A Flexible Matrix Libor Model with Smiles

Abstract

We present a flexible approach for the valuation of interest rate derivatives based on affine processes. We extend the methodology proposed in Keller-Ressel et al. (in press) by changing the choice of the state space. We provide semi-closed-form solutions for the pricing of caps and floors. We then show that it is possible to price swaptions in this multifactor setting with a good degree of analytical tractability. This is done via the Edgeworth expansion approach developed in Collin-Dufresne and Goldstein (2002). A numerical exercise illustrates the flexibility of Wishart Libor model in describing the movements of the implied volatility surface.