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SINGLE CURRENCY INTEREST RATE MODELS

PATRICK S. HAGAN Abstract. Here we analyze one factor and multifactor interest rate models. For the HW, BK, and generalized BK models, we derive zero coupon bond formulas, lightning evaluation methods, calibration strategies and methods, and approximate swaption./caplet formuals. Key words. interest rate models, calibration methods, lightning

(Part head:)One factor models 1. Linear Gauss Markov (LGM) model. The numeraire is (1.1) N (t, x) =
2 2 1 +εH (t)x+ 1 2 ε H (t)ζ (t) . e D(t)

The complete LGM model can be written as (1.2a) ˆ (t, x) ≡ V (t, x) , V N (t, x) Z ˆ (T, X ) 2 V p e−(X −x) /2[ζ (T )−ζ (t)] dX. 2π [ζ (T ) − ζ (t)]

(1.2b)

ˆ (t, x) = V

The value of a zero coupon bond is (1.3)

2 2 ˆ (t, x; T ) = Z (t, x; T ) = D(T )e−εH (T )x− 1 2 ε H (T )ζ (t) . Z N (t, x)

By definition, the instantaneous forward rate for maturity T , which we denote as f (t, x; T ), satisfies (1.3) Z (t, x; T ) = e−
T
t

f (t,x;T 0 )dT 0

,

D(t, T ) = e−

T
t

f0 (T 0 )dT 0

.

where f0 (T ) is today’s instantaneous forward rate for maturity T. So equation (1.3) shows that for the LGM model (1.4) f (t, x; T ) = f0 (T ) + εH 0 (T )x + ε2 H 0 (T )H (T )ζ (t).

We choose the sign of H 0 (T ) to be positive, setting x → −x, H 0 (T ) → −H 0 (T ) if necessary. Then as x increases, the forward rates f (t, x; T ) increase. 1.0.1. Scaling. Interest rates in G7 countries change by ±0.80% or so over the course of a year. Thus, a 6.2% rate environment would typically remain within the range 5.4% to 7% during the next year. Equivalently, the standard deviation of εH 0 (T )x should grow by 1% or less per year. Accordingly, we scale ε to be O(1%) and take H (T ), H 0 (T ), and x to be O(1). Note that the last term in (1.4) is O(10−4 ). 1.0.2. Model invariances. Inspection reveals that LGM has two invariances: • All market prices remain unchanged if H (T ) −→ H (T ) + C for any constant C ; • All market prices remain unchanged if ζ (T ) −→ ζ (T )/C 2 , H (T ) −→ CH (T ) for any constant C . 1.1. Swaption & caplet prices.
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6d) At any t. . x. closed form expressions for swaption prices.5d) αi = cvg (ti−1 . ζe ζe ζe i=1 2 . x)]+ . i=1 1 paid at t0 = ts . be the coverages (accrual fractions) of the fixed leg. tn = fixed leg pay dates. . . all the positive terms in (1. x the value of the receiver swap is (1. x.9a) from −∞ to x∗ . Consequently.1. 0) = N (tex .10a) n X ∗ 2 2 ∗ 2 2 1 2 1 2 (Rf − si )αi Di e−ε(Hi −Hs )x − 2 ε (Hi −Hs )ζ e + Dn e−ε(Hn −Hs )x − 2 ε (Hn −Hs )ζ e = Ds . 2. Exact.7) Vswap (t.8) now yields (1.6b) where (1. . (1.5b) (1. . the value of the receiver swaption is clearly [Vswap (t. .7) into (1. Ds = D(ts ). Consider a swaption with (1. Hi = H (ti ). (1.6c) si = floating basis spread for period i. ts ). . So if we define x∗ as the unique break-even point (1. tn ) − Z (t.9a) become smaller. X ) 2πζ (tex ) where Substituting (1.9a) #+ Z −X 2 /2ζ "X n e 2 2 1 2 2 1 2 2 e −εHi X − 1 ε H ζ − εH X − ε H ζ − εH X − ε H ζ n s i e + D e n e − D e s e 2 2 2 p Vrec (0. ti ) tex = exercise date. 0) = 1. Hs = H (ts ). The floating leg (less the basis spread) is worth (1. Since N (0. As X increases. X )]+ e−X /2ζ (tex ) p dX.9b) Recall that H (t) is an increasing function. which yields à à à ! ! ! n X x∗ + εHi ζ e x∗ + εHn ζ e x∗ + εHs ζ e p p p (1.5a) (1. On the exercise date tex .10b) Vrec = (Rf − si )αi Di N + Dn N − Ds N . ts ≡ t0 = start (settlement) date. t1 . . t2 .6a) (1. ti ) + Z (t. Then the fixed leg payments are (1. we need to integrate (1. x. (Rf − si )αi paid at ti . today’s value of the receiver swaption Z 2 [Vswap (tex .1.3) and (1. and ζ e = ζ (tex ).1. i=1 then the integrand is positive for x < x∗ . n − 1 1+(Rf − sn )αn paid at tn . for i = 1. x) = n X (Rf − si )αi Z (t. 0) = (Rf − si )αi Di e dX n s 2πζ e i=1 Di = D(ti ).8) Vrec (0.5c) and let (1. Thus Hi − Hs = H (ti ) − H (ts ) is positive.

