T

he stochastic, alpha, beta, rho (SABR) model and the Libor

market model (LMM) have become industry standards for
pricing plain-vanilla and complex interest rate products, re-
spectively. (For a description of the SABR model, see, for example,
Hagan et al, 2002. The LMM is described, for example, in Brace,
Gatarek & Musiela (BGM), 1996 and Jamshidian, 1997.) While
similar, the two models do not directly talk to each other. Ulti-
mately, the SABR approach is not a consistent dynamical model for a
collection of forward rates: it simply provides a series of independent
snapshots of the caplet smiles (one snapshot for each maturity), but
does not link these still frames into a coherent movie (that is, does
not prescribe a well dened joint dynamics). For the limited tting
and interpolation purposes of the SABR approach, this is perfectly
reasonable, because it deals with the pricing of European-style op-
tions, for which, roughly speaking, it is only the terminal variance (in
a diffusive setting, the realised quadratic variation) that matters. It
is when it comes to pricing complex (non-European-style) products
that the need for a dynamical model capable of accounting for skew
and smile information becomes crucial. This is ultimately because
the pricing of complex products depends on (possibly conditional)
covariance elements rather than terminal variances.
Several stochastic-volatility extensions of the LMM exist that do
provide a consistent dynamic description of the evolution of the
forward rates (see, for example, Andersen & Andreasen, 2000,
Joshi & Rebonato, 2003, Rebonato & Joshi, 2002 and Rebonato
& Kainth, 2004), but these extensions are not equivalent to the
SABR model. Piterbarg (2003, 2005) presents an interesting
approach based on displaced diffusion that is similar in spirit to a
dynamic extension of the SABR model. The approach is consider-
ably more involved than what is presented here, and a successful
calibration often requires restrictions on the displacement coef-
cient that can be unpleasant. Henry-Labordre (2007) obtains
some interesting exact results (in the short-time-to-expiry limit),
but his attempt to unify the BGM and SABR model using an appli-
cation of hyperbolic geometry is very complex and the computa-
tional issues are daunting.
This article attempts to provide a simple, nancially justiable,
easy-to-calibrate (to caplets), computationally affordable and
SABR-compatible extension of the LMM. More precisely, we
would like to specify a nancially motivated dynamics for the
LMM forward rates and volatilities that very closely match the
SABR prices. This can, of course, be done in several ways. We set
ourselves, however, stringent objectives in terms of computational
ease of calibration and the nancial justiability of the approach.
These are outlined below.
Objectives
In the deterministic-volatility (no-smile) LMM, it is well known
(see, for example, Brigo & Mercurio, 2001 or Rebonato, 2002)
that the desirable feature of time-homogeneity of the caplet implied
volatility surface can only be achieved if the instantaneous volatilities
of the forward rates with expiries {T
i
}, S
i
(t, T
i
), are purely a function,
say, g(
.
), of the residual time to maturity, T
i
t, of the associated
forward rate:

i
t,T
i
g T
i
t

(1)
A common choice for g(T
i
t) (see, for example, Brigo & Mercurio,
2001, Rebonato, 2002 and 2006, White & Rebonato, 2007) is:

i

i
a b
i
exp c
i
d (2)
with T
i
= T
i
t. The treatment below does not depend on the specic
form chosen.
For practical applications, one wants to give a simple form to the
function g(
.
). When this is done, however, perfect recovery of an
Cutting edge | Interest rates
December 2007/January 2008 72
Riccardo Rebonato proposes an extension of the Libor market model (LMM) that
recovers the stochastic, alpha, beta, rho (SABR) caplet prices almost exactly for all
strikes and maturities. The dynamics of the volatility are chosen so as to be consistent
across expiries, to be nancially motivated and to make the evolution of the implied
volatilities as time-homogeneous as possible. Given the SABR parameters, the
associated LMM parameters are found with minimal numerical work
A time-homogeneous,
SABR-consistent
extension of the LMM
Cutting edge | Interest rates
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73
exogenous set of at-the-money prices cannot in general be recovered
even in the absence of smiles. To x this problem, one can correct
the time-homogeneous function as little as possible by introducing
expiry-specic factors (k
i
):

