A Multifactoral Cross-Currency LIBOR Market Model With a FX Volatility Skew

Wolfgang Benner, Lyudmil Zyapkov
2007 Social Science Research Network  
Based on LIBOR Market Models, we develop a rigorous pricing framework for cross-currency exotic interest rate instruments under a uniform probability measure and in a multifactoral environment that accounts for the empirically observed foreign exchange skew. The model resorts to a stochastic volatility approach with volatility dynamics following a square-root process and is designed to be flexible enough to allow for the incorporation of as much market information as possible. Using the Fourier
more » ... . Using the Fourier transform, we produce closed-form valuation formulas for FX options by obtaining an explicit expression for the characteristic function, though in a mildly approximate fashion for the sake of analytical tractability. The main focus is placed on FX markets, in terms of which the calibration of model parameters can be performed on a wide range of FX options expiries and strikes.
doi:10.2139/ssrn.983574 fatcat:kzvhlhhllvan3indducy5qsko4