The Lévy LIBOR model (Q2488483)

The aim of the paper is to push further the market practice to price caps and floors by Black's formula to the derivation of the formula which allows more statistical accuracy. The natural candidates for driving Lévy processes in this context are generalized hyperbolic Lévy motions since they guarantee high flexibility based on five parameters only. In this connection the authors study a market model where LIBOR rates are driven by a Lévy process. They specify the driving Lévy process and show how the LIBOR rates can be represented as ordinary exponentials of stochastic integrals driven by a nonhomogeneous Lévy process. This fact guarantees nonnegative rates. Via backward induction it is established that the rates are martingales under the corresponding forward measures. Furthermore, an explicit pricing formula for caps is derived which uses bilateral Laplace transforms.