PRICING AND CALIBRATION

Hybrid calibration of interest rate models: implied and statistical

by Raphael Douady, 1999

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Problem No 1: Model Choice

  • Number of factors
  • Markov property <=> “recombining” tree i.e. model with state variables
  • Volatility structure:
    • with respect to time
    • with respect to rates

Problem No 2: Calibration

Find model parameters that reproduce market prices of liquid assets.

  • Bond prices, cash rates, swap rates => Discount factors DF(t,T)
  • Option prices:
    • Caplets
    • Swaptions

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