Patrick S.

Hagan
IN THE TRENCHES

Convexity Conundrums: Pricing

CMS Swaps, Caps, and Floors*
Bear, Stearns & Company 383 Madison Avenue New York, NY 10179
phagan@bear.com
1 Introduction specified by the contract. So if interest accrues at rate R , then
cvg(tst , tend , dcb)R is the interest accruing in the interval tst to tend .
I’m sure we’ve all been there: We’re in hot competition with another
bank over a deal. As the deal evolves, our trading team starts getting
1.1 Deal definition
pushed around the market, and it dawns on us that the other bank’s
Consider a CMS swap leg paying, say, the N year swap rate plus a margin
pricing is better than ours, at least for this class of deals. We could fix
m. Let t0 , t1 , . . . , tm be the dates of the CMS leg specified in the contract.
this problem by inventing a universal method for achieving the best
(These dates are usually quarterly). For each period j, the CMS leg pays
possible prices for all deal types. That topic will be covered in a future
column, next to the column on Elvis sightings. Here we focus on a sin-
gle class of deals, the constant maturity swaps, caps, and floors. We δ j (R j + m) paid at t j for j = 1, 2, . . . , m, (1.3a)
develop a framework that leads to the standard methodology for pric-
ing these deals, and then use this framework to systematically improve where R j is the N year swap rate and
the pricing.
δ j = cvg(t j−1 , t j , dcbpay ) (1.3b)
Let us start by agreeing on basic notation. In our notation, today is
always t = 0. We use is the coverage of interval j. If the CMS leg is set-in-advance (this is stan-
dard), then R j is the rate for a standard swap that begins at t j−1 and ends
Z(t; T) = value at date t of a zero coupon bond with maturity T , (1.1a)
N years later. This swap rate is fixed on the date τ j that is spot lag business
D(T) ≡ Z(0, T) = today ’s discount factor for maturity T. (1.1b) days before the interval begins at t j−1 , and pertains throughout the inter-
val, with the accrued interest δ j (R j + m) being paid on the interval’s end
We distinguish between zero coupon bonds and discount factors to
remind ourselves that discount factors are not random, we can always
obtain the current discount factors D(T) by stripping the yield curve, dj
tj
while zero coupon bonds Z(t, T) remain random until the present catches
up to date t. We also use
t j−1 tj
cvg(tst , tend , dcb) (1.2)
interval j
to denote the coverage (also called the year fraction or day count fraction) of
the period tst to tend , where dcb is the day count basis (Act360, 30360, . . .) Fig. 1.1. jth interval of a “set-in-
advance” CMS leg.

* The views presented here are soley the views of the author, and do not necessarily reflect the views of Bear-Stearns or any of its affiliates or subsidiaries.

38 Wilmott magazine
date, t j . Although set-in-advance is the market standard, it is not Crudely speaking, the level L(t) represents the value at time t of receiving
uncommon for contracts to specify CMS legs set-in-arrears. Then R j is the $1 per year (paid annually or semiannually, according to the swap’s fre-
N year swap rate for the swap that begins on the end date t j of the inter- quency) for N years. With this definition, the value of the swap is
val, not the start date, and the fixing date τ j for R j is spot lag business
days before the interval ends at t j . As before, δ j is the coverage for the jth Vsw (t) = [Rs (t) − Rfix ]L(t), (1.9a)
interval using the day count basis dcbpay specified in the contract. Stan-
where
dard practice is to use the 30360 basis for USD CMS legs. Z(t; s0 ) − Z(t; sn )
Rs (t) = . (1.9b)
CMS caps and floors are constructed in an almost identical fashion. L(t)
For CMS caps and floors on the N year swap rate, the payments are Clearly the swap is worth zero when Rfix equals Rs (t), so Rs (t) is the par
swap rate at date t. In particular, today’s level
δ j [R j − K]+ paid at t j for j = 1, 2, . . . , m, (cap), (1.4a) 
n 
n
L0 = L(0) = α jD j = α j D(s j ), (1.10a)
δ j [K − R j ]+ paid at t j for j = 1, 2, . . . , m, (floor), (1.4b) j=1 j=1

