Incorporating an Interest Rate Smile in an Equity Local Volatility Model

Abstract

The focus of this paper is on finding a connection between the interest rate and equity asset classes. We propose an equity interest rate hybrid model which preserves market observable smiles: the equity from plain vanilla products via a local volatility framework and the interest rate from caps and swaptions via the Stochastic Volatility Libor Market Model. We define a multi-factor short-rate process implied from the Libor Market Model via an arbitrage-free interpolation and combine it with the local volatility equity model for stochastic interest rates. We show that the interest rate smile has a significant impact on the equity local volatility. The model developed is intuitive and straightforward, enabling consistent pricing of related hybrid products. Moreover, it preserves the non-arbitrage Heath, Jarrow, Morton conditions.