Sparse Grid Combination Technique for Hagan SABR/LIBOR Market Model

Abstract

SABR models have been used to incorporate stochastic volatility to LIBOR market models (LMM) in order to describe interest rate dynamics and price interest rate derivatives. From the numerical point of view, the pricing of derivatives with SABR/LIBOR market models (SABR/LMMs) is mainly carried out with Monte Carlo simulation. However, this approach could involve excessively long computational times. In the present chapter we propose an alternative pricing based on partial differential equations (PDEs). Thus, we pose the PDE formulation associated to the SABR/LMM proposed by Hagan and Lesniewski (LIBOR market model with SABR style stochastic volatility. Working paper, available at http://lesniewski.us/papers/working/SABRLMM.pdf (2008)). As this PDE is high dimensional in space, traditional full grid methods (like standard finite differences or finite elements) are not able to price derivatives over more than one or two underlying interest rates and their corresponding stochastic volatilities. In order to overcome this curse of dimensionality, a sparse grid combination technique is proposed. So as to assess on the performance of the method a comparison with Monte Carlo is presented.