and today’s (forward) swap rate

where the N year swap rate is set-in-advance or set-in-arrears, as specified
in the contract. D0 − Dn
R0s = Rs (0) = (1.10b)
L0
1.2 Reference swap
are both determined by today’s discount factors.
The value of the CMS swap, cap, or floor is just the sum of the values of
each payment. Any margin payments m can also be valued easily. So all
we need do is value a single payment of the three types, 2 Valuation
According to the theory of arbitrage free pricing, we can choose any
Rs paid at tp , (1.5a)
freely tradeable instrument as our numeraire. Examining 1.8 shows that
[Rs − K]+ paid at tp , (1.5b) the level L(t) is just the value of a collection zero coupon bonds, since the
coverages α j are just fixed numbers. These are clearly freely tradeable
[K − Rs ]+ paid at tp . (1.5c) instruments, so we can choose the level L(t) as our numeraire.1 The usual
theorems then guarantee that there exists a probability measure such
Here the reference rate Rs is the par rate for a standard swap that that the value V(t) of any freely tradeable deal divided by the numeraire
starts at date s0 , and ends N years later at sn . To express this rate mathe- is a Martingale. So
matically, let s1 , s2 , . . . , sn be the swap’s (fixed leg) pay dates. Then a swap   
V(T) 
with rate Rfix has the fixed leg payments V(t) = L(t)E Ft for any T > t, (2.1)
L(T) 
α j Rfix paid at s j for j = 1, 2, . . . , n, (1.6a)
provided there are no cash flows between t and T .
where It is helpful to examine the valuation of a plain vanilla swaption. Con-
α j = cvg(tj−1 , t j , dcb sw ) (1.6b) sider a standard European option on the reference swap. The exercise
date of such an option is the swap’s fixing date τ , which is spot-lag busi-
is the coverage (fraction of a year) for each period j, and dcb sw is the stan-
ness days before the start date s0 . At this exercise date, the payoff is the
dard swap basis. In return for making these payments, the payer receives
value of the swap, provided this value is positive, so
the floating leg payments. Neglecting any basis spread, the floating leg is
worth 1 paid at the start date s0 , minus 1 paid at the end date sn . At any Vopt (τ ) = [Rs (τ ) − Rfix ]+ L(τ ) (2.2)
date t, then, the value of the swap to the payer is

n on date τ . Since the Martingale formula 2.1 holds for any T > t, we can
Vsw (t) = Z(t; s0 ) − Z(t; sn ) − Rfix α j Z(t; s j ). (1.7) evaluate it at T = τ , obtaining
j=1
  
Vopt (τ )    
The level of the swap (also called the annuity, PV01, DV01, or numerical dura- Vopt (t) = L(t)E  Ft = L(t)E [Rs (τ ) − Rfix ]+  Ft . (2.3)
tion) is defined as L(τ )
In particular, today’s value of the swaption is

n
  
L(t) = α j Z(t; s j ). (1.8) Vopt (t) = L0 E [Rs (τ ) − Rfix ]+  F0 . (2.4a)
^
j=1

Wilmott magazine 39
 PATRICK S.HAGAN

Moreover, 1.9b shows that the par swap rate Rs (t) is the value of a freely last

term is the 

“convexity correction”. Since Rs (τ ) is a Martingale and

tradable instrument (two zero coupon bonds) divided by our numeraire. Z(τ ; tp )/L(τ ) / Z(t; tp )/L(t) − 1 is zero on average, this term goes to zero
So the swap rate must also a Martingale, and linearly with the variance of the swap rate Rs (τ ), and is much, much
smaller than the first term.
E { Rs (τ )| F0 } = Rs (0) ≡ R0s . (2.4b) There are two steps in evaluating the convexity correction. The first
step is to model the yield curve movements in a way that allows us to re-
To complete the pricing, one now has to invoke a mathematical write the level L(τ ) and the zero coupon bond Z(τ ; tp ) in terms of the
model (Black’s model, Heston’s model, the SABR model, . . . ) for how Rs (τ ) swap rate Rs . (One obvious model is to allow only parallel shifts of the
is distributed around its mean value R0s . In Black’s model, for example, yield curve.) Then we can write
the swap rate is distributed according to
√ 1 2
Z(τ ; tp )/L(τ ) = G(Rs (τ )), (2.11a)
τ−
Rs (τ ) = R0s eσ x 2
σ τ
, (2.5)
D(tp )/L0 = G(R0s ), (2.11b)
where x is a normal variable with mean zero and unit variance. One
completes the pricing by integrating to calculate the expected value. for some function G(Rs ). The convexity correction is then just the expect-
ed value
   
