Preface

For quantitative researchers working in an investment bank, the process

of writing a fixed income model usually has two stages. First, a theoreti-
cal framework for yield curve dynamics is specified, using the language of
mathematics (especially stochastic calculus) to ensure that the underlying
model is well-specified and internally consistent. Second, in order to use
the model in practice, the equations arising from the first step need to be
turned into a working implementation on a computer. While specification
of the theoretical model may be seen as the difficult part, in quantitative
finance applications the second step is technically and intellectually often
more challenging than the first. In the implementation phase, not only does
one need to translate abstract ideas into computer code, one also needs
to ensure that the resulting numbers being produced are meaningful to a
trading desk, are stable and robust, are in line with market observations,
and are produced in a timely manner. Many of these requirements are, as
it turns out, extremely challenging, and not only demand a strong knowl-
edge of actual market practices (which tend to deviate in significant ways
from “textbook” theory), but also require application of a large arsenal of
techniques from applied mathematics, chiefly approximation methods and
numerical techniques.
While there are many good introductory books on fixed income deriva-
tives on the market, when we hire people who have read them we find that
they still require significant training before they become productive mem-
bers of our quantitative research teams. For one, while existing literature
covers some aspects of the first step above, advanced approaches to spec-
ifying yield curve dynamics are typically not covered in sufficient detail.
More importantly, there is simply too little said in the literature about the
process of getting the theory to work in the real world of trading and risk
management. An important goal of our book series is to close these gaps in
the literature.
VIII Preface

As we write this in early 2010, financial markets are still reeling from
a severe crisis that has, at least in part, been blamed on over-the-counter
(OTC) options markets, the venue where complex derivative securities are
transacted. Stricter regulation of some types of OTC derivatives currently
seems all but inevitable, and many common OTC securities may in the fu-
ture either be outlawed or traded only on public exchanges. In the wake of
the crisis, opinion of financial engineers and bankers has hit an all-time low,
with many in the public convinced that they are peddlers of toxic waste
or “weapons of financial destruction”. All things considered, the present
may therefore seem like an inauspicious moment to launch a series of mono-
graphs on the pricing and risk management of interest rate derivatives. We
disagree, for several reasons. First, in defense of OTC derivatives we note
that although they certainly can be used inappropriately to create excessive
leverage and risk, many complex (or “exotic”) derivatives serve as innova-
tive and cost-effective vehicles for bank clients to reduce their financial
risk. Second, irrespective of what will ultimately transpire on the regula-
tory front, it has become obvious that going forward both regulators and
market participants need a better grasp of the management and charac-
terization of complex financial risk. This is perhaps particularly true for
the quantitative research professionals (the “quants”, in common parlance)
who recently have been taken to task by the press for the failure of their
models and their inability to predict the credit crisis. While this simplis-
tic characterization is actually quite unfair, there is no doubt that many
derivatives models that worked well enough before the credit crisis are no
longer adequate. Indeed, even the simple task of pricing a basic interest rate
swap — possibly the simplest of all interest rate derivatives — has recently
required major methodology revisions1 . If nothing else, a severe crisis serves
to expose weaknesses in the foundation on which models are built, allowing
one to reinforce it for future storms. In this light, we feel that the time is
just about right for a comprehensive, practical, and up-to-date exposition
of interest rate modeling and risk management2 .
The three volumes of Interest Rate Modeling are aimed primarily at
practitioners working in the area of interest rate derivatives, but much of
the material is quite general and, we believe, will also hold significant ap-
peal to researchers working in other asset classes. Students and academics
interested in financial engineering and applied work will find the material
particularly useful for its description of real-life model usage and for its
expansive discussion of model calibration, approximation theory, and nu-
merical methods. In preparing the books we have drawn on nearly 30 years
of combined industry experience, and much of the material has never been
exposed in book form before.

1
We cover this in Chapter 6.
2
We ought to note that interest rate derivatives (unlike credit derivatives) so
far have not been directly implicated in the financial crisis.
 Preface IX

Quantitative finance attracts students and practitioners from many dif-

ferent academic fields, and with varying levels of preparation in mathematics
and computation. (Case in point: L.B.G.A was originally a robotics engi-
neer and V.V.P a probabilist.) To cater to a broad audience, we have kept
the exposition fairly informal; graduate students in applied fields such as
engineering and physics should feel at home with the level (or lack) of rigor
used in the book. We have relied on a proposition-proof format throughout,
largely because this facilitates easier cross-referencing in a long text, but
acknowledge that the format is occasionally more formal than the results
themselves. For instance, we tend to skip over technical regularity condi-
tions in our proofs and also frequently list approximate results in propo-
sitions without explicitly specifying the sense in which they approximate
true values. Although the exposition is largely self-contained, some previ-
ous knowledge of basic option pricing principles (e.g., at the level of Hull
[2006]) may be useful.
Interest Rate Modeling divides into three separate volumes. Volume I
provides the theoretical and computational foundations for the series, em-
phasizing the construction of efficient grid- and simulation-based methods
for contingent claims pricing. Numerical methods serve an extremely impor-
tant role in the text, so we develop this topic to an advanced level suitable
for professional-quality model implementations. Placing this material early
in the text allows us to incorporate it into our discussion of individual mod-
els in subsequent chapters. The second part of Volume I is dedicated to
local-stochastic volatility modeling and to the construction of vanilla mod-
els for individual swap and Libor rates. Although the focus is eventually
turned toward fixed income securities, much of the material in this volume
applies to a broad capital market setting and will be of interest to anybody
working in the general area of asset pricing.
Volume II is dedicated to in-depth study of term structure models of
interest rates. While providing a thorough analysis of classical short rate
models, the primary focus of the volume is on multi-factor stochastic volatil-
ity dynamics, in the setups of both the separable HJM and Libor market
models. Implementation techniques are covered in detail, as are strategies
for model parameterization and calibration to market data.
The first half of Volume III contains a detailed study of several classes
of fixed income securities, ranging from simple vanilla options to highly ex-
otic cancelable and path-dependent trades. The analysis is done in product-
specific fashion, covering, among other subjects, risk characterization, cal-
ibration strategies, and valuation methods. In its second half, Volume III
studies the general topic of derivative portfolio risk management, with a
particular emphasis on the challenging problem of computing smooth price
sensitivities to market input perturbations.
Although much of the material in Interest Rate Modeling is focused on
the technical and theoretical issues surrounding model implementation on a
computer, it is impractical for us to delve into the exercise of writing actual
X Preface

computer routines. Fortunately, there are several specialized books on how

to write good quant code, see, e.g., Hyer [2010] and Joshi [2004]. Both
of these books work with C++ which is still the most common computer
language used in professional quant libraries. For those that choose to work
with C++, we wholeheartedly endorse books by Scott Meyers (see, e.g.,
Meyers [2005]) and Andrei Alexandrescu (see, e.g., Sutter and Alexandrescu
[2004]) as guides to sound and maintainable code.
During the six year process of writing this book series, we have received
encouragement and constructive criticism from many people. We partic-
ularly wish to thank Peter Carr, Peter Forsyth, Alexandre Antonov, Pe-
ter Jäckel, Dominique Bang, Martin Dahlgren, Neil Oliver, Patrick Roome,
Regis van Steenkiste, Natasha Bushueva and many members of the research
teams at Barclays Capital and Bank of America Merrill Lynch. Natalia
Kryzhanovskaya meticulously proofread our first draft, and contributed
greatly to the harmonization of notation across what turned out to be a
very long manuscript. All remaining errors are, of course, entirely our own.
Speaking of errors: with nearly 20,000 equations, it is probable that a few
typos remain, despite our best efforts to weed them out. A list of errata will
be maintained on www.andersen-piterbarg-book.com where supplemen-
tal material and news will also be posted on a running basis. We greatly
appreciate reporting of typos or factual errors to our web address, and will
list the names of all those who contribute to error spotting in future editions
of Interest Rate Modeling.
Lastly, we owe a great debt of gratitude to our families for their support
and patience, even when our initial plans for a brief book on tips and tricks
for working quants ballooned into something more ambitious that consumed
many evenings and weekends over the last six years.

