Explosive behavior in a log-normal interest rate model

DOI10.1142/S0219024913500234MaRDI QIDQ2842536zbMATH OpenFDO

Authors Dan Pirjol

Publication date 15 August 2013

Published in International Journal of Theoretical and Applied Finance (Search for Journal in Brave)

Full work available at URL https://arxiv.org/abs/1104.0322

zbMATH Keywords

log-normal interest rate modelsMarkov functional modelshort rate models

Mathematics Subject Classification ID

Interest rates, asset pricing, etc. (stochastic models) (91G30)

Abstract: We consider an interest rate model with log-normally distributed rates in the terminal measure in discrete time. Such models are used in financial practice as parametric versions of the Markov functional model, or as approximations to the log-normal Libor market model. We show that the model has two distinct regimes, at high and low volatilities, with different qualitative behavior. The two regimes are separated by a sharp transition, which is similar to a phase transition in condensed matter physics. We study the behavior of the model in the large volatility phase, and discuss the implications of the phase transition for the pricing of interest rate derivatives. In the large volatility phase, certain expectation values and convexity adjustments have an explosive behavior. For sufficiently low volatilities the caplet smile is log-normal to a very good approximation, while in the large volatility phase the model develops a non-trivial caplet skew. The phenomenon discussed here imposes thus an upper limit on the volatilities for which the model behaves as intended.

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Cites work

• A Note on the Stability of Lognormal Interest Rate Models and the Pricing of Eurodollar Futures
• Arbitrage-free discretization of lognormal forward Libor and swap rate models
• scientific article; zbMATH DE number 1414609 (Why is no real title available?)
• Interest rate models -- theory and practice. With smile, inflation and credit
• LIBOR and swap market models and measures
• MARKOV MARKET MODEL CONSISTENT WITH CAP SMILE
• Markov-functional interest rate models
• Moment explosion in the LIBOR market model
• Phase transition in a log-normal Markov functional model
• The Market Model of Interest Rate Dynamics

Cited in

(6)

• Explosion in the quasi-Gaussian HJM model
• Explosive behavior in the Black-Derman-Toy model
• Lognormality of rates and term structure models
• Eurodollar futures pricing in log-normal interest rate models in discrete time
• Hogan–Weintraub singularity and explosive behaviour in the Black–Derman–Toy model
• Phase transition in a log-normal Markov functional model

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Uses Software

• Mathematica

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