LIBOR Market Model - Model Dynamic

Model Dynamic

The LIBOR market model models a set of forward rates, as lognormal processes. Under the respective -Forward measure


dL_j(t) = \sigma_j(t) L_j(t) dW^{Q_{T_j}}(t)\text{.}

Here, denotes the forward rate for the period . For each single forward rate the model corresponds to the Black model. The novelty is that, in contrast to the Black model, the LIBOR market model describes the dynamic of a whole family of forward rates under a common measure. The question now is how to switch between the different -Forward measures. By means of the multivariate Girsanov's theorem one can show that


dW^{Q_{T_j}}(t) =
\begin{cases}
dW^{Q_{T_p}}(t) - \sum\limits_{k=j+1}^{p} \frac{\delta L_k(t)}{1 + \delta
L_k(t)} {\sigma}_k(t) dt \qquad j < p \\
dW^{Q_{T_p}}(t)	 \qquad \qquad \qquad \quad \quad \quad \quad \quad \quad j = p \\
dW^{Q_{T_p}}(t) + \sum\limits_{k=p}^{j-1} \frac{\delta L_k(t)}{1 + \delta
L_k(t)} {\sigma}_k(t) dt \qquad \quad j > p \\
\end{cases}

and


dL_j(t) =
\begin{cases}
L_j(t){\sigma}_j(t)dW^{Q_{T_{p}}}(t) - L_j(t)\sum\limits_{k=j+1}^{p} \frac{\delta
L_k(t)}{1 + \delta L_k(t)} {\sigma}_j(t){\sigma}_k(t){\rho}_{jk}dt \qquad j <p\\
L_j(t){\sigma}_j(t)dW^{Q_{T_{p}}}(t)	 \qquad \qquad \qquad \qquad \qquad \qquad
\qquad \qquad \quad \quad j = p \\
L_j(t){\sigma}_j(t)dW^{Q_{T_{p}}}(t) + L_j(t)\sum\limits_{k=p}^{j-1} \frac{\delta
L_k(t)}{1 + \delta L_k(t)} {\sigma}_j(t){\sigma}_k(t){\rho}_{jk}dt \quad \qquad j > p\\
\end{cases}

Read more about this topic:  LIBOR Market Model

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