BFS 2002

Contributed Talk

Efficient HJM Approximations of LIBOR Market Models

Dunstan Marris, Gerald Salkin, Nicos Christofides, Allan Lane

Using asymptotic expansion techniques, a family of arbitrage free term structure models are constructed that approximate the LIBOR Market Model. The models can be mapped to a Gaussian lattice, or other efficient numerical algorithm. This enables the rapid solution of Bellman equations to price exotic interest rate derivatives. Some analytic option pricing formulae are developed. A two-factor model is demonstrated with mean reversion and non-lognormal dynamics. Approximation errors are shown to be low for vanilla and callable swaptions.