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Real World Scenarios for Interest Rates based on the LIBOR Market Model

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  • Sara Lopes
  • Carlos Vázquez

Abstract

In this article, we present a methodology to simulate the evolution of interest rates under real world probability measure. More precisely, using the multidimensional LIBOR market model and a specification of the market price of risk vector process, we explain how to perform simulations of the real world forward rates in future, using the Euler scheme with Predictor-Corrector. The proposed methodology allows the presence of negative interest rates as currently observed in the markets. We use the multidimensional LIBOR market model and a specification of the market price of risk vector process, we perform simulations of the real world forward rates observed in future, using the Euler scheme with Predictor-Corrector. We allow for negative interest rates as currently observed in the markets. In this article we choose to model a set of key forward Libor rates using the Libor Market Model(LMM) which can be directly observed in the market, guarantees no arbitrage opportunities in interest rate markets and provides more flexibility to capture all possible curve movements. We expect to produce interest rate scenarios coherent with past realizations that can be used in assessment of investment strategies in interest-rate sensitive portfolios for Asset-Liability Management studies and calculations of Economic Capital for Solvency II.

Suggested Citation

  • Sara Lopes & Carlos Vázquez, 2016. "Real World Scenarios for Interest Rates based on the LIBOR Market Model," EcoMod2016 9668, EcoMod.
    • Handle: RePEc:ekd:009007:9668
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    References listed on IDEAS

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    1. John C. Cox & Jonathan E. Ingersoll Jr. & Stephen A. Ross, 2005. "A Theory Of The Term Structure Of Interest Rates," World Scientific Book Chapters, in: Sudipto Bhattacharya & George M Constantinides (ed.), Theory Of Valuation, chapter 5, pages 129-164, World Scientific Publishing Co. Pte. Ltd..
    2. Alan Brace & Dariusz G¸atarek & Marek Musiela, 1997. "The Market Model of Interest Rate Dynamics," Mathematical Finance, Wiley Blackwell, vol. 7(2), pages 127-155, April.
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