libor market model

Most multi-factor versions of the LMM use Monte-Carlo simulation to calculate the prices of interest-rate derivatives. The advantage of our recombining Markov model is that it produces a non-exploding state space. The model can price Bermudan-style swaptions off the tree of LIBOR rates and swap rates, whereas Monte-Carlo only provides bounds for the swaption prices. The model provides a fast, accurate pricing tool for complex derivatives. Most LMMs are 'Black boxes'. This model is implementable in EXCEL. All prices can be observed in the spreadsheet version of the model.

Tree of LIBOR rates and bond prices recombines in two dimensions. The rates are conditional lognormal under the period-by-period risk neutral measure. The drift of the rates is controlled by varying the conditional probabilities on the tree. The binomial density of the tree can be varied to increase accuracy of the prices. The two-factor model is extendible to three or more factors.