Rates squared

Vladimir Piterbarg introduces a conveniently parameterised class of multi-factor quadratic Gaussian models, develops calibration formulas and explains the advantages of this class of models over alternatives currently available for the pricing and risk management of interest rate exotic derivatives

Pricing and risk-managing modern exotic interest rate derivatives requires an interest rate model that has a rich volatility structure, multiple sources of randomness, ability to calibrate to a large/complete set of vanilla options (swaptions and caps) and the ability to control volatility smile and rate decorrelation. In recent years, Libor market models have emerged as a clear favourite for the task. While these models satisfy all the criteria listed above, they do have one practical

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