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As I understand, models such as the SABR extension of the Libor Market Model are the "standard" for interest rate derivative valuation in OTC markets, where options tend to be European and it is forwards (not futures) being traded.

In practice, is there an equivalent modelling framework for the exchange-traded market (e.g. CME Eurodollar futures and their options), where options tend to be American and the instruments are futures, not forwards?

I know that simple discrete term-structure models can be used to value American options, but I'm not sure that any can incorporate the volatility smile with the same effectiveness as SABR.

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Liquid market instruments tend to be "building blocks", i.e. the OTC instruments need be "calibrated" to them, since futures/options etc are used in hedging OTC. OTC instruments are valued in risk neutral or equivalent martingale measures, but liquid markets are in physical measure. One can build some models to tackle the liquid markets, but not in the classical "arb-free" sense. In others, empirical models only.

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  • $\begingroup$ I had thought it was the OTC instruments (i.e. swaps, forwards, caplets & swaptions), given their volumes, that served as the "calibrating instruments" for LMM-SABR. My concern is that, if I were to choose (e.g. due to data constraints) to use exchange-traded instruments as calibrating instruments instead, it's not clear that LMM-SABR is a tractable model anymore. To the second part: not sure I follow ... can't prices of futures and American options on futures be valued numerically via a binomial/trinomial lattice with the money market numeraire? Not sure why I need the physical measure. $\endgroup$
    – MikeRand
    Commented May 20, 2019 at 12:37

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