. the swaption value depends ony on H at the pay dates (and stard date) and on ζ on the exercise dates. ζe ζe (1. reliable calibration of the model.14b) where (1. One arranges the series of instruments (swaptions.12b) Hi − Hn = H (ti ) − H (tn ). t1 ). H (t) on the dates: (1. caplets..13a) Vf loor = (1 + α1 [Rf − s1 ])D1 N − Ds N p .11a) (Rf − si )αi Di N Vrec = ζe i=1 à à ! ! y + ε(Hn − Hs )ζ e y p − Ds N p .Here N() is the standard (cumulative) normal distribution function. 2.12a) (1. This is detailed below. ts ).13c) So the value of the floorlet is given by Black’s formula (1. p √ σ B tex = ε[H (t1 ) − H (ts )] ζ (tex ) 3 . σ B tex F = (1 + α1 [Rf − s1 ])D(0.13b) Vcap = Vf loor − F + K. n That is.2 = Vcap = Vf loor − F + K (1.14a) Vf loor = F N(d1 ) − K N(d2 ). We can simplify this expression by defining y = x∗ − εHs ζ e .14c) (1. ε(H1 − Hs ) (1. Then the swaption value is ! à n X y + ε(Hi − Hs )ζ e p (1. y= 2 2 log[(1 + α1 [Rf − s1 ])D(t1 )/D(ts )] − 1 2 ε (H1 − Hs ) ζ e . i = 1. This is the key to fast. so à à ! ! y + ε(H1 − Hs )ζ e y p (1. A floorlet is a one period receiver swaption. .11c) Vpay = Vrec − This expression depends only on the model parameters ζ (t). .11b) n X 2 2 1 2 1 2 (Rf − si )αi Di e−ε(Hi −Hs )y− 2 ε (Hi −Hs ) ζ e + Dn e−ε(Hn −Hs )y− 2 ε (Hn −Hs ) ζ e = Ds . i=1 (1.14d) σ 2 tex log F/K ± 1 √ 2 B . .. ζ e = ζ (tex ). K = D(0. +Dn N ζe ζe where (1. d1. i=1 n X (Rf − si )αi Di − Dn + Ds .) so that one only has to calibrate one or two (new) parameters at a time. .

15e) G(z ) = 2 √1 e−z /2 2π The derivative of payer swaptions is identical to the derivative of the receiver swaptions. x) = [Rf − Rs ]L(t. +ε(Hn − Hs )Dn G ζe à ! n p X y + ε(Hi − Hs )ζ e ∂ p Vrec = −ε ζ e (Rf − si ) αi Di G (1. ∂Hi ζe à ! p ∂ y + ε(Hn − Hs )ζ e p Vrec = ε ζ e (1 + [Rf − si ] αn )Dn G (1. Derviatives of exact swaption prices. ti ) 1 2 2 2 1 2 2 2 (Hn −Hs )ζ (t) (1.1. x) Rs 0 ˆ s = {drift}dt + α(t)Rs ˆ ) dW ˆ.1.15a) ∂ ζe ζe i=1 à ! y + ε(Hn − Hs )ζ e p .15c) . x. −ε ζ e Dn G ζe à ! p y + ε(Hi − Hs )ζ e ∂ p Vrec = ε ζ e (Rf − si ) αi Di G (1.17) Vsw (t.2. x) as the state variable. x) − si ) αi Di e +ε Pn 2 2 2 −ε(Hi −Hs )x− 1 2 ε (Hi −Hs )ζ (t) i=1 αi Di e 4 1 2 2 2 . ti ) as the numeraire. Applying Ito’s formula to (1. ts ) + Pn i=1 αi si Z (t.3. The swap value and swap rate Rs are (1.18) yields Let us change variables from X (1. ti ) − Z (t. Approximate swaption values via equivalent vol techniques. x. dR (t.18) So (1. and the swap rate Rs (t.15d) . 1. x) = n X i=1 αi Z (t.20a) where 0 (t. x. Rs (t. n i=1 αi Z (t. tn ) P . x) = Ds + Pn i=1 ˆ to R ˆ s (t) ≡ Rs (t. X ˆ (t)).1. x.16) L(t. Differentiating yields à ! n X y + ε(Hi − Hs )ζ e ∂ p p Vrec = ε (Hi − Hs ) (Rf − si ) αi Di G (1. The first approximate formula can be derived by switching to the level (1..19) Rs (t. x) = Z (t. X αi si Di e−ε(Hi −Hs )x− 2 ε (Hi −Hs )ζ (t) − Dn e−ε(Hn −Hs )x− 2 ε Pn 2 2 2 −ε(Hi −Hs )x− 1 2 ε (Hi −Hs )ζ (t) i=1 αi Di e (Hn − Hs )Dn e−ε(Hn −Hs )x− 2 ε (Hn −Hs )ζ (t) = ε Pn 2 2 2 −ε(Hi −Hs )x− 1 2 ε (Hi −Hs )ζ (t) i=1 αi Di e Pn 2 2 2 −ε(Hi −Hs )x− 1 2 ε (Hi −Hs )ζ (t) i=1 (Hi − Hs ) (Rs (t. ∂Hn ζe where (1. x). x.15b) ∂Hs ζe i=1 ! à p y + ε(Hn − Hs )ζ e p .

