors gratefully acknowledge the financial support from the FWF grant Y 328 (START prize of the Austrian Science Fund). They would also like to thank Ismail Laachir (INRIA Rocquencourt) for helpful remarks. A previous version was circulated under the title “A new approach to LIBOR modeling.

Josef Teichmann, Departement Mathematik, ETH Zürich, Rämistrasse 101, CH-8092 Zürich, Switzerland; e-mail: josef.teichmann@math.ethz.ch.

Abstract

We provide a general and flexible approach to LIBOR modeling based on the class of affine factor processes. Our approach respects the basic economic requirement that LIBOR rates are nonnegative, and the basic requirement from mathematical finance that LIBOR rates are analytically tractable martingales with respect to their own forward measure. Additionally, and most importantly, our approach also leads to analytically tractable expressions of multi-LIBOR payoffs. This approach unifies therefore the advantages of well-known forward price models with those of classical LIBOR rate models. Several examples are added and prototypical volatility smiles are shown. We believe that the CIR process-based LIBOR model might be of particular interest for applications, since closed form valuation formulas for caps and swaptions are derived.

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