2.1 CMS caplets G(Rs (τ )) 
The payoff of a CMS caplet is cc = D(tp )E [Rs (τ ) − K] +
− 1  F0 (2.12)
G(R0 ) s

over the swap rate Rs (τ ). The second step is to evaluate this expected
[Rs (τ ) − K]+ paid at tp . (2.6)
value.
On the swap’s fixing date τ , the par swap rate Rs is set and the payoff is In the appendix we start with the street-standard model for express-
known to be [Rs (τ ) − K]+ Z(τ ; tp ) , since the payment is made on tp . Evalu- ing L(τ ) and Z(τ ; tp ) in terms of the swap rate Rs . This model uses bond
ating 2.1 at T = τ yields math to obtain
Rs 1
   G(Rs ) = . (2.13a)
[Rs (τ ) − K]+ Z(τ ; tp )  (1 + Rs /q) 1
(t) = L(t)E 1−
 Ft .
CMS
Vcap (2.7a)
L(τ ) (1 + Rs /q)n

In particular, today’s value is Here q is the number of periods per year (1 if the reference swap is annu-
   al, 2 if it is semi-annual, . . .), and
[Rs (τ ) − K]+ Z(τ ; tp ) 
CMS
Vcap (0) = L0 E  F0 . (2.7b) tp − s0
L(τ ) = (2.13b)
s1 − s0
The ratio Z(τ ; tp )/L(τ ) is (yet another!) Martingale, so it’s average value
is the fraction of a period between the swap’s start date s0 and the pay
is today’s value:
date tp . For deals “set-in-arrears”  = 0. For deals “set-in-advance,” if the
  
E Z(τ ; tp )/L(τ ) F0 = D(tp )/L0 . (2.8) CMS leg dates t0 , t1 , . . . are quarterly, then tp is 3 months after the start
date s0 , so  = 12 if the swap is semiannual and  = 14 if it is annual.
By dividing Z(τ ; tp )/L(τ ) by its mean, we obtain In the apprendix we also consider increasingly sophisticated models
for expressing L(τ ) and Z(τ ; tp ) in terms of the swap rate Rs , and obtain
  
Z(τ ; tp )/L(τ )  increasingly sophisticated functions G(Rs ).
CMS
Vcap (0) = D(tp )E [Rs (τ ) − K]+ F0 , (2.9)
D(tp )/L0  We can carry out the second step by replicating the payoff in 2.12 in
terms of payer swaptions. For any smooth function f (Rs ) with f (K) = 0,
which can be written more evocatively as we can write
    
CMS
Vcap (0) = D(tp )E [Rs (τ ) − K]+  F0 ∞
f (Rs ) for Rs > K
    f  (K)[Rs − K]+ + [Rs − x]+ f  (x)dx = . (2.14)
Z(τ ; tp )/L(τ )  (2.10) 0 for Rs < K
− 1  F0 .
+ K
+ D(tp )E [Rs (τ ) − K]
D(tp )/L0 Choosing

The first term is exactly the price of a European swaption with G(x)
f (x) ≡ [x − K] − 1 , (2.15)
notional D(tp )/L0 , regardless of how the swap rate Rs (τ ) is modeled. The G(R0s )

40 Wilmott magazine
and substituting this into 2.12, we find that where 
 G(x)
   fatm (x) ≡ [x − R0s ] −1 (2.19b)
cc = D(tp ) f  (K) E [Rs (τ ) − K]+  F0 G(R0s )
 ∞ 
  
+ f  (x) E [Rs (τ ) − x]+  F0 dx .
K
Together with the first term, this yields
(2.16) is the same as f (x) with the strike K replaced by the par swap rate R0s .
Here, the first term in 2.19a is the value if the payment were exactly
equal to the forward swap rate R0s as seen today. The other terms repre-
sent the convexity correction, written in terms of vanilla payer and
  ∞  receiver swaptions. These too can be evaluated by replication.
D(tp )
 It should be noted that CMS caplets and floorlets satisfy call-put pari-
CMS
Vcap (0) = 1 + f  (K) C(K) + C(x)f  (x)dx , (2.17a)
L0 K ty. Since

as the value of the CMS caplet, where [Rs (τ ) − K]+ − [K − Rs (τ )]+ = Rs (τ ) − K paid at tp , (2.20)