London, New York, Leif B.G Andersen

June 2004 — August 2010 Vladimir V. Piterbarg
Table of Contents for All Volumes

VOLUME I Foundations and Vanilla Models

Part I Foundations

1 Introduction to Arbitrage Pricing Theory . . . . . . . . . . . . . 3

1.1 The Setup . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.2 Trading Gains and Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.3 Equivalent Martingale Measures and Arbitrage . . . . . . . . . . 8
1.4 Derivative Security Pricing and Complete Markets . . . . . . . 10
1.5 Girsanov’s Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
1.6 Stochastic Differential Equations . . . . . . . . . . . . . . . . . . . . . . 14
1.7 Explicit Trading Strategies and PDEs . . . . . . . . . . . . . . . . . . 16
1.8 Kolmogorov’s Equations and the Feynman-Kac Theorem . 18
1.9 Black-Scholes and Extensions . . . . . . . . . . . . . . . . . . . . . . . . . 21
1.9.1 Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
1.9.2 Alternative Derivation . . . . . . . . . . . . . . . . . . . . . . . . 25
1.9.3 Extensions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
1.9.3.1 Deterministic Parameters and Dividends 27
1.9.3.2 Stochastic Interest Rates . . . . . . . . . . . . . 28
1.10 Options with Early Exercise Rights . . . . . . . . . . . . . . . . . . . . 30
1.10.1 The Markovian Case . . . . . . . . . . . . . . . . . . . . . . . . . . 32
XII Contents

1.10.2 Some General Bounds . . . . . . . . . . . . . . . . . . . . . . . . . 34

1.10.3 Early Exercise Premia . . . . . . . . . . . . . . . . . . . . . . . . . 36

2 Finite Difference Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

2.1 1-Dimensional PDEs: Problem Formulation . . . . . . . . . . . . . 43
2.2 Finite Difference Discretization . . . . . . . . . . . . . . . . . . . . . . . . 45
2.2.1 Discretization in x-Direction. Dirichlet Boundary
Conditions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
2.2.2 Other Boundary Conditions . . . . . . . . . . . . . . . . . . . . 47
2.2.3 Time-Discretization . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
2.2.4 Finite Difference Scheme . . . . . . . . . . . . . . . . . . . . . . 50
2.3 Stability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
2.3.1 Matrix Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
2.3.2 Von Neumann Analysis . . . . . . . . . . . . . . . . . . . . . . . . 53
2.4 Non-Equidistant Discretization . . . . . . . . . . . . . . . . . . . . . . . . 56
2.5 Smoothing and Continuity Correction . . . . . . . . . . . . . . . . . . 58
2.5.1 Crank-Nicolson Oscillation Remedies . . . . . . . . . . . . 58
2.5.2 Continuity Correction . . . . . . . . . . . . . . . . . . . . . . . . . 58
2.5.3 Grid Shifting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
2.6 Convection-Dominated PDEs . . . . . . . . . . . . . . . . . . . . . . . . . 60
2.6.1 Upwinding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
2.6.2 Other Techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
2.7 Option Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
2.7.1 Continuous Barrier Options . . . . . . . . . . . . . . . . . . . . 63
2.7.2 Discrete Barrier Options . . . . . . . . . . . . . . . . . . . . . . . 65
2.7.3 Coupon-Paying Securities and Dividends . . . . . . . . 67
2.7.4 Securities with Early Exercise . . . . . . . . . . . . . . . . . . 68
2.7.5 Path-Dependent Options . . . . . . . . . . . . . . . . . . . . . . 69
2.7.6 Multiple Exercise Rights . . . . . . . . . . . . . . . . . . . . . . . 70
2.8 Special Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72
2.8.1 Mesh Refinements for Multiple Events . . . . . . . . . . . 72
2.8.2 Analytics at the Last Time Step . . . . . . . . . . . . . . . . 75
2.8.3 Analytics at the First Time Step . . . . . . . . . . . . . . . 76
2.9 Multi-Dimensional PDEs: Problem Formulation . . . . . . . . . 78
2.10 Two-Dimensional PDE with No Mixed Derivatives . . . . . . . 79
2.10.1 Theta Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
2.10.2 The Alternating Direction Implicit (ADI) Method 81
2.10.3 Boundary Conditions and Other Issues . . . . . . . . . 84
2.11 Two-Dimensional PDE with Mixed Derivatives . . . . . . . . . . 85
2.11.1 Orthogonalization of the PDE . . . . . . . . . . . . . . . . . . 85
2.11.2 Predictor-Corrector Scheme . . . . . . . . . . . . . . . . . . . . 88
2.12 PDEs of Arbitrary Order . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
 Contents XIII

3 Monte Carlo Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93

3.1 Fundamentals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
3.1.1 Generation of Random Samples . . . . . . . . . . . . . . . . 95
3.1.1.1 Inverse Transform Method . . . . . . . . . . . . 96
3.1.1.2 Acceptance-Rejection Method . . . . . . . . . 97
3.1.1.3 Composition . . . . . . . . . . . . . . . . . . . . . . . . 99
3.1.2 Correlated Gaussian Samples . . . . . . . . . . . . . . . . . . 100
3.1.2.1 Cholesky Decomposition . . . . . . . . . . . . . 101
3.1.2.2 Eigenvalue Decomposition . . . . . . . . . . . . 102
3.1.3 Principal Components Analysis (PCA) . . . . . . . . . . 103
3.2 Generation of Sample Paths . . . . . . . . . . . . . . . . . . . . . . . . . . 104
3.2.1 Example: Asian Basket Options in Black-Scholes
Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
3.2.2 Discretization Schemes, Convergence, and Stability 106
3.2.3 The Euler Scheme . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
3.2.3.1 Linear-Drift SDEs . . . . . . . . . . . . . . . . . . . 110
3.2.3.2 Log-Euler Scheme . . . . . . . . . . . . . . . . . . . 110
3.2.4 The Implicit Euler Scheme . . . . . . . . . . . . . . . . . . . . . 111
3.2.4.1 Implicit Diffusion Term . . . . . . . . . . . . . . 112
3.2.5 Predictor-Corrector Schemes . . . . . . . . . . . . . . . . . . . 113
3.2.6 Ito-Taylor Expansions and Higher-Order Schemes . 114
3.2.6.1 Ordinary Taylor Expansion of ODEs . . . 115
3.2.6.2 Ito-Taylor Expansions . . . . . . . . . . . . . . . . 116
3.2.6.3 Milstein Second-Order Discretization
Scheme . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117
3.2.7 Other Second-Order Schemes . . . . . . . . . . . . . . . . . . 119
3.2.8 Bias vs. Monte Carlo Error . . . . . . . . . . . . . . . . . . . . 120
3.2.9 Sampling of Continuous Process Extremes . . . . . . . 122
3.2.10 PCA and Bridge Construction of Brownian
Motion Paths . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
3.2.10.1 Brownian Bridge and Quasi-Random
Sequences . . . . . . . . . . . . . . . . . . . . . . . . . . 126
3.2.10.2 PC Construction . . . . . . . . . . . . . . . . . . . . 128
3.3 Sensitivity Computations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
3.3.1 Finite Difference Estimates . . . . . . . . . . . . . . . . . . . . 129
3.3.1.1 Black-Scholes Delta . . . . . . . . . . . . . . . . . . 129
3.3.1.2 General Case . . . . . . . . . . . . . . . . . . . . . . . 131
3.3.2 Pathwise Estimate . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133
3.3.2.1 Black-Scholes Delta . . . . . . . . . . . . . . . . . . 133
3.3.2.2 General Case . . . . . . . . . . . . . . . . . . . . . . . 134
3.3.2.3 Sensitivity Path Generation . . . . . . . . . . . 136
3.3.3 Likelihood Ratio Method . . . . . . . . . . . . . . . . . . . . . . 136
3.3.3.1 Black-Scholes Delta . . . . . . . . . . . . . . . . . . 137
3.3.3.2 General Case . . . . . . . . . . . . . . . . . . . . . . . 138
3.3.3.3 Euler Schemes . . . . . . . . . . . . . . . . . . . . . . 138
XIV Contents

3.3.3.4 Some Remarks . . . . . . . . . . . . . . . . . . . . . . 139

3.4 Variance Reduction Techniques . . . . . . . . . . . . . . . . . . . . . . . . 140
3.4.1 Variance Reduction and Efficiency . . . . . . . . . . . . . . 141
3.4.2 Antithetic Variates . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
3.4.2.1 The Gaussian Case . . . . . . . . . . . . . . . . . . 141
3.4.2.2 General Case . . . . . . . . . . . . . . . . . . . . . . . 143
3.4.3 Control Variates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143
3.4.3.1 Basic Idea . . . . . . . . . . . . . . . . . . . . . . . . . . 143
3.4.3.2 Non-Linear Controls . . . . . . . . . . . . . . . . . 145
3.4.4 Importance Sampling . . . . . . . . . . . . . . . . . . . . . . . . . 146
3.4.4.1 Basic Idea . . . . . . . . . . . . . . . . . . . . . . . . . . 146
3.4.4.2 Density Formulation . . . . . . . . . . . . . . . . . 147
3.4.4.3 Importance Sampling and SDEs . . . . . . . 149
3.4.4.4 More on SDE Path Simulation . . . . . . . . 150
3.4.4.5 Rare Event Simulation and Linearization 152
3.5 Some Notes on Bermudan Security Pricing . . . . . . . . . . . . . . 156
3.5.1 Basic Idea . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156
3.5.2 Parametric Lower Bound Methods . . . . . . . . . . . . . . 157
3.5.3 Parametric Lower Bound: An Example . . . . . . . . . . 158
3.5.4 Regression-Based Lower Bound . . . . . . . . . . . . . . . . . 159
3.5.5 Upper Bound Methods . . . . . . . . . . . . . . . . . . . . . . . . 160
3.5.6 Confidence Intervals . . . . . . . . . . . . . . . . . . . . . . . . . . 161
3.5.7 Other Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162
3.A Appendix: Constants for Φ−1 Algorithm . . . . . . . . . . . . . . . . 163

