Fixed Income and Credit Risk

Prof. Michael Rockinger

D - 2 - Libor Market Model:

Living in Forward Space: Changing Numéraire

1 / 14
How to Price this Zoo: Historic Overview

The LIBOR Market Model (LMM) is the first model of interest rates dynamics consistent with the market practice of pricing interest rate
derivatives. The model was created in 1994 by Kristan Miltersen, Klaus Sandmann and Dieter Sondermann (1997), then developed in
1995 to a form applicable in practice by Alain Brace, Dariusz Gatarek and Marek Musiela (1997). Its current form (including the name)
belongs to Farshid Jamshidian (1997) and is based on an abstract formulation of LMM by Marek Musiela and Marek Rutkowski (1997).
The LMM is also called Brace-Gatarek-Musiela (BGM) model. Some authors claim that the model was discovered independently, that is
not true - there was close collaboration between the Bonn group (Miltersen, Sandmann, and Sondermann), the Sydney group (Brace,
Gatarek, and Musiela), Mark Rutkoski in Warsaw and Farshid Jamshidian in London. Its popularity is a result of consistency with
practice, allowing the pricing of vanilla products in LMM to be reduced to using standard market formulae. However ease of use does not
suffice to win the market, and there are numerous theoretical advantages to the LMM as well.
The LMM was preceded by so called short rate models - where the dynamics of all interest rates was determined by the dynamics of the
overnight rate. This is a counterintuitive property but practitioners learned how to apply it to a relatively high degree of effectiveness. The
next stage was the seminal Heath-Jarrow-Morton (HJM) model (1992), where attention was shifted correctly from the artificial notion of
the short rate to the whole term structure of interest rates - a mathematically interesting problem of random dynamics in infinite
dimension. We may say that all questions were already answered, the main contribution of the LMM is one more shift of attention to
instantaneous forward dates and interesting for theorists, to forward rates with market compounding - quarterly, semi-annual, annual etc.
The history of science has told us that the simple and obvious properties are the most difficult to spot.

Gatarek, Bachert, Maksymiuk (2006), The LIBOR market model in practice, Wiley Finance.

2 / 14
Practitioners Option Pricing (1990’s)

FRA payoff at Ti :
N∆(rn (Ti−1 , Ti ) − fn (0, Ti−1 , Ti )).

Value at time t of this payoff is:

Z(t, Ti )N∆ (fn (t, Ti−1 , Ti ) − fn (0, Ti−1 , Ti )) .

To price interest rate options (underlying being rn (Ti−1 , Ti ), the strike rate
being rK , and the exercise date being Ti ) use Black (think about massaging
interest rates):
C(rt , t) = Z(t, Ti )N∆ (fn (t, Ti−1 , Ti )Φ(d1 ) − rK Φ(d2 ))
1
d1 = [ln(fn (t, Ti−1 , Ti )/rK ) + σ2i (Ti−1 − t)]/σi Ti−1 − t
p
2
d2 = d1 − σi Ti−1 − t
p

Works in practice. But why?

3 / 14
Once upon a time in quant departments
Black-Scholes:

By setting C = e−r(T−t) ϕ(St , t) could get rid of the r × C term on the RHS
and one obtained a risk neutral dynamic for St after changing numéraire

Forward price Ft,T = er(T−t) St becomes a martingale and thus has a

dynamic with 0 drift

By massaging Black-Scholes into forward space, that is into Black’s

formula one can obtain all sorts of option formulas. Obviously, can get
back from Black to BS. By using Ft,T = St er−d (T − t) where d would be
a continuous dividend payment rate, obtain option price for a dividend
paying asset.

All this suggests:

It could be most interesting to move more generally into forward space

Some kind of change of numéraire will be also required

4 / 14
Once upon a time in quant departments

Big difficulty: Here interest rates are variable!

Equilibrium pricing: In the case of zero coupon bonds

 RT 
Z(rt , t) = E∗t e− t rs ds × 1

obtained a FPDE with rt × Z on RHS

Why can’t we use this for derivatives? Say payoff is gT (potentially, this
payoff may depend on the entire path {rs }s∈[t,T] ). So why can’t we just
evaluate:  R 
T
V(rt , t) = E∗t e− t
rs ds
× g(rT , t)

5 / 14
What’s the problem? (PV 740)
Under Vasicek risk-neutral dynamic obtain
 RT 
Vt = E∗t e− t rs ds gT .

Risk-neutral pricing was easy to implement for a zero-coupon bond since

XT = 1. But what if gT is an option-type payoff?
Since Cov(X, Y) = E[XY] − E[X]E[Y] can write:
 RT   RT 
Vt = E∗t e− t rs ds · E∗t gT + Cov∗t e− t rs ds , gT ,
 

which is in general a nightmare if one seeks a closed-form solution due to

the covariance term. Way out? Forward risk-neutral pricing!