  
C(x) = L0 E [Rs (τ ) − x]+  F0 (2.17b) the payoff of a CMS caplet minus a CMS floorlet is equal to the payoff of a
CMS swaplet minus K . Therefore, the value of this combination must be
is the value of an ordinary payer swaption with strike x. equal at all earlier times as well:
This formula replicates the value of the CMS caplet in terms of Euro-
pean swaptions at different strikes x. At this point some pricing systems
CMS
Vcap (t) − Vfloor
CMS
(t) = Vswap
CMS
(t) − KZ(t; tp ) (2.21a)
break the integral up into 10bp or so buckets, and re-write the convexity
correction as the sum of European swaptions centered in each bucket. In particular,
These swaptions are then consolidated with the other European swap-
tions in the vanilla book, and priced in the vanilla pricing system. This
CMS
Vcap (0) − Vfloor
CMS
(0) = Vswap
CMS
(0) − KD(tp ). (2.21b)
“replication method” is the most accurate method of evaluating CMS legs.
It also has the advantage of automatically making the CMS pricing and Accordingly, we can price an in-the-money caplet or floorlet as a swaplet
hedging consistent with the desk’s handling of the rest of its vanilla book. plus an out-of-the-money floorlet or caplet.
In particular, it incorporates the desk’s smile/skew corrections into the
CMS pricing. However, this method is opaque and compute intensive.
After briefly considering CMS floorlets and CMS swaplets, we develop sim- 3 Analytical formulas
pler approximate formulas for the convexity correction, as an alternative The function G(x) is smooth and slowly varying, regardless of the model
to the replication method. used to obtain it. Since the probable swap rates Rs (τ ) are heavily concen-
trated around R0s , it makes sense to expand G(x) as
2.2 CMS floorlets and swaplets
Repeating the above arguments shows that the value of a CMS floorlet is G(x) ≈ G(R0s ) + G(R0s )(x − R0s ) + · · · . (3.1a)
given by
For the moment, let us limit the expansion to the linear term. This makes
  K 
D(tp )
 f (x) a quadratic function,
CMS
Vfloor (0) = 1 + f  (K) P(K) − P(x)f  (x)dx , (2.18a)
L0 −∞
G(R0s )
f (x) ≈ (x − R0s )(x − K), (3.1b)
where f (x) is the same function as before (see 2.15), and where G(R0s )
and f (x) a constant. Substituting this into our formula for a CMS caplet
 
+

P(x) = L0 E [x − Rs (τ )] F0 (2.18b) (2.17a), we obtain
  ∞ 
is the value of the ordinary receiver swaption with strike x. Thus, the D(tp )
CMS
Vcap (0) = C(K) + G(R0s ) (K − R0s )C(K) + 2 C(x)dx , (3.2)
CMS floolets can also be priced through replication with vanilla L0 K

receivers. Similarly, the value of a single CMS swap payment is where we have used G(R0s ) = D(tp )/L0 . Now, for any K the value of the
  R0s  payer swaption is
∞
D(tp )  
Vswap (0) = D(tp )Rs +
CMS 0
C(x)fatm (x)dx + P(x)fatm (x)dx ,  
L0 
R 0s −∞
C(K) = L0 E [Rs (τ ) − K]+  F0 , (3.3a)
^
(2.19a)

Wilmott magazine 41
 PATRICK S.HAGAN

so the integral can be re-written as caplets and floorlets, the volatility σK for strike K should be used, since
 ∞    the swap rates Rs (τ ) near K provide the largest contribution to the
∞ 
C(x)dx = L0 E [Rs (τ ) − x]+ dx F0 expected value. For in-the-money options, the largest contributions come
K K
(3.3b) from swap rates Rs (τ ) near the mean value R0s . Accordingly, call-put pari-
1  2   ty should be used to evaluate in-the-money caplets and floorlets as a CMS
= L0 E [Rs (τ ) − K]+  F0 .
2 swap payment plus an out-of-the-money floorlet or caplet.
Putting this together yields

CMS
Vcap (0) =
D(tp ) 
  
