Multiple curve L\'evy forward price model allowing for negative interest rates

TL;DR

This paper introduces a multiple curve Lévy forward price model that naturally accommodates negative interest rates and offers improved calibration and measure change simplicity, making it suitable for post-crisis financial environments.

Contribution

It develops a novel multiple curve interest rate model based on Lévy processes that allows for negative rates and simplifies measure changes, enhancing calibration and applicability.

Findings

Model can handle negative interest rates naturally.

Explicit cap valuation formula derived using Fourier transforms.

Successfully calibrated to market data for both variants.

Abstract

In this paper we develop a framework for discretely compounding interest rates which is based on the forward price process approach. This approach has a number of advantages, in particular in the current market environment. Compared to the classical as well as the L\'evy Libor market model, it allows in a natural way for negative interest rates and has superb calibration properties even in the presence of extremely low rates. Moreover, the measure changes along the tenor structure are simplified significantly. These properties make it an excellent base for a post-crisis multiple curve setup. Two variants for multiple curve constructions are discussed. Time-inhomogeneous L\'evy processes are used as driving processes. An explicit formula for the valuation of caps is derived using Fourier transform techniques. Based on the valuation formula, we calibrate the two model variants to market data.