The Libor market model is the standard model used by derivatives dealers to price interest rate derivatives. The reason is simple. Vanilla interest rate caps are priced by convention using Black 76, and their prices are quoted in terms of Black 76 implied volatilities. The Libor market model is consistent with Black 76, so it allows cap implied volatilities to be used to price more exotic structures. Of course, there isn't one single Libor market model. Various implementations of the Heath Jarrow Morton (HJM) methodology have been proposed, differing primarily in how they are calibrated. This is a fascinating area of research at the junction of advanced financial engineering theory and the practical needs of capital markets traders.

Schoenmakers' book is the definitive text on the Libor market model (and related models). He briefly reviews financial engineering theory, explains the HJM framework, describes several Libor market model implementations, and illustrates with practical pricing problems. This is a book for serious financial engineers. Discussions assume you already know all about the fundamental theorem of asset pricing and valuation with equivalent martingale measures. Schoenmakers reviews such concepts only to clarify terminology and notation. His writing is minimalist but extremely well organized. Ideas progress from one to another in a clear mathematical progressing of theorems and proofs.

How does the book compare with Rebonato (2002)? Rebonato targets a less sophisticated audience—readers who are broadly familiar with financial engineering concepts but don't have in-depth understanding. For those readers, Rebonato's lengthy pros may be useful. More sophisticated readers will be frustrated with how slowly he makes points that could easily have been made with a single formula or two. Rebonato is twice as long as Schoenmakers but covers half as much material.

For serious implementers, Schoenmakers is the essential book. If you have the financial engineering background to follow it, you will find his presentation a delightful read—clean, rigorous and masterful.

The two books—Schoenmakers and Rebonato—are so different that they really complement each other. If you are serious about implementing a production Libor market model, I couldn't imagine you not reading both. [11/17/05]