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LECTURE 4
LECTURE 4 Pricing with the LIBOR model: Libor in Arrears; Constant Maturity Swaps (CMS); Ratchet caps and oors; Zero Coupon Swaptions.
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:= := :=
k (t)
1 + j Fj (t)
, k<i
0, k = i k (t)
k X k,j j j (t)Fj (t) j=i+1
1 + j Fj (t)
, k > i.
The distributions or statistical laws of the Fk under Qi are unknown for i = k. This is a problem, because prices are expectations under pricing measures, and if we do not know the laws of the random variables we cannot compute the expectations analytically. We are forced to resort to numerical methods. Can we escape this situation in some cases?
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:= := :=
k (t)
1 + j Fj (t)
, k<i
0, k = i k (t)
k X k,j j j (t)Fj (t) j=i+1
1 + j Fj (t)
, k > i.
:= := :=
k (t)
1 + j Fj (0)
, k<i
0, k = i k (t)
k X k,j j j (t)Fj (0) j=i+1
1 + j Fj (0)
, k > i.
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:= := :=
k (t)
1 + j Fj (0)
, k<i
0, k = i k (t)
k X k,j j j (t)Fj (0) j=i+1
1 + j Fj (0)
, k > i.
This dynamics gives access, in some cases, to a number of techniques which have been developed for the basic Black and Scholes setup, for example, in equity and FX markets. Moreover, this freezing-part-of-the-drift technique can be combined with drift interpolation so as to allow for rates that are not in the fundamental (spanning) family T0, T1, . . . , TM corresponding to the particular model being implemented. Finally, even resorting to MC allows now for a one-shot propagation of the dynamics with no infra-discretization, thus reducing memory requirements and simulation time. A similar idea may work also in some smile extensions.
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An in-advance swap (or LIBOR in arrears) is an IRS that resets at dates T+1, . . . , T and pays at the same dates, with unit notional amount and with xed-leg rate K . With respect to standard swaps, the LIBOR payments are in arrears, since the libor pays immediately when it resets, and not one period later. More precisely, the discounted payo of an in-advance swap (of payer type) can be expressed via
X B(0)
B(Ti) i=+1 =
i+1(L(Ti, Ti+1) K) =
X B(0)
B(Ti) i=+1
i+1(Fi+1(Ti) K).
2
IAS = E 4
B
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Before calculating the expectations, it is convenient to make some adjustments. We shall use the following identity (obtained easily via iterated conditioning):
E =E =E
B(0) XT B(T )
=E
= =
=
=E
=
so that
=E
XT
B(0) B(T )
2
B =E 4
B(0) XT B(S)
3 5
for all 0 < T < S,
P (T, S)
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8 9 < X B(0) = E (F (T ) K) :i=+1 B(Ti) i+1 i+1 i ; 8 9 = <X 1 = ... (1 + i+1K) =E D(0, Ti) ; :i=+1 P (Ti, Ti+1)
Now use our previous result with T = Ti, S = Ti+1, XT = 1/P (Ti, Ti+1) to get
E
2
=E4
3 5=
P (Ti, Ti+1)
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=E
X B(0) i=+1
2
B 6 6 B(0) B(Ti+1)
3 7 1 7 25 P (Ti, Ti+1) 3
1
P (Ti+1 , Ti+1 )
X i=+1
X i=+1
2
P (0, Ti+1 )
X i=+1
6 6 4
7 1 7 25 P (Ti, Ti+1)
X i=+1
X i=+1
P (0, Ti+1)E
i+1
(1 + i+1Fi+1(Ti))
X i=+1
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Computing the expected value is an easy task, since we know that, under Qi+1, Fi+1 has the driftless (martingale) lognormal dynamics
dFi+1(t) = i+1(t)Fi+1(t)dZi+1(t) ,
so that (Ito formula (F ) = F 2, (F ) = 2F, (F ) = 2),
i+1
Fi+1(Ti)
= Fi+1(0) exp
2
"Z
0
Ti
#
i+1(t)dt
2 2
= Fi+1(0) exp(Tivi )
where the v s have been dened in Lecture 2 and are caplet volatilities for Ti Ti+1.
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= +
X i=+1
Contrary to the plain-vanilla case, this price depends on the volatility of forward rates through the caplet volatilities v . Notice however that correlations between dierent rates are not involved in this product, as one expects from the additive and one-rateper-time nature of the payo.
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Notice that if we set Ki := L(Ti2, Ti1) + X for all is this is a set of caplets with (random) strikes Ki.
