Equity swaps in a LIBOR market model

Abstract

This study extends the BGM (A. Brace, D. Gatarek, & M. Musiela, 1997) interest rate model (the London Interbank Offered Rate [LIBOR] market model) by incorporating the stock price dynamics under the martingale measure. As compared with traditional interest rate models, the extended BGM model is both appropriate for pricing equity swaps and easy to calibrate. The general framework for pricing equity swaps is proposed and applied to the pricing of floating-for-equity swaps with either constant or variable notional principals. The calibration procedure and the practical implementation are also discussed. © 2007 Wiley Periodicals, Inc.