4 Fundamentals of Interest Rate Modeling . . . . . . . . . . . . . . . 165

4.1 Fixed Income Notations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165
4.1.1 Bonds and Forward Rates . . . . . . . . . . . . . . . . . . . . . 165
4.1.2 Futures Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167
4.1.3 Annuity Factors and Par Rates . . . . . . . . . . . . . . . . . 168
4.2 Fixed Income Probability Measures . . . . . . . . . . . . . . . . . . . . 169
4.2.1 Risk Neutral Measure . . . . . . . . . . . . . . . . . . . . . . . . . 170
4.2.2 T -Forward Measure . . . . . . . . . . . . . . . . . . . . . . . . . . . 172
4.2.3 Spot Measure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
4.2.4 Terminal and Hybrid Measures . . . . . . . . . . . . . . . . . 174
4.2.5 Swap Measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
4.3 Multi-Currency Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
4.3.1 Notations and FX Forwards . . . . . . . . . . . . . . . . . . . . 176
4.3.2 Risk Neutral Measures . . . . . . . . . . . . . . . . . . . . . . . . 177
4.3.3 Other Measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178
4.4 The HJM Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179
4.4.1 Bond Price Dynamics . . . . . . . . . . . . . . . . . . . . . . . . . 179
4.4.2 Forward Rate Dynamics . . . . . . . . . . . . . . . . . . . . . . . 180
4.4.3 Short Rate Process . . . . . . . . . . . . . . . . . . . . . . . . . . . 181
4.5 Examples of HJM Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182
 Contents XV

4.5.1 The Gaussian Model . . . . . . . . . . . . . . . . . . . . . . . . . . 182

4.5.2 Gaussian HJM Models with Markovian Short Rate 185
4.5.3 Log-Normal HJM Models . . . . . . . . . . . . . . . . . . . . . . 187

5 Fixed Income Instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189

5.1 Fixed Income Markets and Participants . . . . . . . . . . . . . . . . 189
5.2 Certificates of Deposit and Libor Rates . . . . . . . . . . . . . . . . . 192
5.3 Forward Rate Agreements (FRA) . . . . . . . . . . . . . . . . . . . . . . 193
5.4 Eurodollar Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194
5.5 Fixed-for-Floating Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195
5.6 Libor-in-Arrears Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198
5.7 Averaging Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199
5.8 Caps and Floors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199
5.9 Digital Caps and Floors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201
5.10 European Swaptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201
5.10.1 Cash-Settled Swaptions . . . . . . . . . . . . . . . . . . . . . . . 203
5.11 CMS Swaps, Caps and Floors . . . . . . . . . . . . . . . . . . . . . . . . . 204
5.12 Bermudan Swaptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205
5.13 Exotic Swaps and Structured Notes . . . . . . . . . . . . . . . . . . . . 206
5.13.1 Libor-Based Exotic Swaps . . . . . . . . . . . . . . . . . . . . . 207
5.13.2 CMS-Based Exotic Swaps . . . . . . . . . . . . . . . . . . . . . 208
5.13.3 Multi-Rate Exotic Swaps . . . . . . . . . . . . . . . . . . . . . . 208
5.13.4 Range Accruals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209
5.13.5 Path-Dependent Swaps . . . . . . . . . . . . . . . . . . . . . . . . 210
5.14 Callable Libor Exotics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211
5.14.1 Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211
5.14.2 Pricing Callable Libor Exotics . . . . . . . . . . . . . . . . . . 213
5.14.3 Types of Callable Libor Exotics . . . . . . . . . . . . . . . . 214
5.14.4 Callable Snowballs . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214
5.14.5 CLEs Accreting at Coupon Rate . . . . . . . . . . . . . . . 214
5.14.6 Multi-Tranches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215
5.15 TARNs and Other Trade-Level Features . . . . . . . . . . . . . . . . 215
5.15.1 Knock-out Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216
5.15.2 TARNs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216
5.15.3 Global Cap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217
5.15.4 Global Floor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217
5.15.5 Pricing and Trade Representation Challenges . . . . 217
5.16 Volatility Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218
5.16.1 Volatility Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218
5.16.2 Volatility Swaps with a Shout . . . . . . . . . . . . . . . . . . 219
5.16.3 Min-Max Volatility Swaps . . . . . . . . . . . . . . . . . . . . . 220
5.16.4 Forward Starting Options and Other Forward
Volatility Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . 220
5.A Appendix: Day Counting Rules and Other Trivia . . . . . . . . 221
5.A.1 Libor Rate Definitions . . . . . . . . . . . . . . . . . . . . . . . . 222
5.A.2 Swap Payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223
XVI Contents

Part II Vanilla Models

6 Yield Curve Construction and Risk Management . . . . . . 227

6.1 Notations and Problem Definition . . . . . . . . . . . . . . . . . . . . . 228
6.1.1 Discount Curves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228
6.1.2 Matrix Formulation . . . . . . . . . . . . . . . . . . . . . . . . . . . 230
6.1.3 Construction Principles and Yield Curves . . . . . . . . 230
6.2 Yield Curve Fitting with N -Knot Splines . . . . . . . . . . . . . . . 232
6.2.1 C 0 Yield Curves: Bootstrapping . . . . . . . . . . . . . . . . 232
6.2.1.1 Piecewise Linear Yields . . . . . . . . . . . . . . 233
6.2.1.2 Piecewise Flat Forward Rates . . . . . . . . . 234
6.2.2 C 1 Yield Curves: Hermite Splines . . . . . . . . . . . . . . . 236
6.2.3 C 2 Yield Curves: Twice Differentiable Cubic
Splines . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 238
6.2.4 C 2 Yield Curves: Twice Differentiable Tension
Splines . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241
6.3 Non-Parametric Optimal Yield Curve Fitting . . . . . . . . . . . 243
6.3.1 Norm Specification and Optimization . . . . . . . . . . . 243
6.3.2 Choice of λ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 246
6.3.3 Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247
6.4 Managing Yield Curve Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . 248
6.4.1 Par-Point Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . 249
6.4.2 Forward Rate Approach . . . . . . . . . . . . . . . . . . . . . . . 250
6.4.3 From Risks to Hedging: The Jacobian Approach . . 252
6.4.4 Cumulative Shifts and other Common Tricks . . . . . 254
6.5 Various Topics in Discount Curve Construction . . . . . . . . . . 256
6.5.1 Curve Overlays and Turn-of-Year Effects . . . . . . . . 256
6.5.2 Cross-Currency Curve Construction . . . . . . . . . . . . . 257
6.5.2.1 Basic Problem . . . . . . . . . . . . . . . . . . . . . . 257
6.5.2.2 Separation of Discount and Forward
Rate Curves . . . . . . . . . . . . . . . . . . . . . . . . 258
6.5.2.3 Cross-Currency Basis Swaps . . . . . . . . . . 260
6.5.2.4 Modified Curve Construction Algorithm 261
6.5.3 Tenor Basis and Multi-Index Curve Group
Construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263
6.A Appendix: Spline Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268
6.A.1 Hermite Spline Theory . . . . . . . . . . . . . . . . . . . . . . . . 268
6.A.2 C 2 Cubic Splines . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 271
6.A.3 C 2 Exponential Tension Splines . . . . . . . . . . . . . . . . 272

7 Vanilla Models with Local Volatility . . . . . . . . . . . . . . . . . . . 275

7.1 General Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 276
7.1.1 Model Dynamics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 276
7.1.2 Volatility Smile and Implied Density . . . . . . . . . . . . 276
 Contents XVII

7.1.3 Choice of ϕ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277

7.2 CEV Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278
7.2.1 Basic Properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278
7.2.2 Call Option Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . 280
7.2.3 Regularization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282
7.2.4 Displaced Diffusion Models . . . . . . . . . . . . . . . . . . . . 283
7.3 Quadratic Volatility Model . . . . . . . . . . . . . . . . . . . . . . . . . . . 285
7.3.1 Case 1: Two Real Roots to the Left of S(0) . . . . . . 285
7.3.2 Case 2: One Real Root to the Left of S(0) . . . . . . . 289
7.3.3 Extensions and Other Root Configurations . . . . . . . 289
7.4 Finite Difference Solutions for General ϕ . . . . . . . . . . . . . . . 290
7.4.1 Multiple λ and T . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 291
7.4.2 Forward Equation for Call Options . . . . . . . . . . . . . 291
7.5 Asymptotic Expansions for General ϕ . . . . . . . . . . . . . . . . . . 293
7.5.1 Expansion around Displaced Log-Normal Process . 293
7.5.2 Expansion around Gaussian Process . . . . . . . . . . . . 296
7.6 Extensions to Time-Dependent ϕ . . . . . . . . . . . . . . . . . . . . . . 297
7.6.1 Separable Case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297
7.6.2 Skew Averaging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 298
7.6.2.1 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . 302
7.6.2.2 A Caveat About the Process Domain . . 304
7.6.3 Skew and Convexity Averaging by Small-Noise
Expansion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305
7.6.4 Numerical Example . . . . . . . . . . . . . . . . . . . . . . . . . . . 309

8 Vanilla Models with Stochastic Volatility I . . . . . . . . . . . . . 313

8.1 Model Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313
8.2 Model Parameters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315
8.3 Basic Properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316
8.4 Fourier Integration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322
8.4.1 General Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322
8.4.2 Applications to SV Model . . . . . . . . . . . . . . . . . . . . . 325
8.4.3 Numerical Implementation . . . . . . . . . . . . . . . . . . . . . 328
8.4.4 Refinements of Numerical Implementation . . . . . . . 330
8.4.5 Fourier Integration for Arbitrary European Payoffs 334
8.5 Integration in Variance Domain . . . . . . . . . . . . . . . . . . . . . . . 337
8.6 CEV-Type Stochastic Volatility Models and SABR . . . . . . 341
8.7 Numerical Examples: Volatility Smile Statics . . . . . . . . . . . . 343
8.8 Numerical Examples: Volatility Smile Dynamics . . . . . . . . . 345
8.9 Hedging in Stochastic Volatility Models . . . . . . . . . . . . . . . . 350
8.9.1 Hedge Construction, Delta and Vega . . . . . . . . . . . . 350
8.9.2 Minimum Variance Delta Hedging . . . . . . . . . . . . . . 353
8.9.3 Minimum Variance Hedging: an Example . . . . . . . . 354
8.A Appendix: General Volatility Processes . . . . . . . . . . . . . . . . . 356
XVIII Contents

