Abstract
Interest rate derivatives form part of the largest portion of traded financial instruments. Hence, it is important to have models that describe their dynamics accurately. This study aims at pricing quanto caps and floors using the multi-curve cross-currency LIBOR market model (MCCCLMM) dynamics. A Black Scholes MCCCLMM quanto caplet and floorlet formula is first derived. The MCCCLMM parameters are then calibrated to exactly match the USD and GBP cap market prices. The estimated model parameters are then used to price the quanto options in the Black MCCCLMM quanto caplet and floorlet formula. These prices are then compared to the quanto cap and floor prices estimated via Monte Carlo simulations so as to ascertain its pricing accuracy.
Highlights
Interest rate modeling has been a major interest amongst researchers
This study aims at pricing quanto caps and floors using the multi-curve cross-currency LIBOR market model (MCCCLMM) dynamics
The MCCCLMM model parameters were calibrated to real world data using at the money (ATM) cap prices and historical rates
Summary
Interest rate modeling has been a major interest amongst researchers. This is mostly because the interest rate markets have grown to dominate the financial world due to its vast number of traded financial products flooding the markets. Later on, they were extended to model the instantaneous forward rates (see [7]) which were not directly observable. A new class of models better known as the market models were introduced into the financial markets by authors such as [8] [9] [10]. These models were quickly accepted as they made use of market observable rates such as LIBORs and swap rates. Examples of such market models are the LIBOR market model (LMM) and the swap market model (SMM)
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