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Monetary Policy Risk and CMS Spreads Claudio Albanese

Summary: Monetary Policy Risk and CMS Spreads
Claudio Albanese
Manlio Trovato
May 12, 2007
Central banks' monetary policies are regarded by financial institutions
as a key driver for the definition of their interest rate hedging strategies.
However this valuable information is not directly incorporated in most
derivative pricing models commonly used in financial institutions. We
present a novel approach to interest rate modelling, which incorporates a
direct specification of stochastic monetary policy within an arbitrage-free
context. In particular, we take the 3-month spot LIBOR rate as modelling
primitive and propose a three factor interest rate term structure model
solved on a continuous-time lattice. The model is constructed with local
volatility, stochastic volatility regimes and stochastic drift regimes and
can be formally written as dLt = ľat (Lt)dt + bt (Lt)dWt. The drift and
the volatility terms are stochastic and driven by the processes at and bt,
which can be made correlated to the rates themselves.
We show that, with a nearly time-homogeneous parameterisation, the
model can achieve a persistent smile structure across maturities, in agree-


Source: Albanese, Claudio - Department of Mathematics, King's College London


Collections: Mathematics