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LIBOR Market Model Calibration Parameters

A calibrated model is a model whose parameters have values that are consistent with market observations. Calibration involves finding values of the parameters such that the model is able to reproduce (as close as possible) the prices of “calibration instruments" observed in the market. Values of the LIBOR Market Model parameters (forward rate volatilities and correlations) are found by calibrating the model to market-quoted Black volatilities of caps and European-style swaptions. The resulting values of the parameters (forward rate volatilities and correlations) are used when evolving the state variables (forward rates) for the purpose of pricing interest rate derivatives that may or may not have prices available in the market.


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