21a) where L0 is today’s level and (1. n i=1 αi Di We neglect all O(ε2 ) terms. σ B tex (1.24a) ζe i=1 ! ! à à p y y .23c) Rf − 0 Rs = Pn 0 i=1 (Rs Note that as xf → 0. A more accurate approximation can be obtained from the exact solution à ! n X p y Vrec = (Rf − si ) αi Di N p + ε(Hi − Hs ) ζ e (1.22c) L0 = n X i=1 αi Di . Rf ) 0 p √ log(Rf /Rs ) σB tex = ζ (tex ). xf Ds + Pn i=1 This can be re-written as (1. dR (t. This is precisely the setup needed to apply the equivalent vol technique.1. +Dn N p + ε(Hn − Hs ) ζ e − Ds N p ζe ζe 5 P 0 p √ (Hn − Hs )Dn + n i=1 (Hi − Hs )[Rs − si ]αi Di Pn σ B tex ≈ ε ζ (tex ) .23a) where xf is defined by (1.2 = 0 where L0 is today’s level and Rs is today’s swap rate.22a) 0 Vrec = L0 {Rf N(d1 ) − Rs N(d2 )}. Then (1. 0 ± 1 σ 2 tex log Rf /Rs √ 2 B . this goes to (1. Those results show that the swaption value is given by Black’s formula (1.22d) Pn i=1 αi si Di − Dn P . X Here x = x(t. x(0. (1. Then (1.23d) £ ¤ £ ¤ − si )αi Di 1 − e−ε(Hi −Hs )xf + Dn 1 − e−ε(Hn −Hs )xf Pn −ε(Hi −Hs )xf i=1 αi Di e αi si Di e−ε(Hi −Hs )xf − Dn e−ε(Hn −Hs )xf Pn . x) as the numeraire. ¯ Rs (0) = Rs 0 ˆ s = α(t)Rs ˆ ) dW ˆ.We now use the level L(t.21b) ¯ 0 ˆ s (tex )]+ ¯ Vrec = L0 E{ [Rf − R }.23b) Rf = 0 p © ª √ log(Rf /Rs ) σ B tex = ζ (tex ) 1 + O(ε2 ) .4.19). 0 Rs = Ds + and where the equivalent volatility is (1. Alternative approximations. Ds + i=1 αi si Di − Dn .22b) d1. Rs ) is defined implicitly by (1. −ε(Hi −Hs )xf i=1 αi Di e 1.