C(K) + G (R0s )L0 E Rs (τ ) − R0s [Rs (τ ) − K]+  F0 (3.4a)
4 Conclusions
L0 The standard pricing for CMS legs is given by 3.5a–3.5d with G(Rs ) given
by 2.13a. These formulas are adequate for many purposes. When finer
for the value of a CMS caplet, where the convexity correction is now the pricing is required, one can systematically improve these formulas by
expected value of a quadratic “payoff”. An identical arguments yields the using the more sophisticated models for G(Rs ) developed in the Appen-
formula dix, and by adding the quadratic and higher order terms in the expan-
D(tp ) 
   sion 3.1a. In addition, 3.4a–3.4b show that the convexity corrections are
CMS
Vfloor (0) = P(K) − G (R0s )L0 E R0s − Rs (τ ) [K − Rs (τ )]+  F0 (3.4b) essentially swaptions with “quadratic” payoffs. These payoffs emphasize
L0
away-from-the-money rates more than standard swaptions, so the con-
for the value of a CMS floorlet. Similarly, the value of a CMS swap pay- vexity corrections can be quite sensitive to the market’s skew and smile.
ment works out to be CMS pricing can be improved by replacing Black’s model with a model
that matches the market smile, such as Heston’s model or the SABR
 2  
CMS
Vswap (0) = D(tp )R0s + G (R0s )L0 E Rs (τ ) − R0s  F0 . (3.4c) model. Alternatively, when the very highest accuracy is needed, replica-
tion can be used to obtain near perfect results.
To finish the calculation, one needs an explicit model for the swap
rate Rs (τ ). The simplest model is Black’s model, which assumes that the
swap rate Rs (τ ) is log normal with a volatility σ . With this model, one
Appendix A. Models of the yield curve
obtains A.1 Model 1: Standard model
 2  σ 2 τ  The standard method for computing convexity corrections uses bond
CMS
Vswap (0) = D(tp )R0s + G (R0s )L0 R0s e −1 (3.5a) math approximations: payments are discounted at a flat rate, and the
coverage (day count fraction) for each period is assumed to be 1/q, where
for the CMS swaplets, q is the number of periods per year (1 for annual, 2 for semi-annual, etc).
D(tp )  At any date t, the level is approximated as
C(K) + G (R0s )L0 (R0s )2 eσ τ N (d3/2 )
2
CMS
Vcap (0) =
L0 (3.5b)
 
n 
n
Z(t, s j ) 1/q
−R0s (R0s + K)N (d1/2 ) + R0s KN (d−1/2 ) L(t) = Z(t, s0 ) αj ≈ Z(t, s0 ) , (A.1)
Z(t, s0 ) [1 + Rs (t)/q] j
j=1 j=1
for CMS caplets, and
D(tp )  which works out to
P(K) − G (R0s )L0 (R0s )2 eσ τ N (−d3/2 )
2
CMS
Vfloor (0) =  
L0 (3.5c) Z(t, s0 ) 1
 L(t) = 1− . (A.2a)
− R0s (R0s + K)N (−d1/2 ) + R0s KN (−d−1/2 ) Rs (t) (1 + Rs (t)/q)n

for CMS floorlets. Here Here the par swap rate Rs (t) is used as the discount rate, since it repre-
ln R0s /K + λσ 2 τ sents the average rate over the life of the reference swap. In a similar
dλ = √ . (3.5d) spirit, the zero coupon bond for the pay date tp is approximated as
σ τ
Z(t, s0 )
The key concern with Black’s model is that it does not address the Z(t; tp ) ≈ , (A.2b)
(1 + Rs (t)/q)
smiles and/or skews seen in the marketplace. This can be partially miti-
gated by using the correct volatilities. For CMS swaps, the volatility σATM where
tp − s0
for at-the-money swaptions should be used, since the expected value 3.4c = (A.2c)
s1 − s0
includes high and low strike swaptions equally. For out-of-the-money

42 Wilmott magazine
is the fraction of a period between the swap’s start date s0 and the pay where x is the amount of the parallel shift. The level and swap rate Rs are
date tp . Thus the standard “bond math model” leads to given by
L(t) n
D(s j ) −(s j −s0 )x
Z(t; tp ) Rs 1 = αj e (A.10a)
G(Rs ) = ≈ . (A.3) Z(t; s0 ) D(s0 )
L(t) (1 + Rs /q) 1 j=1
1−
(1 + Rs /q)n
D(s0 ) − D(sn )e−(sn −s0 )x
Rs (t) = . (A.10b)
This method a) approximates the schedule and coverages for the ref- n
−(s j −s 0 )x
α j D(s j )e
erence swaption; b) assumes that the initial and final yield curves are j=1
flat, at least over the tenor of the reference swaption; and c) assumes a Turning this around,
correlation of 100% between rates of differing maturities. 
n
Rs α j D(s j )e−(s j −s0 )x + D(sn )e−(sn −s0 )x = D(s0 ) (A.11a)
A.2 Model 2: “Exact yield” model j=1