i
2
T
i
k
i
2
g T
i
t
2
0
T
i

dt

(3)
where
^
S
i
indicates the implied (root-mean-squared) volatility of
the ith caplet. If the function g(
.
) is parametrised by a set of coef-
cients {A
k
, k = 1, 2, ... , m}, then a good tting procedure is to
impose that the m parameters A should be chosen so that the cor-
rection factors k
i
are as close to unity as possible for all forward
rates. When this constraint is imposed, it is generally found (see
Dodds, 1998, Rebonato, 2002, and White & Rebonato, 2007)
that instantaneous-volatility functions for forward rates naturally
display a humped shape.
We would like to retain as much as possible of this important
feature in our extension of the LMM. Unfortunately, a trivial
transliteration of the SABR approach into the LMM (whereby a
SABR-like specication of the volatility is grafted on top of the
deterministic-volatility LMM) suffers from lack of time-homoge-
neity and gives rise to non-physical consequences. An example of
this is shown in gure 1, which presents the SABR volatilities of
volatility for different maturities and clearly shows that they are
forward-rate specic. If these constant parameters were used sim-
ply in the LMM extension, different forward rates will behave dif-
ferently throughout their lives even when they have the same resid-
ual time to expiry. As a consequence, the future smile would bear
no resemblance to the one observed today.
One can try to overcome this problem in at least two simple
ways. The rst is by assuming that in the LMM all forward rates
should have the same volatility of volatility, but that the stochastic
volatility should have mean-reverting behaviour. This approach
implies that different values of the volatility of volatility are
obtained in the SABR tting because recovery of the marginal dis-
tributions does not require an explicit specication of the true
mean-reverting behaviour for the volatility. In this interpretation,
the SABR model is dynamically mis-specied, and the mean-rever-
sion is latent in its parametrisation and appears indirectly as a
volatility of volatility that decays with maturity.
The second route is to assume that the volatility of volatility of
the various forward-rate processes should be a function of their
residual time to maturity. Looked at this way, the variation across
maturities of the SABR volatility of volatilities comes about because
the tted values are different root-mean-squared volatilities of the
same time-homogeneous function integrated out to the different
forward-rate expiries.
In either case, we try to choose the parameters in such a way to
recover the ability for the (expectation of the) volatility function to
display a humped shape as a function of residual maturity. (See, for
example, Rebonato, 2002 and 2006 and White & Rebonato, 2007
as to why this is very important for complex option pricing.)
Finally, and most importantly, for the procedure to be effective
and practical, we propose a formulation that recovers the SABR
prices to a good degree of accuracy with a minimal amount of
numerical burden.
The method
Consider the following SABR dynamics under the forward measure,
Q
T
, of forward rate f
T
t
:

df
t
T

t
T
f
t
T

SABR
dz
t
T

(4)
d
t
T

t
T
v
T
dw
t
T

(5)

E dz
t
T
dw
t
T

dt

(6)
The SABR dynamics are thus fully described by the initial condi-
tions, f
T
0
, S
T
0
, and by the expiry-dependent parameters B
SABR
, R, N
T
.
1
As for the LMM specication, we work under the same forward
measure, Q
T
. The SABR parameters above are assumed to be avail-
able from a previous SABR tting for all maturities. They implicitly
determine the caplet prices for all strikes, and for all the maturities
for which they have been tted. We want to determine the param-
eters of an LMM model such that the LMM caplet prices for all the
same strikes and maturities are as close as possible to the SABR
caplet prices.
To this effect, consider the dynamics of the forward rate of matu-
rity T in the LMM:

df
t
T
s
t
T
f
t
T

LMM
dz
t
T

(7)

s
t
T
= k
t
T
g T t ( ) = k
t
T
g
t
T

(8)

dp t,T ( ) = dp
t
T
= dk
t
T

(9)
with g
T
t
= g(T t) and:

