METHODOLOGY FOR CALLABLE SWAPS AND BERMUDAN “EXERCISE INTO”SWAPTIONS
PATRICK S. HAGANBLOOMBERG LP499 PARK AVENUENEW YORK, NY 10022PHAGAN1@BLOOMBERG.NET212-893-4231
Abstract.
Here we present a methodology for obtaining quick decent prices for callable swaps and Bermudan “exerciseinto” swaps using the LGM model.
Key words.
Bermudans, callable swaps
1. Introduction.
This is part of three related papers:
Evaluating and hedging exotic swap instruments via LGM
explains the theory and usage of the LGM model in detail. This paper,
Methodology for Callable Swaps and Bermudan “Exercise Into” swaptions,
details the methodology, including all steps of the pricingprocedure. Finally,
Procedure for pricing Bermudans and callable swaps,
breaks down the method into aprocedure and set of algorithms.This paper has three appendices. The
fi
rst appendix discusses handling Bermudan options on amortizingswaps (as opposed to bullet swaps). Amortizers require a slightly more sophisticated
deal characterization
step, which results in selecting a di
ff
erent set of vanilla instruments for calibration. Once the deals areselected, the calibration and evaluation steps are identical to those of the bullet Bermudans. The secondappendix discusses American swaptions. With the appropriate pre-processing step, American swaptions canbe priced by by using the Bermudan pricing engine. The third appendix is used to point out the modi
fi
cationsthat are needed if the two legs are in di
ff
erent currencies.
1.1. Notation.
In our notation today is always
t
= 0
, and(1.1a)
D
(
T
) =
today’s discount factor for maturity
T.
For any date
t
in the future, let
Z
(
t
;
T
)
be the value of $1 to be delivered at a later date
T
,(1.1b)
Z
(
t
;
T
) =
zero coupon bond, maturity
T
, as seen at
t.
These discount factors and zero coupon bonds are the ones obtained from the currency’s swap curve. Clearly
D
(
T
) =
Z
(0;
T
)
. We use distinct notation for discount factors and zero coupon bonds to remind ourselvesthat discount factors
D
(
T
)
are
not
random; we can always obtain the current discount factors from thestripper. Zero coupon bonds
Z
(
t
;
T
)
are
random, at least until time catches up to date
t
.Also, we use
N
(
z
)
and
G
(
z
)
to be the standard (cumulative) normal distribution and Gaussian density,respectively:(1.2)
N
(
z
) =
Z
z
−∞
G
(
z
0
)
dz
0
, G
(
z
) =1
√
2
πe
−
z
2
/
2
2. Deal de
fi
nition and representation.
Bermudans arise mainly from two sources. The
fi
rst is adirect Bermudan swaption, also called an “exercise into” Bermudan. The other (more common) source isa cancellable swap, which is invariably priced as a swap plus a Bermudan swaption to enter the oppositeswap. Bermudans from both sources (and virtually any other Bermudan that arises)
fi
t into following deal
1
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