A simple approximation for the no-arbitrage drifts in Libor market model–SABR-family interest-rate models

Riccardo Rebonato

Abstract

ABSTRACT

This paper presents a simple, yet surprisingly effective, approximation for the noarbitrage drifts that appear in Libor market model-SABR-family term structure models. The approximation reduces the burden of the computational bottleneck for these models by one order of magnitude. As the size of the problem increases it becomes asymptotically exact for a wide class of correlation structures. We show the effectiveness of the approximation in a particularly severe stress case.