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In general a sticky ratchet cap has to be valued through Monte Carlo simulation. We have
E{
i=+1 X i=+1
(
i E
= P (0, T )
)
.
Since the Q forward-rate dynamics of F(t)(t), . . . , F (t) can be discretized via the usual scheme, Monte Carlo pricing can be carried out in the usual manner. We can use also the lognormal frozen-drift approximation to implement a faster MC simulation. However, for the non-sticky ratchet cap payo we may investigate possible analytical approximations based on the usual freezing the drift technique for the LIBOR market model.
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E{D(0, Ti) [L(Ti1, Ti) (L(Ti2, Ti1) + X)] } = P (0, Ti)E {[Fi(Ti1) Fi1(Ti2) X] } =: P (0, Ti)mi and then add terms. In the above expectation, the rates evolve as follows under the measure Qi: dFi(t) = i(t)Fi(t)dZi(t), dFi1(t) = i1,iii(t)Fi(t) Fi1(t)dt + i1(t)Fi1(t)dZi1(t) 1 + iFi(t)
i +
As usual, in such dynamics we do not know the distribution of Fi1(t). But, since Fi1 and Fis reset times are adjacent, we may freeze the drift in Fi1 and be rather condent on the resulting approximations. We thus replace the second SDE by
dFi1(t) (t)
= :=
Now both Fi1 and Fi follow (correlated) geometric Brownian motions as in the Black and Scholes model.
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dS1(t) = S1(t)[(r q1)dt + 1dW1 (t)], S1(0) = s1, dS2(t) = S2(t)[(r q2)dt + 2dW2 (t)], S2(0) = s2,
Q Q where W1 and W2 are Brownian motions under Q with instantaneous correlation . Fix a maturity T , a positive real number a, a negative real number b, a strike price K . The spread-option payo at time T is then dened by Q
(9)
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t = e
Z
t =
1 1 v2 e 2 f (v)dv, 2
where
0
wh(v)e
and
r
@w
ln
+ (1 p 1 1 2
1 2 2 1 )
1 + 1 v
h(v) = KbS2(t)e
2 (2 1 2 ) +2 v 2
, 1,2 = rq1,2, = T t.
Copyright 2005 Damiano Brigo: The LIBOR and Swap market models
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mi := E {[Fi(Ti1) Fi1(Ti2) X] }
is given by our formula above for the spread option when taking into account the above substitutions, i.e. one needs to apply said formula with a = 1, = 1, t = 0,
Z
S1(t) = Fi(0), q1 = 0, q2 = r = 0,
2 1
Ti2 0
(u)du,
Ti2
Z
=
0
Ti1
2 i (u)du,
2 2
Z
0
i1(u)du,
= i1,i, K = X.
Once we have the mis, our ratchet price is given by
X i=+1
P (0, Ti)imi.
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(Fi(Ti1) Fi1(Ti2))
H = (S1(T ) S2(T ))
This payo is the so called option to exchange one asset (S1) for another (S2). Indeed, if we hold S2, when we are at T the option pays
Copyright 2005 Damiano Brigo: The LIBOR and Swap market models
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So, when holding S2, if S1(T ) > S2(T ) by means of option we end up with S1, so we have exchanged S2 with more valuable S1. On the contrary, if S1(T ) < S2(T ), option expires worthless and there is no exchange, so we keep more valuable S2.
This means that the exchange is a right but no obligation, since it occurs only when it favors us. This is then indeed an option to exchange one asset for another. In the market this kind of option is priced with Margrabes formula, which we derive below by using the change of numeraire technique.
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"
= S1
where Yt = Note that we took S1 as numeraire, assuming q1 = 0, since the numeraire has to be a positive non-dividend paying asset (q1 = 0). Notice also that in the numerator, to have the price of a tradable asset, we got rid of the dividend by inserting the forward price
S2(T ) 1 S1(T )
+ #
= S1(0)E
S1
(1 Y (T ))
Et
(without dividends the forward price would be S2(t) itself). Now we need to derive the dynamics of Yt under the S1 measure. We know this is a martingale, since Yt is a ratio between a tradable asset and our numeraire S1, so that by FACT ONE on the change of numeraraire (rst lecture) we have that Yt is a martingale (=zero drift).
