The Zero-Coupon Rate Model for Derivatives Pricing

TL;DR

This paper introduces a dual-term structure interest rate model using zero-coupon rates to improve derivatives pricing, calibration, and risk management, with a focus on swaption matrices and structured products.

Contribution

It presents a novel zero-coupon rate-based model that directly calibrates volatility and computes bucket vegas, addressing key challenges in interest rate derivatives modeling.

Findings

Successful model calibration demonstrated

Effective structured product pricing achieved

Accurate bucket vegas calculation shown

Abstract

The aim of this paper is to present a dual-term structure model of interest rate derivatives in order to solve the two hardest problems in financial modeling: the exact volatility calibration of the entire swaption matrix, and the calculation of bucket vegas for structured products. The model takes a series of long-term zero-coupon rates as basic state variables that are driven directly by one or more Brownian motion. The model volatility is assigned in a matrix form with two terms. A numerical scheme for implementing the model has been developed in the paper. At the end, several examples have been given for the model calibration, the structured products pricing and the calculation of bucket vegas.