A Method Of Interest Rate Swap Option Estimation Based On Stochastic Volatility Model

Swaption is one of the most basic and liquid interest rate derivatives in the market. In this paper, we have built a new stochastic volatility LIBOR Market Model, based on A. Brace, D.Gatarek and M. Musiela’s classical BGM model. We have given a fast way to approximate the swaption price:using Markovian Projection and Gaussian approximation to reduce the multi-factor model to the one-factor model; then applying Hagan’s result to connect our stochastic volatility model with Black’s formula. Enlightened by Piterbarg’s average parameter method, we have proposed a better way to reduce the time cost in approximating the swaption price.