Approximate option pricing in the Lévy Libor model.

Summary In this paper we consider the pricing of options on interest rates such as caplets and swaptions in the Lévy Libor model developed by Eberlein and Özkan (Financ. Stochast. 9:327-348 (2005) [9]). This model is an extension to Lévy driving processes of the classical log-normal Libor market model (LMM) driven by a Brownian motion. Option pricing is significantly less tractable in this model than in the LMM due to the appearance of stochastic terms in the jump part of the driving process when performing the measure changes which are standard in pricing of interest rate derivatives. To obtain explicit approximation for option prices, we propose to treat a given Lévy Libor model as a suitable perturbation of the log-normal LMM. The method is inspired by recent works by Černý, Denkl, and Kallsen (Preprint (2013) [6]) and Ménassé and Tankov (Preprint (2015) [14]). The approximate option prices in the Lévy Libor model are given as the corresponding LMM prices plus correction terms which depend on the characteristics of the underlying Lévy process and some additional terms obtained from the LMM model.