Extended Libor market models with stochastic volatility

ABSTRACT This paper introduces stochastic volatility to the Libor market model of interest rate dynamics. As in Andersen and Andreasen (2000a) we allow for nonparametric volatility structures with freely specifiable level dependence (such as, but not limited to, the CEV formulation), but now also include a multiplicative perturbation of the forward volatility surface by a general mean-reverting stochastic volatility process. The resulting model dynamics allow for modeling of non-monotonic volatility smiles while explicitly allowing for control of the stationarity properties of the resulting model dynamics. We examine a number of parameterizations of the model, paying particular attention to the development of computationally efficient pricing formulas for calibration of the model to European option prices. Monte Carlo schemes for general pricing applications are proposed and examined.