A Field Theory Model for Pricing and Hedging Libor Derivatives
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.
Hedging, Quantum finance, Libor-based derivatives
Finance and Financial Management | Portfolio and Security Analysis
Physica A: Statistical Mechanics and its Applications
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. Research Collection Lee Kong Chian School Of Business.
Available at: http://ink.library.smu.edu.sg/lkcsb_research/1549