We can account for the reference swaption’s schedule and day count
exactly by approximating determines the parallel shift x implicitly in terms of the swap rate Rs .
With x determined by Rs , the level is given by

j
1
Z(t; s j ) ≈ Z(t; s0 ) , (A.4) L(Rs ) D(s0 ) − D(sn )e−(sn −s0 )x
1 + αk Rs (t) = (A.11b)
k=1 Z(t; s0 ) D(s0 )Rs

where αk is the coverage of the kth period of the reference swaption. At

in terms of the swap rate. Thus this model yields
any date t, the level is then

j 
n n  1 Z(t; tp ) Rs e−(tp −s0 )x
L(t) = α j Z(t; s j ) = Z(t; s0 ) αj . (A.5) G(Rs ) = ≈ , (A.12a)
1 + αk Rs (t) L(t) 1 − D(s
D(sn ) −(sn −s0 )x
0)
e
j=1 j=1 k=1

We can establish the following identity by induction: where x is determined implicitly in terms of Rs by


Z(t; s0 ) 
n
1 
n

L(t) = 1− . (A.6) Rs α j D(s j )e−(s j −s0 )x + D(sn )e−(sn −s0 )x = D(s0 ). (A.12b)
Rs (t) [1 + αk Rs (t)] j=1
k=1

In the same spirit, we can approximate This model’s limitations are that it allows only parallel shifts of the yield
curve and it presumes perfect correlation between long and short term
1 rates.
Z(t; tp ) = Z(t; s0 ) , (A.7)
(1 + α1 Rs (t))

where  = (tp − s0 )/(s1 − s0 ) as before. Then A.4 Model 4: Non-parallel shifts

We can allow non-parallel shifts by approximating
Z(t; tp ) Rs 1
G(Rs ) = ≈ . (A.8) Z(t; s j ) D(s j ) −[h(s j )−h(s0 )]x
L(t) (1 + α1 Rs ) 
n 1 ≈ e , (A.13)
1− Z(t; s0 ) D(s0 )
k=1 (1 + α j Rs )
where x is the amount of the shift, and h(s) is the effect of the shift on
This approximates the yield curve as flat and only allows parallel shifts,
maturity s. As above, the shift x is determined implicitly in terms of the
but has the schedule right.
swap rate Rs via
A.3 Model 3: Parallel shifts 
n
Rs α j D(s j )e−[h(s j )−h(s0 )]x + D(sn )e−[h(sn )−h(s0 )]x = D(s0 ). (A.14a)
This model takes into account the initial yield curve shape, which can be j=1
significant in steep yield curve environments. We still only allow parallel
yield curve shifts, so we approximate Then
L(Rs ) D(s0 ) − D(sn )e−[h(sn )−h(s0 )]x
Z(t; s j ) D(s j ) −(s j −s0 )x = (A.14b)
^
≈ e for j = 1, 2, . . . , n (A.9) Z(t; s0 ) D(s0 )Rs
Z(t; s0 ) D(s0 )

Wilmott magazine 43
 PATRICK S.HAGAN

determines the level in terms of the swap rate. This model then yields

Z(t; tp ) Rs e−[h(tp )−h(s0 )]x

G(Rs ) = ≈ , (A.15a)
L(t) 1 − D(s
D(sn ) −[h(sn )−h(s0 )]x
0)
e

where x is determined implicitly in terms of Rs by


n
Rs α j D(s j )e−[h(s j )−h(s0 )]x + D(sn )e−[h(sn )−h(s0 )]x = D(s0 ). (A.15b)
j=1

To continue further requires selecting the function h(s j ) which deter-

mines the shape of the non-parallel shift. This is often done by postulat-
ing a constant mean reversion,
1

h(s) − h(s0 ) = 1 − e−κ (s−s0 ) . (A.16)
κ
Alternatively, one can choose h(s j ) by calibrating the vanilla swaptions
which have the same start date s0 and varying end dates to their market
prices.

FOOTNOTE
1. We follow the standard (if bad) practice of referring to both the physical instrument
and its value as the “numeraire”.

44 Wilmott magazine