Calibration of the Libor Market Model Using Correlations Implied by CMS Spread Options

Posted: 15 Nov 2009 Last revised: 17 Aug 2011

See all articles by Jan van Heys

Jan van Heys

affiliation not provided to SSRN

Reik H. Boerger

RWE AG

Date Written: February 8, 2009

Abstract

This work discusses the calibration of instantaneous Libor correlations in the Libor market model. We extend existing calibration strategies by incorporation of spread option implied correlation information. The correlation structure implied by CMS spread options observed in the present-day’s market motivates us to extend existing parameterizations of ratio correlations by a new three parameter approach. For the first time, this paper presents an extensive empirical study of different parameterizations and their capability of matching market correlations. We can show that our approach leads to stable calibrations and gives a satisfactory fit to the market. We conclude our investigation with a pricing of a callable swap on cms spread using the parameterizations compared before.

Keywords: LMM, Libor Market Model, calibration, correlation, market analysis, CMS spread option

JEL Classification: C13, C51, G13

Suggested Citation

Heys, Jan van and Boerger, Reik H., Calibration of the Libor Market Model Using Correlations Implied by CMS Spread Options (February 8, 2009). Applied Mathematical Finance, Vol. 17, No. 5, 2010, Available at SSRN: https://ssrn.com/abstract=1506402

Jan van Heys

affiliation not provided to SSRN ( email )

Reik H. Boerger (Contact Author)

RWE AG ( email )

Essen, DE
Germany

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