p t,T ( ) =
s
t
T
g
t
T

(10)
Note that, if k
T
t
were a deterministic function of t and T (or a con-
stant), then we would be in the traditional deterministic-volatility
1
To lighten notation, we omit the dependence of the correlation R and the exponent B
SABR
on the expiry T
1. The SABR volatility of volatility as a
function of the caplet expiry (in years) for the
ftting on September 26, 2006
33
31
29
27
25
23
21
19
17
15
%
0 5 10 15 20 25 30 35
t (years)
Cutting edge | Interest rates
December 2007/January 2008 74
LMM setting. Instead, we prescribe for k
T
t
a process of the type
(Schwartz, 1997):
dk
t
T
= k
t
T
a
T
RVL ln k
t
T
( )
dt + k
t
T
h
t
T
dB
t
T
(11)

E dB
t
T
dz
t
T

1
]
rdt

(12)
This formulation will allow us to explore both the mean-reverting
and the time-homogeneous volatility-of-volatility case.
If the rst avenue is taken, in keeping with the intuition that
applies to the deterministic-volatility case, we would like k
T
t
to
revert to one. By so doing, the volatility function would be
attracted over time to the most time-homogeneous solution com-
patible with the current observed prices.
As for the second route, we simply set a
T
= 0 in the expressions
above, but impose that the volatility of volatility should have the
functional form:

h t,T ( ) = h T t ( )

(13)
with the function h(
.
) parametrised by a set of parameters [l, m, n,
...]. Therefore:
k
t
T
k
0
T
exp
1
2
h
2
T s ( )ds + h T s ( )dB
s
0
T
[
0
T
(
]
(

1
]
1
(14)
and:
s
t
T
g
t
T
k
0
T
exp
1
2
h
2
T s ( )ds + h T s ( )dB
s
0
T
[
0
T
(
]
(

1
]
1
(15)
The problem is how to choose the parameters of the two specica-
tions in a way compatible with the objectives outlined above.
Calibration
To start with, the following obvious choices can be made:

r

(16)

dw
t
= dB
t

(17)

SABR

LMM

(18)
We now have to choose between a mean-reverting process for the
volatility or a maturity-dependent volatility of volatility. We begin by
examining the rst possibility.
If the market believed in a mean-reverting process for the vola-
tility, we would expect the root-mean-squared volatility of volatility
to be a monotonically declining function of maturity. This is indeed
the case on many tting days, but gure 1 shows a trading day
when, because of the hump in the volatility-of-volatility-as-a-func-
tion-of-maturity graph, a mean-reverting process with constant
parameters cannot account for the SABR-tted market values.
Trading days with a humped volatility-of-volatility curve are by no
means exceptional. We also observe that the same mean-reversion
parameters do not provide an acceptable t for different trading
days. A signicant variation of the mean-reverting parameters with
forward-rate expiry implies lack of time-homogeneity. We therefore
abandon this route.
We move to the second possibility that is, we assume a depen-
dence of the volatility of volatility on the residual time to maturity
of the underlying forward rate, h
T
t
= h(T t) and choose the func-
tion form:

h

exp

(19)
To choose the parameters A, B, G and D in equation (19) and a, b, c
and d in equation (2), we proceed as follows.
The formal solution for the SABR evolution to time t of the T-
maturity forward rate is:
f
t
T
f
0
T
+ f
s
T
( )

SABR
0
t
(
]
( o
s
T
dz
s
T
f
0
T
+ f
s
T
( )

SABR
o
0
T
0
t
(
]
( exp
1
2
v
2
du + vdw
u
0
s
[
0
s
(
]
(

1
]
1
dz
s
T (20)
The equivalent expression for the LMM evolution (with zero rever-
sion speed) is:
2. The market and ftted volatility of volatility
function against caplet expiry (in years) for
September 26, 2006
33
31
29
27
25
23
21
19
17
15
%
0 10 20 30 40
Sep 26, 2006
Fit
t (years)
3. SABR and LMM implied volatilities (
SABR
=
0.75, T = 4 years, = 27.5%,
= -0.1, f(0) = 4%)
20
18
16
14
12
10
8
6
4
2
0
%
SABR
LMM
1 2 3 4 5 6 7 8 9 10 11 12
Strike
ATM strike = 6
Cutting edge | Interest rates
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75

f
t
T
f
0
T
+ f
s
T
( )
0
t
[

LMM
s
s
T
dz
s
T
f
0
T
+ f
s
T
( )

