A Field Theory Model for Pricing and Hedging Libor Derivatives
Publication Type
Journal Article
Publication Date
2007
Abstract
The industry standard for pricing an interest-rate caplet is Black's formula. Another distinct price of the same caplet can be derived using a quantum field theory model of the forward interest rates. An empirical study is carried out to compare the two caplet pricing formulae. Historical volatility and correlation of forward interest rates are used to generate the field theory caplet price; another approach is to fit a parametric formula for the effective volatility using market caplet price. The study shows that the field theory model generates the price of a caplet and cap fairly accurately. Black's formula for a caplet is compared with field theory pricing formula. It is seen that the field theory formula for caplet price has many advantages over Black's formula.
Keywords
Hedging, Quantum finance, Libor-based derivatives
Discipline
Finance and Financial Management | Portfolio and Security Analysis
Research Areas
Finance
Publication
Physica A: Statistical Mechanics and its Applications
Volume
374
Issue
1
First Page
331
Last Page
348
ISSN
0378-4371
Identifier
10.1016/j.physa.2006.07.024
Publisher
Elsevier
Citation
WARACHKA, Mitchell Craig; Baaquie, B.E.; and Liang, C..
A Field Theory Model for Pricing and Hedging Libor Derivatives. (2007). Physica A: Statistical Mechanics and its Applications. 374, (1), 331-348.
Available at: https://ink.library.smu.edu.sg/lkcsb_research/1549