9 Vanilla Models with Stochastic Volatility II . . . . . . . . . . . . 359

9.1 Fourier Integration with Time-Dependent Parameters . . . . 359
9.2 Asymptotic Expansion with Time-Dependent Volatility . . 362
9.3 Averaging Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 366
9.3.1 Volatility Averaging . . . . . . . . . . . . . . . . . . . . . . . . . . 367
9.3.2 Skew Averaging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 369
9.3.3 Volatility of Variance Averaging . . . . . . . . . . . . . . . . 370
9.3.4 Calibration by Parameter Averaging . . . . . . . . . . . . 372
9.4 PDE Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 377
9.4.1 PDE Formulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 377
9.4.2 Range for Stochastic Variance . . . . . . . . . . . . . . . . . . 378
9.4.3 Discretizing Stochastic Variance . . . . . . . . . . . . . . . . 379
9.4.4 Boundary Conditions for Stochastic Variance . . . . . 381
9.4.5 Range for Underlying . . . . . . . . . . . . . . . . . . . . . . . . . 382
9.4.6 Discretizing the Underlying . . . . . . . . . . . . . . . . . . . . 383
9.5 Monte Carlo Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 383
9.5.1 Exact Simulation of Variance Process . . . . . . . . . . . 384
9.5.2 Biased Taylor-Type Schemes for Variance Process 385
9.5.2.1 Euler Schemes . . . . . . . . . . . . . . . . . . . . . . 385
9.5.2.2 Higher-Order Schemes . . . . . . . . . . . . . . . 385
9.5.3 Moment Matching Schemes for Variance Process . . 386
9.5.3.1 Log-normal Approximation . . . . . . . . . . . 386
9.5.3.2 Truncated Gaussian . . . . . . . . . . . . . . . . . 387
9.5.3.3 Quadratic-Exponential . . . . . . . . . . . . . . . 388
9.5.3.4 Summary of QE Algorithm . . . . . . . . . . . 390
9.5.4 Broadie-Kaya Scheme for the Underlying . . . . . . . 390
9.5.5 Other Schemes for the Underlying . . . . . . . . . . . . . . 392
9.5.5.1 Taylor-Type Schemes . . . . . . . . . . . . . . . . 392
9.5.5.2 Simplified Broadie-Kaya . . . . . . . . . . . . . . 392
9.5.5.3 Martingale Correction . . . . . . . . . . . . . . . 392
9.A Appendix: Proof of Proposition 9.3.4 . . . . . . . . . . . . . . . . . . . 393
9.B Appendix: Coefficients for Asymptotic Expansion . . . . . . . . 397
 Contents XIX

VOLUME II Term Structure Models

Part III Term Structure Models

10 One-Factor Short Rate Models I . . . . . . . . . . . . . . . . . . . . . . . 401

10.1 The One-Factor Gaussian Short Rate Model . . . . . . . . . . . . 402
10.1.1 The Ho-Lee Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . 402
10.1.1.1 Notations and First Steps . . . . . . . . . . . . 402
10.1.1.2 Fitting the Term Structure of
Discount Bonds . . . . . . . . . . . . . . . . . . . . . 403
10.1.1.3 Analysis and Comparison with HJM
Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . 405
10.1.2 The Mean-Reverting GSR Model . . . . . . . . . . . . . . . 407
10.1.2.1 The Vasicek Model . . . . . . . . . . . . . . . . . . 407
10.1.2.2 The General One-Factor GSR Model . . . 409
10.1.2.3 Time-Stationarity and Caplet Hump . . . 412
10.1.3 European Option Pricing . . . . . . . . . . . . . . . . . . . . . . 414
10.1.3.1 The Jamshidian Decomposition . . . . . . . 414
10.1.3.2 Gaussian Swap Rate Approximation . . . 416
10.1.4 Swaption Calibration . . . . . . . . . . . . . . . . . . . . . . . . . 417
10.1.5 Finite Difference Methods . . . . . . . . . . . . . . . . . . . . . 418
10.1.5.1 PDE and Spatial Boundary Conditions . 419
10.1.5.2 Determining Spatial Boundary
Conditions from PDE . . . . . . . . . . . . . . . . 420
10.1.5.3 Upwinding . . . . . . . . . . . . . . . . . . . . . . . . . 421
10.1.6 Monte Carlo Simulation . . . . . . . . . . . . . . . . . . . . . . . 421
10.1.6.1 Exact Discretization . . . . . . . . . . . . . . . . . 421
10.1.6.2 Approximate Discretization . . . . . . . . . . . 423
10.1.6.3 Using other Measures for Simulation . . . 424
10.2 The Affine One-Factor Model . . . . . . . . . . . . . . . . . . . . . . . . . 425
10.2.1 Basic Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 425
10.2.1.1 SDE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 425
10.2.1.2 Regularity Issues . . . . . . . . . . . . . . . . . . . . 426
10.2.1.3 Volatility Skew . . . . . . . . . . . . . . . . . . . . . . 426
10.2.1.4 Time-Dependent Parameters . . . . . . . . . . 427
10.2.2 Discount Bond Pricing and Extended Transform . . 427
10.2.2.1 Constant Parameters . . . . . . . . . . . . . . . . 428
10.2.2.2 Piecewise Constant Parameters . . . . . . . 430
10.2.3 Discount Bond Calibration . . . . . . . . . . . . . . . . . . . . . 431
10.2.3.1 Change of Variables . . . . . . . . . . . . . . . . . 431
10.2.3.2 Algorithm for ω(t) . . . . . . . . . . . . . . . . . . . 432
10.2.4 European Option Pricing . . . . . . . . . . . . . . . . . . . . . . 433
XX Contents

10.2.5 Swaption Calibration . . . . . . . . . . . . . . . . . . . . . . . . . 435

10.2.5.1 Basic Problem . . . . . . . . . . . . . . . . . . . . . . 435
10.2.5.2 Calibration Algorithm . . . . . . . . . . . . . . . 436
10.2.6 Quadratic One-Factor Model . . . . . . . . . . . . . . . . . . . 437
10.2.7 Numerical Methods for the Affine Short Rate
Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 437

11 One-Factor Short Rate Models II . . . . . . . . . . . . . . . . . . . . . . 439

11.1 Log-Normal Short Rate Models . . . . . . . . . . . . . . . . . . . . . . . 439
11.1.1 The Black-Derman-Toy Model . . . . . . . . . . . . . . . . . 439
11.1.2 Black-Karasinski Model . . . . . . . . . . . . . . . . . . . . . . . 441
11.1.3 Issues in Log-Normal Models . . . . . . . . . . . . . . . . . . . 441
11.1.4 Sandmann-Sondermann Transformation . . . . . . . . . 442
11.2 Other Short Rate Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 445
11.2.1 Power-Type Models and Empirical Model
Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 445
11.2.2 The Black Shadow Rate Model . . . . . . . . . . . . . . . . . 446
11.2.3 Spanned and Unspanned Stochastic Volatility:
the Fong and Vasicek Model . . . . . . . . . . . . . . . . . . . 448
11.3 Numerical Methods for General One-Factor Short Rate
Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 449
11.3.1 Finite Difference Methods . . . . . . . . . . . . . . . . . . . . . 450
11.3.2 Calibration to Initial Yield Curve . . . . . . . . . . . . . . . 451
11.3.2.1 Forward Induction . . . . . . . . . . . . . . . . . . . 452
11.3.2.2 Forward-from-Backward Induction . . . . . 453
11.3.2.3 Yield Curve and Volatility Calibration . 455
11.3.2.4 The Dybvig Parameterization . . . . . . . . . 457
11.3.2.5 Link to HJM Models . . . . . . . . . . . . . . . . . 458
11.3.2.6 The Hagan and Woodward
Parameterization . . . . . . . . . . . . . . . . . . . . 459
11.3.3 Monte Carlo Simulation . . . . . . . . . . . . . . . . . . . . . . . 462
11.3.3.1 SDE Discretization . . . . . . . . . . . . . . . . . . 462
11.3.3.2 Practical Issues with Monte Carlo
Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . 464
11.A Appendix: Markov-Functional Models . . . . . . . . . . . . . . . . . . 466
11.A.1 State Process and Numeraire Mapping . . . . . . . . . . 466
11.A.2 Libor MF Parameterization . . . . . . . . . . . . . . . . . . . . 467
11.A.3 Swap MF Parameterization . . . . . . . . . . . . . . . . . . . . 469
11.A.4 Non-Parametric Calibration . . . . . . . . . . . . . . . . . . . . 470
11.A.5 Numerical Implementation . . . . . . . . . . . . . . . . . . . . . 471
11.A.6 Comments and Comparisons . . . . . . . . . . . . . . . . . . . 472
 Contents XXI