LMM
k
s
T
0
t
(
]
( g
s
T
dz
s
T

(21)
with:
k
s
T
k
0
T
exp
1
2
h T u ( )
2
du + h T u ( )dz
u
0
s
[
0
s
(
]
(

1
]
1
(22)
In a deterministic-volatility setting, one would choose the
parameters a, b, c and d in such a way as to match as closely as pos-
sible the root-mean-squared volatility
^
S
i
. See equation (3). In a
stochastic-volatility setting, there is no single root-mean-squared
volatility, as it depends on the realised path. In this more complex
setting, it is plausible to choose the parameters a, b, c and d so as
to match as closely as possible the expectation at time zero of S
T
s
,
that is, S
T
0
. So, we minimise over a, b, c and d the sum, C
2
, of the
squared discrepancies:

2
o
0
T
i
g T
i
( )

1
]
2
i
N
_

(23)
where:
g T
i
( ) =
1
T
i
a + b
i
( )exp c
i
( ) + d

2
d
i
0
T
i

(24)
The initial values k
Ti
0
in equation (3) are then chosen so as to provide
exact recovery of the quantities S
Ti
0
. To the extent that the chosen
function g(T) allows for a good t to the dependence of the initial
SABR value S
Ti
0
on the maturities T
i
, these correction factors will all
be close to one. Empirical ts, discussed in the following, show that
this is indeed the case.
Using the tted SABR values, N
T
, we then follow a very similar
procedure, that is, we determine the coefcients A, B, G and Dthat
minimise the sum, C
2
, of the squared discrepancies:

2
v
T
i

h T
i
( )