26) Vrec = N y/ ζ e i=1 ) ( n ³ p ´ X p 2 2 2 (Rf − si ) αi Di (Hi − Hs ) + Dn (Hn − Hs ) + · · · −1 2 ε y ζ e G y/ ζ e i=1 ) ( n ³ p ´ X p (Rf − si ) αi Di (Hi − Hs ) + Dn (Hn − Hs ) + ε ζ e G y/ ζ e i=1 where y is defined by (1.29a) and (1.29b) n ¡ ¢X 0 αi Di .24b) n X i=1 (Rf − si ) αi Di e−ε(Hi −Hs )y + Dn e−ε(Hn −Hs )y = Ds .25) n ³ p ´£ ¤X 0 αi Di Vrec =N y/ ζ e Rf − Rs i=1 We can re-write this as ) ( n ³ p ´ X (Rf − si ) αi Di + Dn − Ds (1. y . To intepret this formula.28b) Vrec = (F − K )N σ N tex σ N tex Suppose we set (1. ≈ Pn F −K i=1 (Rf − si ) αi Di (Hi − Hs ) + Dn (Hn − Hs ) 6 √ F −Kp σN tex = ζ e. We expand (1.After neglecting the small ε2 ζ e terms. (1. consider a normal asset whose forward value F satisfies (1.30) y 1 . F − K = Rf − Rs i=1 Then the normal call option price is identical to our approximate swaption price If we are reasonably close to the money.28a) dF = σ N dW.24b). y is determined by (1.27b) Using (1.27a) Vrec = i=1 n X i=1 ( n ) p h i h i ζe ³ p ´ X −ε(Hi −Hs )y −ε(Hn −Hs )y (Rf − si ) αi Di 1 − e + Dn 1 − e + ··· + G y/ ζ e y i=1 (Rf − si ) αi Di e−ε(Hi −Hs )y + Dn e−ε(Hn −Hs )y = Ds . our second approximation for swaption prices is " n # ³ p ´i X p ¡ ¢h ³ p ´ 0 αi D Rf − Rs N y/ ζ e + ( ζ e /y )G y/ ζ e . This yields (1. then (1. The value of European call option on a normal asset is ½ µ µ ¶ ¶¾ √ F −K F −K √ √ + σ N tex G .24a) in powers of ε. (1.

< tn = tlast < tn+1 < tn+2 . start date. and all other parameters (the start date. define the standard cap dates for a cap which has a theoretical end date at tlast and start date at tst : (1. < τm be the exotic deal’s exercise dates which are after today (the eval date). then the stub is in front. 1. as is standard. once a month). If this end date would result in a swap shorter than. which requires calibrating to two series of swaptions/caplets. if the length of the swap is a non-integral number of periods. ten months.32b) tk end = tp n+1 tp if tst ≤ tp n = tlast n − 10 mos p if tn − 10 mos < tst ≤ tp n+1 − 10 mos p tp if t − 10 mos < tst n+2 n+1 7 .31b) tst = spot(τ 1 ).) are set by market practices. Finally. For exotics which have discrete exercise dates (like Bermudans). after calibration.2. These swaptions share the common end date tlast = tp n whenever possible.31a) τ1 < τ2 < . depending on the situation and the trader’s instinct. One can fit both functions H (t) and ζ (t). Throughout we use piecewise constant interpolation for H 0 (t) and ζ 0 (t) = α2 (t). In this case one should ensure (by adding extra dates if needed) that the first and last possible exercise dates are included in the reference set.1. and end date (1. (1. .. or per six month period. say. these dates are only going to be used to construct the calibration instruments. This is a series of m swaptions. the frequency of the fixed leg. For legs with fractional periods. Construction of the reference instruments.31d) c c tst = tc 0 < t1 < . to fit. Also define the pay dates for a standard fixed leg in the market with theoretical end date tlast and start date tst . one swaption for each exercise date τ k . per quarter. the final pay date of its swap tend . and then use a single series of swaptions/caplets to calibrate the other. the day count basis. define the start date as the standard spot date of the first exercise date: (1. For any given exotic. . • Diagonal swaptions. . The length of the caplet is set by the market. . (Remember.. tc 1 is the last regular cap date which is strictly after tst . So. LGM has two model parameters. . and its strike Rf . H (t) and ζ (t).1. then the exercise dates should be limited to either one per month. Each reference caplet can be specified by its fixing date tex and the strike Rf . In particular. not to evaluate the deal). Once the set of exercise dates has been obtained. The set of reference instruments used in each strategy depend on the following sets of dates.31c) p p p p tst = tp 0 < t1 < . . . k tk st = spot(tex ). Alternatively. the standard calibration methods use one or two of the following series for reference instruments. H (t) and ζ (t) are piecewise linear functions. So swaption k is defined by the exercise date. and tst is inserted into the date series as an extra caplet start date. (1. calibrating to a receiver is equivalent to calibrating to a payer. say. Auto-calibration strategies. one can choose one of the functions H (t) or ζ (t) a priori. < t n ˜ = tlast . Each reference swaption can be specified by its exercise date tex .32a)    tk ex = τ k .2. If the exotic has continuous exercises (like American deals) or frequent exercises (more than. let (1. and include two extra periods after tlast . then one or two extra periods need to be added to make the swap at least ten months long. Due to call-put parity.

