Abstract:
From practical application perspective, many interest rate smile models are complex and smile calibration processes are numerically intensive. This talk will present a new type of interest rate smile model that can be made as efficient as the equivalent equity smile model. By postulating a spot Libor process and using the numeraire-change technique, the Dupire-style local volatility stripping from market quotes (implied smile) becomes possible in the asset class of interest rate. The presentation will derive the formulation of a self-contained backward pricing PDE which can be used to price path-dependent interest rate derivatives with smile. This type of Libor smile model can be an ideal candidate for incorporating interest rate smile in hybrids too.