2
i
N

(25)
Again, small correction factors, X
i
, then ensure the exact recovery of
the root-mean-squared volatility of volatility,
^
h(T
i
). Figure 2 dis-
plays the results for two such typical ts.
The main justication for this calibration lies in its simplicity
(while retaining nancial plausibility). The success of the proce-
dure will depend on the degree of convexity that is neglected in
the approximations.
2
This empirical issue is dealt with in the next
section.
Results
Figures 36 show that, after the calibration outlined above is car-
ried out using typical market values, the agreement between the
SABR and the LMM prices ranges from good to excellent over a
very large range of strikes and maturities.
3
We stress that the same
parameters A, B, G and D and a, b, c and d are used for all the strikes
and all the maturities for a given trading day.
For the procedure suggested in the previous section to make
sense, the correction factors, X
i
, must all be close to one. Figure 7
shows that this is indeed the case for a typical trading day (Septem-
ber 26, 2006, dollar market).
Generally, one can say that for a xed volatility of volatility the
quality of the approximation deteriorates as the quantity S
T
0
increases, or as the maturity increases. However, we observe from
market ts that both N
T
and S
T
0
tend to decline for increasing matu-
rities, thereby producing a compensating effect. We stress, however,
that these results have been obtained with recent market-typical
parameters (dollar).
Since fast analytic approximations are available for the SABR
2
By matching the expectation at time zero of S
T
s
rather than the expectation of
T
0
(S
T
s
)
2
ds, we are neglecting
two convexities (two Jensen inequality eects), one coming from the fact that the square of the expectation is
not equal to the expectation of the square and the other stemming from the dierence of the expectation over
prices from the price calculated with the expected variance
3
Te parameters used were typical of market ts to dollar data. Te exact caplet prices used for comparison
were obtained using a purpose-built Monte Carlo pricer using up to 106 simulations
4. SABR and LMM implied volatilities
(
SABR
= 0.75, T = 10 years, = 25%,
= -0.1, f(0) = 4%)
20
18
16
14
12
10
8
6
4
2
0
%
SABR
LMM
1 2 3 4 5 6 7 8 9 10 11 12
Strike
ATM strike = 6
5. SABR and LMM implied volatilities
(
SABR
= 0.75, T = 10 years, = 20%,
= -0.1, f(0) = 4%)
25
20
15
10
5
0
%
SABR
LMM
1 2 3 4 5 6 7 8 9 10 11 12
Strike
ATM strike = 6
Cutting edge | Interest rates
December 2007/January 2008 76
prices, these constitute a simple and ideal control-variate variable
to reduce the error further. It should be kept in mind that the
asymptotic expansions typically used (Hagan et al, 2002) are them-
selves approximations, and that these begin to break down for out-
of-the-money strikes and long maturities. In order not to confuse
sources of error coming from different approximations, we have
therefore not included the control-variate correction, and we
present the comparison between the LMM extension and the true
SABR process.
The simplest non-static application
This article presents a dynamic model calibrated to static products
(caplets) that is, to products whose valuation depends only on
the terminal variance of the individual forward rates, and therefore
does not require the specication of a joint dynamics. An interest-
ing question is: what does the model buy the user when products
are valued whose value depends on the joint realisation of forward
rates before their resets?
A systematic comparison along these lines would indeed be
interesting, but an article in itself. One can, however, address this
problem by looking at what the proposed model implies for the
simplest product that has non-static features when forward rates
are evolved: a European-style swaption. This allows us to under-
stand the qualitative features of the proposed model very clearly,
and many of the insights can be transferred to more complex prod-
ucts. Furthermore, since many forward-rate-based products have
callability features, understanding what the model implies for
European-style swaptions (the natural hedging instruments of cal-
lability) has a clear applied interest.
Starting from the obvious, the LMM-SABR extension proposed
here can give rise to non-monotonic smiles, while the determinis-
tic-volatility LMM does not.
4
Figure 8 shows the effects of switch-
ing on the volatility-of-volatility term, and of having a non-at
volatility-of-volatility function.
We can understand the behaviour as follows. As the SABR vola-
tility-of volatility parameter N
T
increases, to obtain a t to the mar-
ket caplets in our scheme, we must either increase the root-mean-
square of the function h(T),
^
h(T), for a xed k
T
0
, or, for a xed k
T
0
,
correspondingly increase
^
h(T) (see equation (25)). As N
T
increases,
there are two main effects: the at-the-money volatility modestly
increases (by 50 basis points in this example), and the curvature of
the smile increases (up to 180bp in the wings). The rst effect is
easily understood at a qualitative level, if we think of the zero cor-
relation case. As Hull & White (1987) pointed out, the option
price in the presence of stochastic volatility is equal to the integral
of Black option prices conditional on the realisation of the root-
mean-squared volatility. As the Black price is close to linear in the
root-mean-squared volatility, convexity effects only come in for
very high volatility of volatility or long maturities. So, increasing k
T
0
or
^
h(T) has the rst effect of a modest increase in the prices (implied
volatility) of at-the-money swaptions.
Since the linearity of the Black formula in root-mean-squared
volatility decreases as one moves away from the at-the-money
strike, the convexity effect become more pronounced, and there-
fore the increase in implied volatility (swaption prices) is not paral-
lel. As a consequence, increasing k
T
0
or
^
h(T) has the effect of making
the swaption smile more pronounced.
More interesting is the dependence of the swaption prices on the
time dependence of the volatility of volatility. By writing the expres-
sion for the volatility of a swap rate (see Rebonato & White, 2007),
one encounters terms of the form:
W
k
t
W
m
t
k
t
T
k
k
t
T
m
g
t
T
k
g
t
Tm

k, m
dt
0
T
j

k, m1, ..., n
j

(26)
where {W
t
k
} are suitably dened weights, and R
k,m
is the correlation
between the volatility of the kth and the mth forward rate. This
demonstrates that the overall swap-rate volatility will depend not
only on the cross time-dependence of the functions g
t
Tk
, as in the
deterministic-volatility case (and explained in Rebonato, 2006),
but also on the cross time-dependence with the functions h
t
Tk
. As
the overlap among the functions h
t
Tk
is maximum when these are
4
With a displaced-diusion version of the LMM a monotonic smile is achievable
6. SABR and LMM implied volatilities
(
SABR
= 0.75, T = 30 years, = 20%,
= -0.1, f(0) = 4%)
25
20
15
10
5
0
%
SABR
LMM
1 2 3 4 5 6 7 8 9 10 11 12
Strike
ATM strike = 6
7. The correction factors as a function of caplet
expiry (in years)
1.0
0.8
0.6
0.4
0.2
0
C
o
r
r
e
c
t
i
o
n