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RT
RT
=
First notice that the rst term would only give a dt contribution when dierentiated. Then we compute directly
=
RT
RT t q2 (s)ds e d
S2(t) S1(t)
+ (. . .)dt =
1 1 q (s)ds =e t 2 d (S2(t)) + S2(t)d + S1(t) S1(t) 1 + (. . .)dt = + dS2(t) d S1(t) RT 1 1 q (s)ds =e t 2 d (S2(t)) + S2(t)d +(. . .)dt = S1(t) S1(t) RT 1 q (s)ds B =e t 2 S2(t)[(r q2)dt + 2dW2 ]+ S1(t) 1 + S2(t)d + (. . .)dt = ... S1(t) 1 1 Since (Ito (S) = S , (S) = S 2 , (S) = 2/(S 3))
d
1 S1(t)
=
Copyright 2005 Damiano Brigo: The LIBOR and Swap market models
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by substituting we obtain
... = e
t q2 (s)ds
RT
1 B 1dW1 S1
q2
dYt = Yt(0dW0 1 )
provided that Var(2dW2 1 1dW1 1 ) = Var(0dW0 1 )
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This equation reads Var(2dW2 1 1dW1 1 ) = 1 dt + 2 dt 212dt and since we have Var(0dW0 1 ) = 0 dt
S 2 S S 2 2
0 = 1 + 2 212
Let us now go back to
S1(0)E
with the dynamics
S1
(1 Y (T ))
dYt = Yt(0dW0 1 )
This is a put option with strike 1 for which we get the formula
S1(0)[(d2) Y (0)(d1)]
with
d1,2 =
ln(Y (0)/1)
R T
0
1 2
RT
0
2 0 (t)dt
1
2
2 0 (t)dt
[S1(0)(d2) S2
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RT 0 q2 (t)dt (0)e (d
1 )]
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d1,2 =
ln(S2(0)/S1(0))
RT
0
q2(t)dt
R T
0
1 2
RT
0
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[...]dt
1
2
As before, set
Z
S1(t) = Fi(0), q1 = 0,
Z
q2(t)dt =
0
Ti2
(u)du,
Z
r = 0,
T 0
2 1 (t)dt
Z
=
0 2
0 Ti1
i (t)dt,
Z
0
2 2 (t)dt
Z
=
0
Ti2
i1(t)dt, = i1,i
to get:
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8 < X D(0, Ti )i L(Ti1 , Ti ) L(Ti2 , Ti1 ) E : 8 < X =E D(0, Ti )i Fi (Ti1 ) Fi1 (Ti2 ) :
i=+1 i=+1 +
9 = ;
9 = ; ! #
(d2 ) ,
i
X i=+1
"
i P (0, Ti ) Fi (0)(d1 ) Fi1 (0) exp
i
Z
0
Ti2
(u)du
Z
0
Ti2
!1
2 (i1 (u) 2i1,i i1 (u)i (u))du
In this section we dealt with ratchet caps. The treatment of ratchet oors is analogous.
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A payer (receiver) zero-coupon swaption is a contract giving the right to enter a payer (receiver) zero-coupon IRS at a future time. A zero-coupon IRS is an IRS where a single xed payment is due at the unique (nal) payment date T for the xed leg in exchange for a stream of usual oating payments iL(Ti1, Ti) at times Ti in T+1, T+2, . . . , T (usual oating leg). In formulas, the discounted payo of a payer zero-coupon IRS is, at time t T:
Copyright 2005 Damiano Brigo: The LIBOR and Swap market models
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The value of K that renders the contract fair is obtained by equating to zero the above value. K = F (t; T, T ). Indeed, the value of the swap is independent of the number of payments on the oating leg, since the oating leg always values at par, no matter the number of payments. Therefore, we might as well have taken a oating leg paying only in T the amount , L(T, T ). This would have given us again a standard swaption, standard in the sense that the two legs of the underlying IRS have the same payment dates (collapsing to T ) and the unique reset date T. In such a one-payment case, the swap rate collapses to a forward rate, so that we should not be surprised to nd out that the forward swap rate in this particular case is simply a forward rate.
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An option to enter a payer zero-coupon IRS is a payer zerocoupon swaption, and the related payo is
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1 + F (t) =
It follows that
Y j=+1
(1 + j Fj (t)).
ln(1 + F (t)) =
so that d ln(1 + F (t)) =
X j=+1
ln(1 + j Fj (t)),
X j=+1
d ln(1 + j Fj (t)) =
Copyright 2005 Damiano Brigo: The LIBOR and Swap market models
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Var
dF (t) F (t)
=
1 + F (t) F (t)
(1 + iFi(t))(1 + j Fj (t))
dt.