By construction. c tk end = tk . This is a series of n options into (roughly) one year swaps which is determined by the last pay date tlast . Then the row swaptions are defined by (1. there is one short reference swaption for each exercise date τ k in (1.35a) and has the fixed leg pay dates (1. • Short swaptions (exercise dates). The strikes of these deals are determined by the standard method below. . The strikes Rf of these reference swaptions (and all other calibration instruments) are chosen to match the strike of the exotic deal using the “standard strike matching” method described below.31a). p tk st = tk .. Let tex = τ 1 be the exotic’s first exercise date after today (the eval date). If this exercise date tex is earlier than some minimum date tmin (usually three or six months after today) then take tex = tmin . all dates in (1. . . • Row swaptions. n − 1. . say. These swaptions are given by (1. . 1. . the p k last few swaptions may also included the dates tp n+1 and/or tn+2 . which makes the start date tst = spot{tex }. m. Like the diagonal swaptions. where ∆ is one or 2. • Caplets (exercise dates). tk st = spot{τ k }. Instead of ending at the last pay date tlast . then we need to change the end date to tp n+1 or tn+2 .31c). . tk st = spot{tex }.35b) tp j for j = ik . . This is a series of m caplets. and pay dates which are part of swaption pay date series tp k in (1. not by the exercise schedule.for k = 1. These swaptions all have a common exercise date tex .the start and end dates or the caplet are (1. . The fixed legs of these swaptions all share a common set of pay dates. 2. and an p end date of either tp n+1 or tn+2 as needed so that the swap is at least 10 months long. and. n ˜ − 1. . .31c).34) tk ex = tex . • Caplets (pay dates). k p where tp ik is the first date pay date strictly after tst and tnk is the first pay date in the sequence that k is at least 10 months after tst . Here tp kmin is the first pay date at least. n. these swaptions also share the common set of pay dates (1. one for each of the above exercise dates. The strikes Rf are chosen by the standard method below. k = 1.. start date tst . depending on whether the dates tp k are a semi-annual or annual series. The fixing dates of the caplets are (1. p tk end = tk for k = kmin . 2. The swaption “series” will then consist of a single swaption with exercise date tex . 8 .36) p tk ex = spot{tk }. .31c) which are strictly after the start date of the swaption and on or before tlast . 10 months after the common start date tst . .. k k Caplet k is the caplet whose fixing date is tk ex = τ k . . Namely.33a) c tk ex = fixing date{tk−1 }. . • Short swaptions (pay dates). and the strikes are chosen by the standard method below.33b) c tk st = tk−1 . kmin +1 . p tk end = tk+∆ for k = 0. Also set the start date tst to be spot-of-the exercise date. ik + 1. nk tk ex = τ k . The strikes Rf are chosen by the standard method given below. these swaps only use enough of the date sequence tp j so that they are at least 10 months long. start date (1. and not by the exercise schedule. . If none of p these swaptions are over ten months long. This is a series of n ˜ caplets determined by the last pay date tlast . . So swaption k is defined by the exercise date. The caplets each have the market-standard length (usually 3 months).

