Arbitrage-free discretization of lognormal forward Libor and swap rate models (Q1979076)

A major development in the modeling of interest rates for pricing term structure derivatives is the emergence of models that incorporate lognormal volatility for forward Libor or forward swap rates while keeping interest rates stable. In the general class of models based on continuously compounded forward rates lognormal volatility leads to rates that become infinite in finite time with positive probability. By working instead with various types of discretely compounded rates several authors have overcome this difficulty and developed well-posed models that indeed admit deterministic diffusion coefficients for the logarithms of forward rates, i.e. lognormal volatility. The rates themselves are not simultaneously lognormal, but each becomes lognormal under an appropriate change of measure. This class of models -- often referred to as ``market models'' because of their consistency with market conventions -- have three principal attractions: 1) they preclude arbitrage among bonds; 2) they keep rates positive; 3) they price caplets or swaptions according to Black's formula consistent with market practice. But these features of continuous-time formulations are easily lost when the models are discretized for simulation. The authors introduce methods for discretizing these models giving particular attention to precluding arbitrage among bonds and to keeping interest rates positive even after discretization. These methods transform the Libor or swap rates to positive martingales, discretize the martingales, and then recover the Libor and swap rates from these discretized variables, rather than discretizing the rates themselves. Choosing the martingales proportional to differences of ratios of bond prices to numeraire prices turns out to be particularly convenient and effective. The authors numerically investigate the accuracy of other caplet and swaption prices as a gauge of how closely a model calibrated to implied volatility reproduces market prices. Numerical results indicate that several of the methods proposed in the paper often outperform more standard discretization.