Freeze all t s to 0 except for the s, and integrate over [0, T]: zc (v, )2 := (1/T)
1 + F (0) F (0)
2 X
Z
0
i(t)j (t)dt.
To price the zero-coupon swaption it is then enough to put this quantity into the related Blacks Caplet formula: ZCPS = P (0, T )[F (0)(d1(F (0), K, v, ))
zc
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We have checked the accuracy of this formula against the usual Monte Carlo pricing based on the exact dynamics of the forward rates. In the tests all swaptions are at-the-money. We have done this under a number of situations , corresponding to possible modications of the data coming from a standard calibrations of the LIBOR model to at-the-money swaptions data. All cases show the formula to be suciently accurate for practical purposes. When using the formula we notice that the at-the-money standard swaption has always a lower volatility (and hence price) than the corresponding at-the-money zero-coupon swaption. We may wonder whether this is a general feature. Indeed, we have the following.
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Comparison between zero-coupon swaptions and corresponding standard swaptions: A rst remark is due for a comparison zc between the zero-coupon swaption volatility v, and the LFM corresponding European-swaption approximation v, . If we rewrite the latter as
LFM 2 T(v, )
X i,j=+1
Z
i,j ij
0
i(t)j (t)dt, i =
wi(0)Fi(0) , S, (0)
X i,j=+1
Z
i,j ij
0
i(t)j (t)dt,
where
P (0, T) i i , P (0, Ti) the discrepancy increasing with the payment index i. It follows that, for positive correlations, the zero-coupon swaption volatility is always larger than the corresponding plain vanilla swaption volatility, the dierence increasing with the tenor T T, for each given T. i =
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A constant-maturity swap is a nancial product structured as follows. We assume a unit nominal amount. Let us denote by {T0, . . . , Tn} a set of payment dates at which coupons are to be paid. At time Ti1 (in some variants at time Ti), i 1, institution A pays to B the c-year swap rate resetting at time Ti1 in exchange for a xed rate K . Formally, at time Ti1 institution A pays to B
Si1,i1+c(Ti1) i ,
instead of
L(Ti1, Ti)i = Fi(Ti1) i , as would be natural (standard Interest Rate Swap with model independent valuation, see Lecture 1).
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E
n X i=1
n X i=1
iP (0, Ti1) E
i1
(Si1,i1+c(Ti1)) K
2
n X i=1
3
B(0) B(Ti1)
i E
B 6 6
7 Si1,i1+c(Ti1)7 5
n X i=1
K
We can change numeraire in two ways:
iP (0, Ti1)
1:
n X i=1
iP (0, Ti1) E
i1
(Si1,i1+c(Ti1)) K
2:
n X i=1
i P (0, Tn) E
KP (0, Ti1)) .
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CMSs
i1
At rst sight, one might think to discretize the dynamics of the forward swap rate in the swap model under the relevant forward measure, and compute the required expectation through a Monte Carlo simulation. However, notice that forward rates appear in the drift of such equation, so that we are forced to evolve forward rates anyway. As a consequence, we can build forward swap rates as functions of the forward LIBOR rates obtained by the Monte Carlo simulated dynamics of the LIBOR model. Find the swap rate Si1,i1+c(Ti1) from the Ti1 values of the (Monte Carlo generated) spanning forward rates
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CMSs
Alternatively, resort to S, (T) and compute
P
i=+1
wi(0)Fi(T)
E S, (T)
X i=+1
X i=+1
wi(0)E Fi(T)
wi(0)e
R T
0
,i (t)dt
Fi(0)
E S, (T)
X i=+1
X i=+1
wi(0)E Fi(T)
0 ,i (t)dt
wi(0)e
R T
Fi(0)
We have frozen again the drift in the Fis dynamics of the F s under Q. This can be compared with classical market convexity adjustments. The two methods give similar results when volatilities are not too high. Notation for was given at the beginning of this unit. The method is general and can be used whenever swap rates or forward rates are paid at times that are not natural in swaps and similar contracts. A dynamics can be obtained by the freezing procedures outlined above.
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For questions, further references, etc www.damianobrigo.it damiano.brigo@gmail.com For the exam, it is highly recommended to have a look at the exercises done during the course. For further developments or to expand on the course contents the second edition of Interest Rate Models: Theory and Practice, With Smile, Ination and Credit is a good reference. http://www.damianobrigo.it/book.html
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