Eurodollar futures pricing in log-normal interest rate models in discrete time

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Abstract

We demonstrate the appearance of explosions in three quantities in interest rate models with log-normally distributed rates in discrete time. (1) The expectation of the money market account in the Black, Derman, Toy model, (2) the prices of Eurodollar futures contracts in a model with log-normally distributed rates in the terminal measure and (3) the prices of Eurodollar futures contracts in the one-factor log-normal Libor market model (LMM). We derive exact upper and lower bounds on the prices and on the standard deviation of the Monte Carlo pricing of Eurodollar futures in the one factor log-normal Libor market model. These bounds explode at a non-zero value of volatility, and thus imply a limitation on the applicability of the LMM and on its Monte Carlo simulation to sufficiently low volatilities.

Original languageEnglish
Pages (from-to)445-464
Number of pages20
JournalApplied Mathematical Finance
Volume23
Issue number6
DOIs
StatePublished - 1 Nov 2016

Keywords

  • Eurodollar futures
  • Interest rate models
  • Libor market model

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