f
a
c
t
o
r
0 10 20 30 40
T (years)
77
at, one can understand the behaviour in gure 8.
When the volatility is stochastic, what affects the payout of non-
static products is the joint realisation of at least some forward rates
before their expiries. This is affected both by the functions g(
.
)
and h(
.
) and by the interaction between the two. To see this, con-
sider the two time-dependent volatility-of-volatility functions,
with the same root-mean-squared volatility,
^
h(T
i
). Despite the
same root-mean-squared volatility, it is easy to see that it does
matter when the high volatility-of-volatility period occurs: to
begin with, if, for instance, the volatility of volatility were high
when the volatility itself were low, this stochasticity of the volatil-
ity would effectively be wasted. More importantly, even if the
function g(
.
) were at, when the volatility of volatility is concen-
trated, it has a large effect on the smile: if it were concentrated
towards the expiry, for instance, it would again produce a small
effect on the joint realisation of the forward rates, and hence on
the complex-option prices.
Finally, it is worthwhile noticing that the effective-SABR cor-
relation between the swap rate and its volatility is not given by a
simple weighted sum of the correlations of the underlying forward
rates. To see this, consider the limiting case when the volatilities of
forward rates are strongly correlated with their own forward rates,
but the forward rates themselves have zero correlation among
themselves. In this situation, the correlation between the change in
a given underlying forward rate and the swap rate could be low (the
Cutting edge | Interest rates
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8. A 10 10-year swaption
16
15
14
13
12
11
10
9
8
%
3.5 4.5 5.5 5.0 4.0 6.0 6.5 7.0 7.5 8.0 8.5
%
Full calibration
Const h(
.
)
Const g(
.
)
Zero
Displaced diffusion
Note: the line with no markers shows the calibration to the market
prices (dollar, August 2007), the line with the crosses the effect of
switching to zero the volatility of volatility with the same
parameters, the lines with the squares and the triangles the effect
of using the same volatility of volatility and parameters as in the
full calibration but with flat functions h(
.
) and g(
.
) respectively. The
dashed line shows the best fit that can be achieved with a zero-
volatility-of-volatility displaced-diffusion LMM. Note how the best
deterministic-volatility fit is not able to capture the curvature of
the swaption smile
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Cutting edge | Interest rates
December 2007/January 2008 78
more so, the longer the swap), and, therefore, so would be the cor-
relation between the swap rate and its volatility. Since the effect of
the correlation between the swap rate and its volatility, as implied
by the dynamics of a set of forward rates, is to control the slope of
the swaption smile, it is clear that the latter will depend on the full
correlation structure among forward rates, volatilities and forward
rates, and volatilities.
This analysis only scratches the surface of a very complex prob-
lem, but gives an idea of the richness of the simple model intro-
duced here and of its impact on the pricing of those complex prod-
ucts whose value depends on risk-reversal or straddle risk.
Conclusions and extensions
We have presented a simple-to-calibrate and nancially motivated
extension of the LMM that recovers to a high degree of accuracy
the caplet prices produced by the SABR model. Since, in turn, this
has become the market standard for plain-vanilla caplet prices, the
proposed procedure extends the LMM in such a way that a small
number of time-homogeneous parameters simultaneously recover
the market caplet prices for all strikes and maturities. The calibra-
tion burden on top of what is required for a no-smile LMM is min-
imal. The computational burden of Monte Carlo applications can
be reduced by using an efcient control-variate scheme. The time-
homogeneity of the model ensures that future smiles will resemble
the current one.
Further substantial numerical improvements can be obtained if a
displaced diffusion process is posited for the forward rates, instead
of a constant elasticity of variance process. This can be done ef-
ciently and accurately thanks to the correspondence between con-