12 Multi-Factor Short Rate Models . . . . . . . . . . . . . . . . . . . . . . . 473

12.1 The Gaussian Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 474
12.1.1 Development from Separability Condition . . . . . . . . 474
12.1.1.1 Mean-Reverting State Variables . . . . . . . 475
12.1.1.2 Further Changes of Variables . . . . . . . . . 479
12.1.2 Classical Development . . . . . . . . . . . . . . . . . . . . . . . . 481
12.1.2.1 Diagonalization of Mean Reversion
Matrix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 482
12.1.3 Correlation Structure . . . . . . . . . . . . . . . . . . . . . . . . . 484
12.1.4 The Two-Factor Gaussian Model . . . . . . . . . . . . . . . 485
12.1.4.1 Some Basics . . . . . . . . . . . . . . . . . . . . . . . . 485
12.1.4.2 Variance and Correlation Structure . . . . 486
12.1.4.3 Volatility Hump . . . . . . . . . . . . . . . . . . . . . 487
12.1.4.4 Another Formulation of the
Two-Factor Model . . . . . . . . . . . . . . . . . . . 488
12.1.5 Multi-Factor Statistical Gaussian Model . . . . . . . . . 491
12.1.6 Swaption Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 496
12.1.6.1 Jamshidian Decomposition . . . . . . . . . . . 496
12.1.6.2 Gaussian Swap Rate Approximation . . . 500
12.1.7 Calibration via Benchmark Rates . . . . . . . . . . . . . . . 501
12.1.8 Monte Carlo Simulation . . . . . . . . . . . . . . . . . . . . . . . 504
12.1.9 Finite Difference Methods . . . . . . . . . . . . . . . . . . . . . 505
12.2 The Affine Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 506
12.2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 506
12.2.2 Basic Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 507
12.2.3 Regularity Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 508
12.2.4 Discount Bond Prices . . . . . . . . . . . . . . . . . . . . . . . . . 509
12.2.5 Some Concrete Models . . . . . . . . . . . . . . . . . . . . . . . . 511
12.2.5.1 Fong-Vasicek Model . . . . . . . . . . . . . . . . . 511
12.2.5.2 Longstaff-Schwartz Model . . . . . . . . . . . . 512
12.2.5.3 Multi-Factor CIR Models . . . . . . . . . . . . . 513
12.2.6 Brief Notes on Option Pricing . . . . . . . . . . . . . . . . . . 514
12.3 The Quadratic Gaussian Model . . . . . . . . . . . . . . . . . . . . . . . 514
12.3.1 Quadratic Gaussian Models are Affine . . . . . . . . . . . 515
12.3.2 The Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 516
12.3.3 Parameterization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 518
12.3.3.1 Smile Generation . . . . . . . . . . . . . . . . . . . . 518
12.3.3.2 Quadratic Term . . . . . . . . . . . . . . . . . . . . . 519
12.3.3.3 Linear Term . . . . . . . . . . . . . . . . . . . . . . . . 521
12.3.4 Swaption Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 522
12.3.4.1 State Vector Distribution Under the
Annuity Measure . . . . . . . . . . . . . . . . . . . . 522
12.3.4.2 Exact Pricing of European Swaptions . . 523
12.3.4.3 Approximations for European Swaptions 524
12.3.5 Calibration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 527
XXII Contents

12.3.6 Spanned Stochastic Volatility . . . . . . . . . . . . . . . . . . 528

12.3.7 Numerical Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . 528
12.A Appendix: Quadratic Forms of Gaussian Vectors . . . . . . . . 528

13 The Quasi-Gaussian Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . 533

13.1 One-Factor Quasi-Gaussian Model . . . . . . . . . . . . . . . . . . . . . 533
13.1.1 Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 533
13.1.2 Local Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 535
13.1.3 Swap Rate Dynamics . . . . . . . . . . . . . . . . . . . . . . . . . 536
13.1.4 Approximate Local Volatility Dynamics for Swap
Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 537
13.1.4.1 Simple Approximation . . . . . . . . . . . . . . . 538
13.1.4.2 Advanced Approximation . . . . . . . . . . . . . 538
13.1.5 Linear Local Volatility . . . . . . . . . . . . . . . . . . . . . . . . 541
13.1.6 Linear Local Volatility for a Swaption Strip . . . . . . 543
13.1.7 Volatility Calibration . . . . . . . . . . . . . . . . . . . . . . . . . 544
13.1.8 Mean Reversion Calibration . . . . . . . . . . . . . . . . . . . . 546
13.1.8.1 Effects of Mean Reversion . . . . . . . . . . . . 546
13.1.8.2 Calibrating Mean Reversion to
Volatility Ratios . . . . . . . . . . . . . . . . . . . . . 548
13.1.8.3 Calibrating Mean Reversion to
Inter-Temporal Correlations . . . . . . . . . . 551
13.1.8.4 Final Comments on Mean Reversion
Calibration . . . . . . . . . . . . . . . . . . . . . . . . . 553
13.1.9 Numerical Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . 554
13.1.9.1 Direct Integration . . . . . . . . . . . . . . . . . . . 554
13.1.9.2 Finite Difference Methods . . . . . . . . . . . . 556
13.1.9.3 Monte Carlo Simulation . . . . . . . . . . . . . . 559
13.1.9.4 Single-State Approximations . . . . . . . . . . 559
13.2 One-Factor Quasi-Gaussian Model with Stochastic
Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 563
13.2.1 Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 563
13.2.2 Swap Rate Dynamics . . . . . . . . . . . . . . . . . . . . . . . . . 564
13.2.3 Volatility Calibration . . . . . . . . . . . . . . . . . . . . . . . . . 566
13.2.4 Mean Reversion Calibration . . . . . . . . . . . . . . . . . . . . 567
13.2.5 Non-Zero Correlation . . . . . . . . . . . . . . . . . . . . . . . . . 567
13.2.6 PDE and Monte Carlo Methods . . . . . . . . . . . . . . . . 568
13.3 Multi-Factor Quasi-Gaussian Model . . . . . . . . . . . . . . . . . . . . 568
13.3.1 General Multi-Factor Model . . . . . . . . . . . . . . . . . . . 568
13.3.2 Local and Stochastic Volatility Parameterization . 570
13.3.3 Swap Rate Dynamics and Approximations . . . . . . . 572
13.3.4 Volatility Calibration . . . . . . . . . . . . . . . . . . . . . . . . . 577
13.3.5 Mean Reversions, Correlations, and Numerical
Schemes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 578
13.A Appendix: Density Approximation . . . . . . . . . . . . . . . . . . . . . 579
 Contents XXIII

13.A.1 Simplified Forward Measure Dynamics . . . . . . . . . . 579

13.A.2 Effective Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . 580
13.A.3 The Forward Equation for Call Options . . . . . . . . . 581
13.A.4 Asymptotic Expansion . . . . . . . . . . . . . . . . . . . . . . . . 582
13.A.5 Proof of Theorem 13.1.14 . . . . . . . . . . . . . . . . . . . . . . 583

14 The Libor Market Model I . . . . . . . . . . . . . . . . . . . . . . . . . . . . 585

14.1 Introduction and Setup . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 586
14.1.1 Motivation and Historical Notes . . . . . . . . . . . . . . . . 586
14.1.2 Tenor Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 587
14.2 LM Dynamics and Measures . . . . . . . . . . . . . . . . . . . . . . . . . . 587
14.2.1 Setting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 587
14.2.2 Probability Measures . . . . . . . . . . . . . . . . . . . . . . . . . . 588
14.2.3 Link to HJM Analysis . . . . . . . . . . . . . . . . . . . . . . . . . 591
14.2.4 Separable Deterministic Volatility Function . . . . . . 592
14.2.5 Stochastic Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . 594
14.2.6 Time-Dependence in Model Parameters . . . . . . . . . 597
14.3 Correlation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 597
14.3.1 Empirical Principal Components Analysis . . . . . . . 598
14.3.1.1 Example: USD Forward Rates . . . . . . . . 599
14.3.2 Correlation Estimation and Smoothing . . . . . . . . . . 600
14.3.2.1 Example: Fit to USD Data . . . . . . . . . . . 603
14.3.3 Negative Eigenvalues . . . . . . . . . . . . . . . . . . . . . . . . . . 604
14.3.4 Correlation PCA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 605
14.3.4.1 Example: USD Data . . . . . . . . . . . . . . . . . 607
14.3.4.2 Poor Man’s Correlation PCA . . . . . . . . . 608
14.4 Pricing of European Options . . . . . . . . . . . . . . . . . . . . . . . . . . 608
14.4.1 Caplets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 609
14.4.2 Swaptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 610
14.4.3 Spread Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 613
14.4.3.1 Term Correlation . . . . . . . . . . . . . . . . . . . . 614
14.4.3.2 Spread Option Pricing . . . . . . . . . . . . . . . 615
14.5 Calibration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 615
14.5.1 Basic Principles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 615
14.5.2 Parameterization of kλk (t)k . . . . . . . . . . . . . . . . . . . . 616
14.5.3 Interpolation on the Whole Grid . . . . . . . . . . . . . . . . 617
14.5.4 Construction of λk (t) from kλk (t)k . . . . . . . . . . . . . . 619
14.5.4.1 Covariance PCA . . . . . . . . . . . . . . . . . . . . 620
14.5.4.2 Correlation PCA . . . . . . . . . . . . . . . . . . . . 620
14.5.4.3 Discussion and Recommendation . . . . . . 621
14.5.5 Choice of Calibration Instruments . . . . . . . . . . . . . . 621
14.5.6 Calibration Objective Function . . . . . . . . . . . . . . . . . 624
14.5.7 Sample Calibration Algorithm . . . . . . . . . . . . . . . . . . 626
14.5.8 Speed-Up Through Sub-Problem Splitting . . . . . . . 627
14.5.9 Correlation Calibration to Spread Options . . . . . . . 629
XXIV Contents

