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The SABR/LIBOR Market Model. Pricing, Calibration and Hedging for Complex Interest-Rate Derivatives. Edition No. 1

  • ID: 2243111
  • Book
  • March 2009
  • 296 Pages
  • John Wiley and Sons Ltd
This book presents a major innovation in the interest rate space. It explains a financially motivated extension of the LIBOR Market model which accurately reproduces the prices for plain vanilla hedging instruments (swaptions and caplets) of all strikes and maturities produced by the SABR model. The authors show how to accurately recover the whole of the SABR smile surface using their extension of the LIBOR market model. This is not just a new model, this is a new way of option pricing that takes into account the need to calibrate as accurately as possible to the plain vanilla reference hedging instruments and the need to obtain prices and hedges in reasonable time whilst reproducing a realistic future evolution of the smile surface. It removes the hard choice between accuracy and time because the framework that the authors provide reproduces today's market prices of plain vanilla options almost exactly and simultaneously gives a reasonable future evolution for the smile surface.

The authors take the SABR model as the starting point for their extension of the LMM because it is a good model for European options. The problem, however with SABR is that it treats each European option in isolation and the processes for the various underlyings (forward and swap rates) do not talk to each other so it isn't obvious how to relate these processes into the dynamics of the whole yield curve. With this new model, the authors bring the dynamics of the various forward rates and stochastic volatilities under a single umbrella. To ensure the absence of arbitrage they derive drift adjustments to be applied to both the forward rates and their volatilities. When this is completed, complex derivatives that depend on the joint realisation of all relevant forward rates can now be priced.

The Libor Market model
The SABR Model
The LMM-SABR Model

Calibrating the LMM-SABR model to Market Caplet prices
Calibrating the LMM/SABR model to Market Swaption Prices
Calibrating the Correlation Structure

The Empirical problem
Estimating the volatility of the forward rates
Estimating the correlation structure
Estimating the volatility of the volatility

Hedging the Volatility Structure
Hedging the Correlation Structure
Hedging in conditions of market stress
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Acknowledgements xi

1 Introduction 1

I The Theoretical Set-Up 7

2 The LIBOR Market Model 9

3 The SABR Model 25

4 The LMM-SABR Model 51

II Implementation and Calibration 79

5 Calibrating the LMM-SABR Model to Market Caplet Prices 81

6 Calibrating the LMM-SABR Model to Market Swaption Prices 101

7 Calibrating the Correlation Structure 125

III Empirical Evidence 141

8 The Empirical Problem 143

9 Estimating the Volatility of the Forward Rates 159

10 Estimating the Correlation Structure 181

IV Hedging 203

11 Various Types of Hedging 205

12 Hedging against Moves in the Forward Rate and in the Volatility 221

13 (LMM)-SABR Hedging in Practice: Evidence from Market Data 231

14 Hedging the Correlation Structure 247

15 Hedging in Conditions of Market Stress 257

References 271

Index 275

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Riccardo Rebonato Royal Bank of Scotland Group, UK.

Kenneth McKay London School of Economics.

Richard White
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