Affine LIBOR models driven by real-valued affine processes

2015/03/03 by Waldenberger, Stefan, Müller, Wolfgang
#FOS: Economics and business #Pricing of Securities (q-fin.PR)

paper · doi:10.48550/arxiv.1503.00864

Abstract

The class of affine LIBOR models is appealing since it satisfies three central requirements of interest rate modeling. It is arbitrage-free, interest rates are nonnegative and caplet and swaption prices can be calculated analytically. In order to guarantee nonnegative interest rates affine LIBOR models are driven by nonnegative affine processes, a restriction, which makes it hard to produce volatility smiles. We modify the affine LIBOR models in such a way that real-valued affine processes can be used without destroying the nonnegativity of interest rates. Numerical examples show that in this class of models pronounced volatility smiles are possible.

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