Abstract
As in paper 1 this paper develops an n-dimensional Markov-functional interest rate model. While parts of the construction are similar to the model in paper 1 this model is formulated in the terminal measure and is based on parametric functional forms of exponential type. The parametric functional forms enable analytical expressions for forward discount bonds and forward LIBORs at all times and allows for calibration of the model to caplet prices given by a displaced diffusion Black model. These analytical expressions provide a theoretical tool for understanding the structure of Markov-functional models and comparisons with the LIBOR market model. In particular it is shown that for ´typical`market data the model is close enough to the LIBOR market model to be able to calibrate using the LIBOR market model calibration setup and machinery. This provides further information about the similarities (as well as some of the differences) between Markov-functional and LIBOR market models. The parametric n-dimensional Markov-functional model may be used for products that require high-dimensional models for appropriate pricing and risk management. Compared with an n-factor LIBOR market model it has the virtue of being (much) faster for certain types of products.