14.5.10 Volatility Skew Calibration . . . . . . . . . . . . . . . . . . . . 631

14.6 Monte Carlo Simulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 631
14.6.1 Euler-Type Schemes . . . . . . . . . . . . . . . . . . . . . . . . . . 632
14.6.1.1 Analysis of Computational Effort . . . . . . 633
14.6.1.2 Long Time Steps . . . . . . . . . . . . . . . . . . . . 634
14.6.1.3 Notes on the Choice of Numeraire . . . . . 636
14.6.2 Other Simulation Schemes . . . . . . . . . . . . . . . . . . . . . 636
14.6.2.1 Special-Purpose Schemes with Drift
Predictor-Corrector . . . . . . . . . . . . . . . . . . 637
14.6.2.2 Euler Scheme with Predictor-Corrector . 638
14.6.2.3 Lagging Predictor-Corrector Scheme . . . 638
14.6.2.4 Further Refinements of Drift Estimation 640
14.6.2.5 Brownian-Bridge Schemes and Other
Ideas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 641
14.6.2.6 High-Order Schemes . . . . . . . . . . . . . . . . . 643
14.6.3 Martingale Discretization . . . . . . . . . . . . . . . . . . . . . . 644
14.6.3.1 Deflated Bond Price Discretization . . . . 645
14.6.3.2 Comments and Alternatives . . . . . . . . . . 646
14.6.4 Variance Reduction . . . . . . . . . . . . . . . . . . . . . . . . . . . 647
14.6.4.1 Antithetic Sampling . . . . . . . . . . . . . . . . . 647
14.6.4.2 Control Variates . . . . . . . . . . . . . . . . . . . . 648
14.6.4.3 Importance Sampling . . . . . . . . . . . . . . . . 648

15 The Libor Market Model II . . . . . . . . . . . . . . . . . . . . . . . . . . . . 651

15.1 Interpolation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 651
15.1.1 Back Stub, Simple Interpolation . . . . . . . . . . . . . . . . 652
15.1.2 Back Stub, Arbitrage-Free Interpolation . . . . . . . . . 653
15.1.3 Back Stub, Gaussian Model . . . . . . . . . . . . . . . . . . . . 655
15.1.4 Front Stub, Zero Volatility . . . . . . . . . . . . . . . . . . . . . 656
15.1.5 Front Stub, Exogenous Volatility . . . . . . . . . . . . . . . 657
15.1.6 Front Stub, Simple Interpolation . . . . . . . . . . . . . . . 660
15.1.7 Front Stub, Gaussian Model . . . . . . . . . . . . . . . . . . . 661
15.2 Advanced Swaption Pricing via Markovian Projection . . . . 662
15.2.1 Advanced Formula for Swap Rate Volatility . . . . . . 664
15.2.2 Advanced Formula for Swap Rate Skew . . . . . . . . . 666
15.2.3 Skew and Smile Calibration in LM Models . . . . . . . 668
15.3 Near-Markov LM Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 670
15.4 Swap Market Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 670
15.5 Evolving Separate Discount and Forward Rate Curves . . . . 672
15.5.1 Basic Ideas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 673
15.5.2 HJM Extension . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 674
15.5.3 Applications to LM Models . . . . . . . . . . . . . . . . . . . 677
15.5.4 Deterministic Spread . . . . . . . . . . . . . . . . . . . . . . . . . . 681
15.6 SV Models with Non-Zero Correlation . . . . . . . . . . . . . . . . . . 681
15.7 Multi-Stochastic Volatility Extensions . . . . . . . . . . . . . . . . . . 683
 Contents XXV

15.7.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 683

15.7.2 Setup . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 684
15.7.3 Pricing Caplets and Swaptions . . . . . . . . . . . . . . . . . 685
15.7.4 Spread Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 686
15.7.5 Another Use of Multi-Dimensional Stochastic
Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 687
XXVI Contents

VOLUME III Products and Risk Management

Part IV Products

16 Single-Rate Vanilla Derivatives . . . . . . . . . . . . . . . . . . . . . . . . 691

16.1 European Swaptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 691
16.1.1 Smile Dynamics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 692
16.1.2 Adjustable Backbone . . . . . . . . . . . . . . . . . . . . . . . . . . 693
16.1.3 Stochastic Volatility Swaption Grid . . . . . . . . . . . . . 696
16.1.4 Calibrating Stochastic Volatility Model to
Swaptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 697
16.1.5 Some Other Interpolation Rules . . . . . . . . . . . . . . . . 699
16.2 Caps and Floors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700
16.2.1 Basic Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700
16.2.2 Setup and Norms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 701
16.2.3 Calibration Procedure . . . . . . . . . . . . . . . . . . . . . . . . . 702
16.3 Terminal Swap Rate Models . . . . . . . . . . . . . . . . . . . . . . . . . . 703
16.3.1 TSR Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 703
16.3.2 Linear TSR Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . 705
16.3.3 Exponential TSR Model . . . . . . . . . . . . . . . . . . . . . . . 708
16.3.4 Swap-Yield TSR Model . . . . . . . . . . . . . . . . . . . . . . . 709
16.4 Libor-in-Arrears . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 710
16.5 Libor-with-Delay . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 713
16.5.1 Swap-Yield TSR Model . . . . . . . . . . . . . . . . . . . . . . . 714
16.5.2 Other Terminal Swap Rate Models . . . . . . . . . . . . . 715
16.5.3 Approximations Inspired by Term Structure
Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 715
16.5.4 Applications to Averaging Swaps . . . . . . . . . . . . . . . 716
16.6 CMS and CMS-Linked Cash Flows . . . . . . . . . . . . . . . . . . . . 717
16.6.1 The Replication Method for CMS . . . . . . . . . . . . . . . 718
16.6.2 Annuity Mapping Function as a Conditional
Expected Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 720
16.6.3 Swap-Yield TSR Model . . . . . . . . . . . . . . . . . . . . . . . 722
16.6.4 Linear and Other TSR Models . . . . . . . . . . . . . . . . . 722
16.6.5 The Quasi-Gaussian Model . . . . . . . . . . . . . . . . . . . . 724
16.6.6 The Libor Market Model . . . . . . . . . . . . . . . . . . . . . . 725
16.6.7 Correcting Non-Arbitrage-Free Methods . . . . . . . . . 728
16.6.8 Impact of Annuity Mapping Function and Mean
Reversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 729
16.6.9 CDF and PDF of CMS Rate in Forward Measure . 730
16.6.10 SV Model for CMS Rate . . . . . . . . . . . . . . . . . . . . . . 734
 Contents XXVII

16.6.11 Dynamics of CMS Rate in Forward Measure . . . . . 735

16.6.12 Cash-Settled Swaptions . . . . . . . . . . . . . . . . . . . . . . . 738
16.7 Quanto CMS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 740
16.7.1 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 740
16.7.2 Modeling the Joint Distribution of Swap Rate
and Forward Exchange Rate . . . . . . . . . . . . . . . . . . . 742
16.7.3 Normalizing Constant and Final Formula . . . . . . . . 743
16.8 Eurodollar Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 744
16.8.1 Fundamental Results on Futures . . . . . . . . . . . . . . . . 745
16.8.2 Motivations and Plan . . . . . . . . . . . . . . . . . . . . . . . . . 747
16.8.3 Preliminaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 748
16.8.4 Expansion Around the Futures Value . . . . . . . . . . . 748
16.8.5 Forward Rate Variances . . . . . . . . . . . . . . . . . . . . . . . 751
16.8.6 Forward Rate Correlations . . . . . . . . . . . . . . . . . . . . . 753
16.8.7 The Formula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 754
16.9 Convexity and Moment Explosions . . . . . . . . . . . . . . . . . . . . 755

17 Multi-Rate Vanilla Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . 759

17.1 Introduction to Multi-Rate Vanilla Derivatives . . . . . . . . . . 759
17.2 Marginal Distributions and Reference Measure . . . . . . . . . . 761
17.3 Dependence Structure via Copulas . . . . . . . . . . . . . . . . . . . . . 762
17.3.1 Introduction to Gaussian Copula Method . . . . . . . . 762
17.3.2 General Copulas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 764
17.3.3 Archimedean Copulas . . . . . . . . . . . . . . . . . . . . . . . . . 766
17.3.4 Making Copulas from Other Copulas . . . . . . . . . . . . 767
17.4 Copula Methods for CMS Spread Options . . . . . . . . . . . . . . 770
17.4.1 Normal Model for the Spread . . . . . . . . . . . . . . . . . . 770
17.4.2 Gaussian Copula for Spread Options . . . . . . . . . . . . 771
17.4.3 Spread Volatility Smile Modeling with the Power
Gaussian Copula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 774
17.4.4 Copula Implied From Spread Options . . . . . . . . . . . 775
17.5 Rates Observed at Different Times . . . . . . . . . . . . . . . . . . . . . 778
17.6 Numerical Methods for Copulas . . . . . . . . . . . . . . . . . . . . . . . 779
17.6.1 Numerical Integration Methods . . . . . . . . . . . . . . . . . 780
17.6.2 Dimensionality Reduction for CMS Spread Options 783
17.6.3 Dimensionality Reduction for Other Multi-Rate
Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 785
17.6.4 Dimensionality Reduction by Conditioning . . . . . . . 787
17.6.5 Dimensionality Reduction by Measure Change . . . 791
17.6.6 Monte Carlo Methods . . . . . . . . . . . . . . . . . . . . . . . . . 793
17.7 Limitations of the Copula Method . . . . . . . . . . . . . . . . . . . . . 795
17.8 Stochastic Volatility Modeling for Multi-Rate Options . . . . 796
17.8.1 Measure Change by Drift Adjustment . . . . . . . . . . . 797
17.8.2 Measure Change by CMS Caplet Calibration . . . . . 798
17.8.3 Impact of Correlations on the Spread Smile . . . . . . 799
XXVIII Contents