Choosing strikes of reference instruments is not straightforward for non-Bermudan deals or for Bermudans with amortizing or step-up features. and fixed tau/swaption column methods. This generally requires extending the date series tp k by including other dates after tp .32b). Unfortunately. Note that H (t) is not purely exponential since linear interpolation is used between the nodes ti .” Since H (t) is already known.37) Hi = H (tp i) = e−κti 1 − e−κ p for i = 1. The characterization is the set of exercise dates and the corresponding set of parallel shifts. for each ex ) which fits the k k. However.37). and then finding selecting the strike Rf so that the swaption/caplet is at the money when this shift is applied to the yield curve.2. and autocaps. The fixed tau/short swaption method is identical to the “fixed tau/diagonal” method except that it calibrates against the “short swaptions (exercise dates)” swaptions defined in (1. and pay dates ti . like captions. The standard method of choosing these strikes is to first characterize the exotic by setting the vols to zero and. parallel shifting the yield curve until the payoff obtained by exercising the exotic is at-themoney.35a). and other callable deals.This generally requires p extending the date series tp k by including other dates after tn+2 . chooser caps.37) is used to obtain H (t) p p on the set of dates tp 0 . . . See eqs. fixed tau/short swaption. The interpolation should use a linear interpolation method with flat extensions beyong the end points. 2. Generally autocalibration of the Hull-White model employs one of the following strategies. these swaptions are constructed p exactly like the “short swaptions (payment)” except that ∆ is chosen so that the swap from tk st = tk p to tk+∆ is longer than the prescribed tenor less a fudge factor of.11a).• Swaption column (exercise dates). say 2 months. We emphasize that the purpose is to obtain Hi = H (ti ) and ζ k = ζ (τ k ) at a series of points ti and τ k . See eqs. it is often difficult to calibrate for long dated deals when κ = 1/τ is too small.14b).14a) . especially swaption-like exotics like Bermudan swaptions. .3. Since H (t) is already known from (1. say 2 months. for each k we need to use global Newton to determine th the unique value of ζ k = ζ (tk caplet to its market price. and (1. This calibration scheme should be reserved for exotics which can be represented well in terms of a series of 1 year swaptions. 9 . 1.11b).32a). This ex ) which fits the k method has the same strengths and weaknesses as the “fixed tau/diagonal” methods.(1. and the final exotic’s price depends on the arbitrary input τ . After choosing a tenor (like 5 years). for each exercise date τ k of the exotic. n + 2. Fixed tau methods give good prices for exotics. these swaptions are constructed exactly like the “short swaptions p (exercise)” except that each nk is chosen so that the swap from tk st to tnk is longer than the prescribed tenor less a fudge factor of. Since A and B are arbitrary – see eq. Fixed tau/caplet. we need only use global Newton to th determine the unique value of ζ k = ζ (tk diagonal swaption to its market price. . (1. n+2 • Swaption column (pay dates). The fixed tau/caplet method againn requires the user to choose κ = 1/τ . n + 1. The one year tenor of the short swaptions is an arbitrary choice.2. After choosing a tenor (like 5 years). (1. We now calibrate on the diagonal series of m swaptions defined in (1. tn . one arbitrarily chooses (1. with the best price being obtained when κ = 1/τ is very near zero or even negative. 1.2. The LGM model is then calibrated on the series of caplets defined above in “caplet(exercise dates). Recall that the value k of a swaption depends only on ζ (t) on the exercise date tk ex . callable inverse floaters. . (1. (1. n. Fixed tau/diagonal calibration method.35b). The normalizing factor 1 − e−κ is arbitrary. . The strike of the swaption/caplet is matched to this characterization by first interpolating to find the parallel shift for the exercise date (fixing date) τ ex of the swaption (caplet). For this method the user abritrarily chooses a κ = 1/τ . (1. t1 . . and H (t) on the start date tst . the exotic prices depend on the arbitrary input τ . but this choice works well enough. . except that one gets good pricing for deals which have strong cap-like characteristics. piecewise linear interpolation (with linear extrapolation beyond the end points) is used to obtain H (t) and ζ (t) at other points t.

1.. we obtain H (tst ). it is called fixed σ due to a historical quirk.The fixed tau/swaption column method is identical to the “fixed tau/diagonal” method except it calibrates to the “swaption column (exercise dates)” instruments defined above. and the value of H (t) at the start date and all pay dates. We then move onto the m − 1 swaption. Thus we can write the price of the mth swaption in terms of Hm = H (tm st ) and known quantities. and Hm+1 = H (tn ) = 0.5. the values at the rest of the dates are known by linear interpolation: (1. callable range notes.. . The market prices of all instruments are independent of the value of a0 chosen.38a) ζ (t) = α2 0t Recall that the LGM model has two invariances.39) H1 = H (t1 st ). Repeating this procedure. .0001. Fixed sigma/caplet. continuing to the (m − 1)th swaption. and set (1.32b) to determine H (t) at their start dates tk st : (1. We eliminate the second LGM invariance by setting H (tp n ) to zero: (1. The model is calibrated to the diagonal swaptions in (1. Then (1.40a) H (t) = Hm + (t − tm st ) Hm+1 − Hm m tp n − tst for t ≥ tm st .40b) −1 ) H (t) = Hm−1 + (t − tm st Hm − Hm−1 m−1 tm st − tst m−1 for tst ≤ t ≤ tm st m−1 for times earlier than tm ) by fitting st .32a). it should be used for deals which are represented fairly well in terms of a column of swaptions.. Piecewise linear interpolation (linear extrapolation beyond the end points) is used to find H (t) for other values of t. although they may be slightly too agressive. p Hm = H (tm st ). This is important for a nightly MTM application. are independent of the value of α0 chosen.. H (t1 st ). Another substantial advantage is that the exotic prices do not depend on any adjustable parameters (since α0 scales out). and use a global Newton routine to determine Hm by matching the swaption to its market value.2. We eliminate one by choosing α0 . For all three methods. Fixed sigma/diagonal. the market price of all instruments. and ending with the first swaption. (1. We calibrate backwards. 1.0001.41a) ζ (t) = α2 0 t. This calibration method fixes α(t) to be a constant α0 . typically 0.. This is really a fixed α calibration. Due to these invariances. and fixed sigma/swaption column.38b) H (tp n ) = 0. 10 .41b) H (tp n ) = 0. we again fix α(t) to be a constant α0 . writing (1. H2 = H (t2 st ). Given Hm at the start date tm st . The “fixed sigma” technique yields excellent prices.4. callable inverser floaters. . both exotic and vanilla.40a) for later times. This allows us to determine H (tst m−2 th the (m − 1) swaption to its market value. and using (1. Recall that the value of the mth swaption depends on the volatility ζ (tm ex ) at its exercise date. starting with the mth swaption. and is an excellent choice for “swaption-like” exotics such as Bermudan swaptions. we eliminate the other by setting H (tp n ) to zero: (1. . fixed sigma/short swaption. .2. Again. and other callables. typically chosen to be 0. .