stant elasticity of variance and displaced diffusion processes rst
highlighted by Marris (1999), and then studied further by Svo-
boda-Greenwood & Hambly (2007).
Current work shows that very efcient semi-analytical approxi-
mations to European-style swaption prices can be obtained. This
would make tting to co-terminal swaptions or the whole swaption
matrix very simple.
Finally, we point out that, after the SABR tting is carried out,
the correlation coefcients R and the exponent B
SABR
also typically
display a variation as a function of expiry. As a consequence, the
calibration choices (16) and (18) do not provide a truly time-homo-
geneous solution: different forward rates remain different even
when the residual time to maturity is the same. The same approach
suggested for the volatility of volatility could of course be followed.
However, it is well known that the parameters R and B
SABR
are
strongly negatively correlated: both mainly inuence the slope of
the skew (more negative correlation and exponents closer to zero
make the smile steeper), and the same quality of t can often be
obtained with very different combinations of R and B
SABR
. For this
reason, establishing a dependence on the forward-rate expiry of
either parameter is difcult. Indeed, to avoid this instability of the
ts many trading houses x either parameter to a given value, and
only optimise over the other. When this is done, a modest variation
across expiries is found in the free parameter. O
Riccardo Rebonato is global head of market risk and quantitative
research at the Royal Bank of Scotland. He would like to thank
Dherminder Kainth and Matthew Dodson for useful discussions.
Email: Riccardo.Rebonato@rbos.com
Andersen L and J Andreasen, 2000
Volatility skews and extensions of the Libor market
model
Applied Mathematical Finance 7(1), pages 132
Brace A, D Gatarek and M Musiela, 1996
The market model of interest rate dynamics
Mathematical Finance 7, pages 127154
Brigo D and D Mercurio, 2001
Interest rate models theory and practice
Springer Verlag, Berlin
Dodds S, 1998
Private communication, quoted in
R Rebonato, 2002, Modern Pricing of Interest-Rate
Derivatives, Princeton University Press
Hagan P, D Kumar, A Lesniewski and D
Woodward, 2002
Managing smile risk
Wilmott Magazine, autumn, pages 84108
Henry-Labordre P, 2007
Combining the SABR and LMM models
Risk October, pages 102107
Hull J and A White, 1987
The pricing of options on assets with stochastic volatility
Journal of Finance 42(2), pages 357378
Jamshidian F, 1997
Libor and swap market models and measures
Finance and Stochastics 1(4), September, pages
293330
Joshi M and R Rebonato, 2003
A displaced-diffusion stochastic volatility Libor market
model: motivation, definition and implementation
Quantitative Finance 3, pages 458469
Marris D, 1999
Financial option pricing and skewed volatility
Master of Philosophy thesis, Statistical Laboratory,
University of Cambridge
Piterbarg V, 2003
A stochastic volatility forward Libor model with a term
structure of volatility smiles
October 25, available at http://ssrn.com/
abstract=472061
Piterbarg V, 2005
Time to smile
Risk May, pages 8792
Rebonato R, 2002
Modern pricing of interest-rate derivatives
Princeton University Press and Oxford
Rebonato R, 2006
Forward-rate volatilities and the swaption matrix: why
neither time-homogeneity nor time-dependence will do
International Journal of Theoretical and Applied
Finance, August, pages 320345
Rebonato R and M Joshi, 2002
A joint empirical and theoretical investigation of
the modes of deformation of swaption matrices:
implications for the stochastic-volatility Libor market
model
International Journal of Theoretical and Applied
Finance 5(7), pages 667694
Rebonato R and D Kainth, 2004
A two-regime, stochastic-volatility extension of the Libor
market model
International Journal of Theoretical and Applied
Finance 7(5), pages 555575
Schwartz E, 1997
The stochastic behaviour of commodity prices
Journal of Finance LII, pages 923973
Svoboda-Greenwood S and
B Hambly, 2007
Equivalence of CEV and DD processes
Submitted to Applied Mathematical Finance,
available at www.maths.ox.ac.uk\~svoboda
White R and R Rebonato, 2007
A swaption volatility model using Markov regime
switching
Working paper, Royal Bank of Scotland, available at
www3.imperial.ac.uk/riskman
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