17.8.4 Connection to Term Structure Models . . . . . . . . . . . 800

17.9 CMS Spread Options in Term Structure Models . . . . . . . . . 802
17.9.1 Libor Market Model . . . . . . . . . . . . . . . . . . . . . . . . . . 802
17.9.2 Quadratic Gaussian Model . . . . . . . . . . . . . . . . . . . . . 804
17.A Appendix: Implied Correlation in Displaced Log-Normal
Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 805
17.A.1 Preliminaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 805
17.A.2 Implied Log-Normal Correlation . . . . . . . . . . . . . . . . 806
17.A.3 A Few Numerical Results . . . . . . . . . . . . . . . . . . . . . . 807

18 Callable Libor Exotics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 809

18.1 Model Calibration for Callable Libor Exotics . . . . . . . . . . . . 809
18.1.1 Risk Factors for CLEs . . . . . . . . . . . . . . . . . . . . . . . . . 810
18.1.2 Model Choice and Calibration . . . . . . . . . . . . . . . . . . 813
18.2 Valuation Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 814
18.2.1 Preliminaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 814
18.2.2 Recursion for Callable Libor Exotics . . . . . . . . . . . . 815
18.2.3 Marginal Exercise Value Decomposition . . . . . . . . . 816
18.3 Monte Carlo Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 817
18.3.1 Regression-Based Valuation of CLEs, Basic Scheme 817
18.3.2 Regression for Underlying . . . . . . . . . . . . . . . . . . . . . 819
18.3.3 Valuing CLE as a Cancelable Note . . . . . . . . . . . . . . 821
18.3.4 Using Regressed Variables for Decision Only . . . . . 822
18.3.5 Regression Valuation with Boundary Optimization 824
18.3.6 Lower Bound via Regression Scheme . . . . . . . . . . . . 825
18.3.7 Iterative Improvement of Lower Bound . . . . . . . . . . 827
18.3.8 Upper Bound . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 830
18.3.8.1 Basic Ideas . . . . . . . . . . . . . . . . . . . . . . . . . 830
18.3.8.2 Nested Simulation (NS) Algorithm . . . . 831
18.3.8.3 Bias and Computational Cost of NS
Algorithm . . . . . . . . . . . . . . . . . . . . . . . . . . 834
18.3.8.4 Confidence Intervals and Practical
Usage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 836
18.3.8.5 Non-Analytic Exercise Values . . . . . . . . . 837
18.3.8.6 Improvements to NS Algorithm . . . . . . . 839
18.3.8.7 Other Upper Bound Algorithms . . . . . . . 841
18.3.9 Regression Variable Choice . . . . . . . . . . . . . . . . . . . . 842
18.3.9.1 State Variables Approach . . . . . . . . . . . . . 842
18.3.9.2 Explanatory Variables . . . . . . . . . . . . . . . 843
18.3.9.3 Explanatory Variables with Convexity . 846
18.3.10 Regression Implementation . . . . . . . . . . . . . . . . . . . . 848
18.3.10.1 Automated Explanatory Variable
Selection . . . . . . . . . . . . . . . . . . . . . . . . . . . 848
18.3.10.2 Suboptimal Point Exclusion . . . . . . . . . . 850
18.3.10.3 Two Step Regression . . . . . . . . . . . . . . . . . 851
 Contents XXIX

18.3.10.4 Robust Implementation of Regression

Algorithm . . . . . . . . . . . . . . . . . . . . . . . . . . 852
18.4 Valuation with Low–Dimensional Models . . . . . . . . . . . . . . . 856
18.4.1 Single-Rate Callable Libor Exotics . . . . . . . . . . . . . . 856
18.4.2 Calibration Targets for the Local Projection
Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 856
18.4.3 Review of Suitable Local Models . . . . . . . . . . . . . . . 857
18.4.4 Defining a Suitable Analog for Core Swap Rates . . 859
18.4.5 PDE Methods for Path-Dependent CLEs . . . . . . . . 861
18.4.5.1 CLEs Accreting at Coupon Rate . . . . . . 862
18.4.5.2 Snowballs . . . . . . . . . . . . . . . . . . . . . . . . . . 864

19 Bermudan Swaptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 867

19.1 Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 867
19.2 Local Projection Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 868
19.3 Smile Calibration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 870
19.4 Amortizing, Accreting, Other Non-Standard Swaptions . . . 872
19.4.1 Relationship Between Non-Standard and
Standard Swap Rates . . . . . . . . . . . . . . . . . . . . . . . . . 874
19.4.2 Same-Tenor Approach . . . . . . . . . . . . . . . . . . . . . . . . . 875
19.4.3 Representative Swaption Approach . . . . . . . . . . . . . 876
19.4.4 Basket Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 879
19.4.5 Super-Replication for Non-Standard Bermudan
Swaptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 882
19.4.6 Zero-Coupon Bermudan Swaptions . . . . . . . . . . . . . 886
19.4.7 American Swaptions . . . . . . . . . . . . . . . . . . . . . . . . . . 887
19.4.7.1 American Swaptions vs. High-
Frequency Bermudan Swaptions . . . . . . . 888
19.4.7.2 The Proxy Libor Rate Method . . . . . . . . 889
19.4.7.3 The Libor-as-Extra-State Method . . . . . 890
19.4.8 Mid-Coupon Exercise . . . . . . . . . . . . . . . . . . . . . . . . . 891
19.5 Flexi-Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 892
19.5.1 Purely Global Bounds . . . . . . . . . . . . . . . . . . . . . . . . . 893
19.5.2 Purely Local Bounds . . . . . . . . . . . . . . . . . . . . . . . . . . 893
19.5.3 Marginal Exercise Value Decomposition . . . . . . . . . 895
19.5.4 Narrow Band Limit . . . . . . . . . . . . . . . . . . . . . . . . . . . 896
19.6 Monte Carlo Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 897
19.6.1 Regression Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . 897
19.6.2 Parametric Boundary Methods . . . . . . . . . . . . . . . . . 898
19.6.2.1 Sample Exercise Strategies for
Bermudan Swaptions . . . . . . . . . . . . . . . . 898
19.6.2.2 Some Numerical Tests . . . . . . . . . . . . . . . 901
19.6.2.3 Additional Comments . . . . . . . . . . . . . . . . 904
19.7 Other Topics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 904
XXX Contents

19.7.1 Robust Bermudan Swaption Hedging with

European Swaptions . . . . . . . . . . . . . . . . . . . . . . . . . . 904
19.7.2 Carry and Exercise . . . . . . . . . . . . . . . . . . . . . . . . . . . 907
19.7.3 Fast Pricing via Exercise Premia Representation . 908
19.A Appendix: Forward Volatility and Correlation . . . . . . . . . . . 912
19.B Appendix: A Primer on Moment Matching . . . . . . . . . . . . . . 913
19.B.1 Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 913
19.B.2 Example 1: Asian Option in BSM Model . . . . . . . . 914
19.B.3 Example 2: Basket Option in BSM Model . . . . . . . 916

20 TARNs, Volatility Swaps, and Other Derivatives . . . . . . 919

20.1 TARNs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 919
20.1.1 Definitions and Examples . . . . . . . . . . . . . . . . . . . . . . 919
20.1.2 Valuation and Risk with Globally Calibrated
Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 921
20.1.3 Local Projection Method . . . . . . . . . . . . . . . . . . . . . . 922
20.1.4 Volatility Smile Effects . . . . . . . . . . . . . . . . . . . . . . . . 923
20.1.5 PDE for TARNs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 925
20.2 Volatility Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 927
20.2.1 Local Projection Method . . . . . . . . . . . . . . . . . . . . . . 928
20.2.2 Shout Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 929
20.2.3 Min-Max Volatility Swaps . . . . . . . . . . . . . . . . . . . . . 932
20.2.4 Impact of Volatility Dynamics on Volatility Swaps 934
20.3 Forward Swaption Straddles . . . . . . . . . . . . . . . . . . . . . . . . . . 939

21 Out-of-Model Adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . 945

21.1 Adjusting the Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 946
21.1.1 Calibration to Coupons . . . . . . . . . . . . . . . . . . . . . . . 946
21.1.2 Adjusters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 948
21.1.3 Path Re-Weighting . . . . . . . . . . . . . . . . . . . . . . . . . . . 950
21.1.4 Proxy Model Method . . . . . . . . . . . . . . . . . . . . . . . . . 955
21.1.5 Asset-Based Adjustments . . . . . . . . . . . . . . . . . . . . . . 957
21.1.6 Mapping Function Adjustments . . . . . . . . . . . . . . . . 959
21.2 Adjusting the Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 959
21.3 Adjusting the Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 960
21.3.1 Fee Adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 961
21.3.2 Fee Adjustment Impact on Exotic Derivatives . . . . 962
21.3.3 Strike Adjustment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 963