y ) = E e− t r V (T.2.7. We prefer the equivalent formulation in terms of the state variable X ¯ n T o ˆ (τ ))dτ ˆ(τ . (2. H (t1 ). . a backward bootstrap calibration method is used to consecutively determine H (t) at the start dates tk st of the swaptions. Using the money market as a numeraire. Here we summarize the formulas of the LGM model. Column swaptions/diagonal swaptions method. the fixed sigma/short swaptions method uses either the short swaptions (exercise dates) set of swaptions or the short swaptions (pay dates) set of swaptions.3. d 1. X ˆ . Black Karasinski. d 1. H (tn ˜ ). first calibrating the mth caplet m−1 to determine H (tm ). Fixed sigma/swaption row method. In all four cases.42) 2 m p H (t1 st ). d 1. 1. the Black Karasinski model is usually written as ¯ o n T ˆ (τ ))dτ ˆ(τ .10. As above. Piecewise linear interpolation (linear extrapolation beyond the end points) is used to find H (t) for other values of t. . Row swaption/diagonal swaptions method. H (tst ). . The second fixed sigma/caplet method is identical except that it uses the “caplet (pay dates)” set of caplets. This method determines H (t) on the start dates of the caplets (1.. and the fixed sigma/swaption column method uses either the swaption column (exercise dates) or swaption column (pay dates) sets of swaptions. this is accomplished by a backwards bootstrap scheme. General theory.There are actually two distinct fixed sigma/caplet methods.1. Short swaptions/diagonal swaptions method.2. .1a) V (t. 2. V (T.1c) ˆ = log r.9.. Y ¯Y 11 . The first calibrates to the “caplet (exercise dates)” set of caplets. and H (tn ) = 0. and finally calibrating the first st ). X (2. and excellent pricing can be expected if the calibration instruments are representative of the exotic deal. Caplets/diagonal swaptions method.2a) V (t. and determines H (t) on the dates c c p H (tc 0 ).Y ˆ (T )) ¯ ˆ (t) = y . At each stage we are determining a single parameter by fitting a single market price. . starting with the last swaption and working backwards. .2.2. x) = E e− t r ¯X where the state variable evolves according to (2. LGM formulas.6. Both the “fixed sigma/caplet” techniques yield excellent prices for exotic deals with strong “caplike” characteristics. Similarly. Exotic prices obtained from the calibrated model will not depend on any arbitrary parameters.1b) ˆ = [θ(t) − κ(t)X ˆ ] dt + σ (t) dW ˆ. then calibrating caplet m − 1 to determine H (tst 1 caplet to determine H (tst ). 2. . X and the short rate is given by (2. and H (tn ) = 0 by using a backwards bootstrapping scheme. .X ˆ (T )) ¯ ˆ (t) = x .2. . H (tst ). d 1. d 1.8.. dX ˆ (0) = 0. and the exotic prices do not depend on any adjustable parameters.

the Black Karasinski model is not overly efficient: in terms of the short rate Y • By using a money market numeraire. T ) = e− T t ˆ (t0 ) − Y ˆ (t) = Y ˆ (t0 ) − y. . so we need to roll back through the tree for each payment. dY ˆ (0) = 0. y . A(τ )eεb(τ )y dτ Observe that (2.2b) and the short rate is given by (2. Even though we know the transition density for Y knowledge is wasted by using the money market as a numeraire.3b) The value of a zero coupon bond is Z (t. ¯q E e− t A(τ )e 12 ­ 2® I1 = ε2 Z T σ (τ ) 2 t ÃZ T 0 0 b(t )A(t )e εb(t0 )y dt 0 τ !2 dτ . log r = log A(t) + εb(t)Y ˆ . • There is no obvious closed form formula for zero coupon bonds.4% to 7% during ˆ + 1 ε2 A(t)b2 (t)Y ˆ 2 + · · · . Define some time t in the future. Expanding (2. dq ˆ(t0 ) = α(t0 )dW q ˆ(t) = 0.1. Thus. Then A(t) has to be of the orderThus Equivalently.2c) ˆ ˆ ) = A(t)eεb(t)Y r(t. this tree. We choose to the next year.where the state variable evolves according to (2. The objective of our analysis is to overcome both of these inefficiencies by using singular perturbation methods to develop a closed form (approximate) formula for zero coupon bonds.80% or so over the course of a year. we must evaluate deals by stepping backward through the ˆ (t) explicitly (it is a simple Gaussian). and x to be O(1). H 0 (T ). and to switch from the money market numeraire to a zero coupon bond numeraire. Accordingly.3a) so (2.4a) ¯ o n T 2 2 3 3 − A(τ )eεb(τ )y [εb(τ )ˆ q (τ )+ 1 q 2 (τ )+ 1 q 3 (τ )+··· ]dτ ¯ 2 ε b (τ )ˆ 6 e b (τ )ˆ ˆ(t) = 0 ¯q E e t I1 = ε Z T b(τ )A(τ )eεb(τ )y q (τ )dτ t is Gaussian with mean zero and variance (2.4) is O(10−4 ). a 6. q ˆ(t0 ) = Y ˆ (t0 ). Imagine that we are at ˆ (t) = y. and that Y (2. Note that the last term in (1.2% rate environment would typically remain within the range 5. Y ˆ = α (t) dW ˆ. We can eliminate the second problem by using singular perturbation methods to derive a closed form (approximate) formula for zero coupon bond prices.2c) shows that r ∼ A(t) + εA(t)b(t)Y 2 scale α(t) to be O(1).4b) Thus (2. Recall that interest rates typically change by ±0. the standard deviation of εH 0 (T )x should grow by 1% or less per year. Zero coupon bonds.1. 2. which enables us to understand and exploit the sizes of the different terms in the model. As written. Y ⇐⇒ ˆ. we scale ε to be O(1%) and take H (T ).5a) ¯ o n T T 2 εby 0 2 ε(τ )y 1 2 T εb(τ )ˆ q (τ )dτ ¯ ˆ(t) = 0 = e 2 ε t σ (τ )( τ bAe dt ) dτ . The key to interest rate modeling is correct scaling.

T ) = e− ·e T 2 T εb(τ )y [ζ (τ )−ζ (t)]( τ b(τ 1 )A(τ 1 )eεb(τ 1 )y dτ 1 )dτ ·e+ε t b(τ )A(τ )e 2 T −1 b(τ )A(τ )eεb(τ )y [ζ (τ )−ζ (t)]dτ +O(ε4 ) 2ε t T t E ( 1 2 2ε Z T t ¯ ) Z T ¯ ¯ εb(τ )y 2 2 1 2 A(τ )e b (τ )ˆ q (τ )dτ ¯ q ˆ(t) = 0 = 2 ε A(τ )eεb(τ )y b2 (τ )[ζ (τ ) − ζ (t)]dτ ¯ t ζ (t) = Z t σ 2 (τ )dτ .5b) where (2. T )e− T 2 T εb(τ )y [ζ (τ )−ζ (t)]( τ b(τ 1 )A(τ 1 )eεb(τ 1 )y dτ 1 )dτ ·e+ε t b(τ )A(τ )e εb(τ )y 1 2 T [ζ (τ )−ζ (t)]dτ +O(ε4 ) ·e− 2 ε t b(τ )A(τ )e . 0 A(τ )eεb(τ )y dτ .6) Thus the zero coupon bond prices are (2. T ) equal to today’s discount curve: (2. we have ( ) Z T 0 2 2 4 A(τ )b(τ )ζ (τ )dτ + 1 2 ε b (T )ζ (T ) + O (ε ) . y .7) Z (t. 4 ) Z (t. T ) = D(t.9) f0 (τ )dτ f0 (T ) = A(T ) 1 − ε2 b(T ) ( . (2. 0. T ) = e−− (2. y . Matching today’s yield curve requires setting Z (0.Also. T t 2 2 A(τ )[eεb(τ )y −1]dτ + 1 2 ε [H2 (T )−H2 (t)−[H1 (T )−H1 (t)] ]ζ (t) 13 . A(T ) = f0 (T ) 1 + ε b(T ) 2 Z T 0 f0 (τ )b(τ )ζ (τ )dτ − 1 2 2 2 ε b (T )ζ (T ) + O (ε ) .8c) Therefore (2. T ) = e− T 0 T 0 A(τ ){1−ε2 b(τ )ζ (τ ) T τ 2 2 4 b(τ 1 )A(τ 1 )dτ 1 + 1 2 ε b (τ )ζ (τ )+O (ε )}dτ Since D(0.8b) so (2.8a) D(0. where f0 (T ) is today’s instantaneous forward rate curve.