Part V Risk Management

 Contents XXXI

22 Introduction to Risk Management . . . . . . . . . . . . . . . . . . . . . 969

22.1 Risk Management and Sensitivity Computations . . . . . . . . 970
22.1.1 Basic Information Flow . . . . . . . . . . . . . . . . . . . . . . . . 970
22.1.2 Risk: Theory and Practice . . . . . . . . . . . . . . . . . . . . . 972
22.1.3 Example: the Black-Scholes Model . . . . . . . . . . . . . . 974
22.1.4 Example: Black-Scholes Model with
Time-Dependent Parameters . . . . . . . . . . . . . . . . . . . 977
22.1.5 Actual Risk Computations . . . . . . . . . . . . . . . . . . . . . 979
22.1.6 What about Θprm and Θnum ? . . . . . . . . . . . . . . . . . . 980
22.1.7 A Note on Trading P&L and the Computation
of Implied Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . 981
22.2 P&L Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 984
22.2.1 P&L Predict . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 985
22.2.2 P&L Explain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 987
22.2.2.1 Waterfall Explain . . . . . . . . . . . . . . . . . . . 987
22.2.2.2 Bump-and-Reset Explain . . . . . . . . . . . . 988
22.3 Value-at-Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 989
22.A Appendix: Alternative Proof of Lemma 22.1.1 . . . . . . . . . . . 992

23 Payoff Smoothing and Related Methods . . . . . . . . . . . . . . 995

23.1 Issues with Discretization Schemes . . . . . . . . . . . . . . . . . . . . . 995
23.1.1 Problems with Grid Dimensioning . . . . . . . . . . . . . . 996
23.1.2 Grid Shifts Relative to Payout . . . . . . . . . . . . . . . . . 996
23.1.3 Additional Comments . . . . . . . . . . . . . . . . . . . . . . . . . 999
23.2 Basic Techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1000
23.2.1 Adaptive Integration . . . . . . . . . . . . . . . . . . . . . . . . . . 1000
23.2.2 Adding Singularities to the Grid . . . . . . . . . . . . . . . . 1001
23.2.3 Singularity Removal . . . . . . . . . . . . . . . . . . . . . . . . . . 1003
23.2.4 Partial Analytical Integration . . . . . . . . . . . . . . . . . . 1004
23.3 Payoff Smoothing For Numerical Integration and PDEs . . 1006
23.3.1 Introduction to Payoff Smoothing . . . . . . . . . . . . . . . 1006
23.3.2 Payoff Smoothing in One Dimension . . . . . . . . . . . . 1008
23.3.2.1 Box Smoothing . . . . . . . . . . . . . . . . . . . . . 1009
23.3.2.2 Other Smoothing Methods . . . . . . . . . . . 1012
23.3.3 Payoff Smoothing in Multiple Dimensions . . . . . . . . 1013
23.4 Payoff Smoothing for Monte Carlo . . . . . . . . . . . . . . . . . . . . . 1016
23.4.1 Tube Monte Carlo for Digital Options . . . . . . . . . . . 1016
23.4.2 Tube Monte Carlo for Barrier Options . . . . . . . . . . 1018
23.4.3 Tube Monte Carlo for Callable Libor Exotics . . . . . 1023
23.4.4 Tube Monte Carlo for TARNs . . . . . . . . . . . . . . . . . . 1023
23.A Appendix: Delta Continuity of Singularity-Enlarged
Grid Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1024
23.B Appendix: Conditional Independence for Tube Monte
Carlo . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1026
XXXII Contents

24 Pathwise Differentiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1029

24.1 Pathwise Differentiation: Foundations . . . . . . . . . . . . . . . . . . 1029
24.1.1 Callable Libor Exotics . . . . . . . . . . . . . . . . . . . . . . . . 1029
24.1.1.1 CLE Greeks . . . . . . . . . . . . . . . . . . . . . . . . 1030
24.1.1.2 Keeping the Exercise Time Constant . . . 1032
24.1.1.3 Noise in CLE Greeks . . . . . . . . . . . . . . . . 1033
24.1.2 Barrier Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1034
24.2 Pathwise Differentiation for PDE Based Models . . . . . . . . . 1038
24.2.1 Model and Setup . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1038
24.2.2 Bucketed Deltas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1039
24.2.3 Survival Density . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1042
24.3 Pathwise Differentiation for Monte Carlo Based Models . . 1045
24.3.1 Pathwise Derivatives of Forward Libor Rates . . . . . 1045
24.3.2 Pathwise Deltas of European Options . . . . . . . . . . . 1048
24.3.2.1 Pathwise Deltas of the Numeraire . . . . . 1048
24.3.2.2 Pathwise Deltas of the Payoff . . . . . . . . . 1049
24.3.3 Adjoint Method For Greeks Calculation . . . . . . . . . 1050
24.3.4 Pathwise Delta Approximation for Callable
Libor Exotics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1052
24.4 Notes on Likelihood Ratio and Hybrid Methods . . . . . . . . . 1054

25 Importance Sampling and Control Variates . . . . . . . . . . . . 1057

25.1 Importance Sampling In Short Rate Models . . . . . . . . . . . . . 1057
25.2 Payoff Smoothing by Importance Sampling . . . . . . . . . . . . . 1059
25.2.1 Binary Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1059
25.2.2 TARNs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1062
25.2.3 Removing the First Digital . . . . . . . . . . . . . . . . . . . . 1062
25.2.4 Smoothing All Digitals by One-Step Survival
Conditioning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1063
25.2.5 Simulating Under the Survival Measure Using
Conditional Gaussian Draws . . . . . . . . . . . . . . . . . . . 1066
25.2.6 Generalized Trigger Products in Multi-Factor
LM Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1068
25.3 Model-Based Control Variates . . . . . . . . . . . . . . . . . . . . . . . . . 1071
25.3.1 Low-Dimensional Markov Approximation for LM
models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1072
25.3.2 Two-Dimensional Extension . . . . . . . . . . . . . . . . . . . . 1075
25.3.3 Approximating Volatility Structure . . . . . . . . . . . . . 1076
25.3.4 Markov Approximation as a Control Variate . . . . . 1078
25.4 Instrument-Based Control Variates . . . . . . . . . . . . . . . . . . . . 1080
25.5 Dynamic Control Variates . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1084
25.6 Control Variates and Risk Stability . . . . . . . . . . . . . . . . . . . . 1087
 Contents XXXIII

26 Vegas in Libor Market Models . . . . . . . . . . . . . . . . . . . . . . . . . 1089

26.1 Basic Problem of Vega Computations . . . . . . . . . . . . . . . . . . 1089
26.2 Review of Calibration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1091
26.3 Vega Calculation Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1092
26.3.1 Direct Vega Calculations . . . . . . . . . . . . . . . . . . . . . . 1092
26.3.1.1 Definition and Analysis . . . . . . . . . . . . . . 1092
26.3.1.2 Numerical Example . . . . . . . . . . . . . . . . . . 1095
26.3.2 What is a Good Vega? . . . . . . . . . . . . . . . . . . . . . . . . 1096
26.3.3 Indirect Vega Calculations . . . . . . . . . . . . . . . . . . . . . 1099
26.3.3.1 Definition and Analysis . . . . . . . . . . . . . . 1099
26.3.3.2 Numerical Example and Performance
Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1102
26.3.4 Hybrid Vega Calculations . . . . . . . . . . . . . . . . . . . . . . 1105
26.3.4.1 Definition and Analysis . . . . . . . . . . . . . . 1105
26.3.4.2 Numerical Example . . . . . . . . . . . . . . . . . . 1107
26.4 Skew and Smile Vegas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1107
26.5 Vegas and Correlations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1109
26.5.1 Term Correlation Effects . . . . . . . . . . . . . . . . . . . . . . 1109
26.5.2 What Correlations should be Kept Constant? . . . . 1110
26.5.3 Vegas with Fixed Term Correlations . . . . . . . . . . . . 1112
26.5.4 Numerical Example . . . . . . . . . . . . . . . . . . . . . . . . . . . 1113
26.6 Deltas with Backbone . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1114
26.7 Vega Projections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1116
26.8 Some Notes on Computing Model Vegas . . . . . . . . . . . . . . . . 1118

Appendix

A Markovian Projection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1123

A.1 Marginal Distributions of Ito Processes . . . . . . . . . . . . . . . . . 1123
A.2 Approximations for Conditional Expected Values . . . . . . . . 1128
A.2.1 Gaussian Approximation . . . . . . . . . . . . . . . . . . . . . . 1128
A.2.2 Least-Squares Projection . . . . . . . . . . . . . . . . . . . . . . 1130
A.3 Applications to Local Stochastic Volatility Models . . . . . . . 1131
A.3.1 Markovian Projection onto an SV Model . . . . . . . . 1131
A.3.2 Fitting the Market with an LSV Model . . . . . . . . . . 1133
A.3.3 On Calculating Proxy Local Volatility . . . . . . . . . . . 1137
A.4 Basket Options in Local Volatility Models . . . . . . . . . . . . . . 1139
A.5 Basket Options
p in Stochastic Volatility p Models . . . . . . . . . . 1143
A.A Appendix: E( zn (t)zm (t)) and E( zn (t)) . . . . . . . . . . . . . . 1146
A.A.1 Proof of Proposition A.A.1 . . . . . . . . . . . . . . . . . . . . 1147
A.A.1.1 Step 1. Reduction to Covariance . . . . . . . 1147
A.A.1.2 Step 2. Linear Approximation . . . . . . . . . 1148
A.A.1.3 Step 3. Coefficients . . . . . . . . . . . . . . . . . . 1148
A.A.1.4 Step 4. Order of Approximation . . . . . . . 1149
A.A.2 Proof of Lemma A.A.2 . . . . . . . . . . . . . . . . . . . . . . . . 1149