One needs to go back to changing numéraire !!

Try to express prices in terms of zero-coupon prices...

6 / 14
Building some intuition 0

Equilibrium/no-arbitrage pricing

drt = m∗ (rt , t)dt + s(rt , t)dWt∗

FPDE for a derivative asset with time-t price Z(rt , t) is by (equilibrium-no arb
pricing)

1 2 ∂2 Z ∂Z ∂Z
s (rt , t) 2 + m∗ (rt , t) + = rt Z (1)
2 ∂r ∂r ∂t

7 / 14
Building some intuition 1

Equilibrium/no-arbitrage pricing

drt = m∗ (rt , t)dt + s∗ (rt , t)dWt∗

Let gT (rT , T) by some interest dependent payoff at T

 RT 
Vt = E∗t e− t rs ds gT .

FPDE followed by Vt is (equilibrium-no arb pricing)

1 2 ∂2 V ∂V ∂V
s (rt , t) 2 + m∗ (rt , t) + = rt V (2)
2 ∂r ∂r ∂t

8 / 14
Building some intuition 2
Idea: consider Ṽ = VZ . Change numéraire by expressing value in terms of a
pure discount bond maturing at T
V = Z Ṽ and
∂V ∂Z ∂Ṽ ∂V ∂Z ∂Ṽ ∂2 V ∂2 V ∂Ṽ ∂Z ∂2 Ṽ
= Ṽ +Z , = Ṽ +Z , = Ṽ 2 + 2 + 2Z
∂t ∂t ∂t ∂r ∂r ∂r ∂r 2 ∂r ∂r ∂r ∂r

Inject into PDE with V :

∂ Ṽ ∂Ṽ ∂Z ∂2 Ṽ
" 2 #
1 2
s (rt , t) Ṽ 2 + 2 + 2Z
2 ∂r ∂r ∂r ∂r
∂Z ∂Ṽ
" #
+ m∗ (rt , t) Ṽ +Z
∂r ∂r
∂Z ∂Ṽ
" #
+ Ṽ +Z = rt Z Ṽ
∂t ∂t

And remember that Z still satisfies the FPDE (1)!

9 / 14
Building some intuition 3

Regroup terms in Ṽ to get:

1 2 ∂2 Z ∗ ∂Z ∂Z 1 2 ∂2 Ṽ ∂Ṽ ∂Z 2 ∂Ṽ
" # " #
Ṽ s + m + − r t Z + s Z + s + m∗
Z +Z =0
2 ∂r2 ∂r ∂t 2 ∂r2 ∂r ∂r ∂t
| {z }
=0 because of FPDE (1)

Hence Ṽ satisfies as PDE:

1 2 ∂2 Ṽ ∂Z 2 ∂Ṽ ∂Ṽ
" #
s Z + s + m ∗
Z +Z =0
2 ∂r2 ∂r ∂r ∂t

Dividing by Z one gets.... suspense... see next slide...

10 / 14
Building some intuition 4
For the given short-term risk-neutral interest rate dynamic, a zero coupon
bond with price Z(t, T), and Ṽ = V/Z get the PDE:

1 2 ∂2 Ṽ  ∗  ∂Ṽ ∂Ṽ
s + m + sσZ + =0
2 ∂r2 ∂r ∂t
1 ∂Z
with σZ = s
Z ∂r

Which is compatible with a risk-neutral dynamic

∗
drt = [m∗ + sσZ ]dt + sdWtT

Obviously: Since the PDE in Ṽ has no right hand side term and is
associated with this risk-neutral dynamic, it must be that Ṽ is a martingale
under this new dynamic.

11 / 14
Why is this such a Divine Idea?
If rt has the dynamic
∗
dr = (m∗ + sσZ ) dt + sdW T ,
then Ṽ is a martingale and it must, hence, satisfy
∗
h i
Ṽt = ETt ṼT , (3)

Superscript T ∗ denotes that we compute the expectation under this new

measure (a dynamic of r with a drift m∗ + sσZ )

V
Replace Ṽ by Z in equation (3).

Key stuff Z(T, T) = 1 (this is the trick!), and setting VT = gT , one obtains:
∗ 
Vt = Z(t, T) · ETt gT

(4)

12 / 14
Name

If rt has the dynamic

∗
dr = (m∗ + sσZ ) dt + sdW T ,

and the associated PDE, then we have a so called forward risk-neutral

measure or the T−forward measure.

13 / 14
Why do we refer to ‘forward’ in the new measure?
In the forward risk-neutral pricing formula (4), gT is any T−payoff
Let gT = PT − Pfwd (t, T, T + ∆), where PT is the time T price of an asset P
with maturity T + ∆, and Pfwd (t, T, T + ∆) is the forward price of PT agreed
upon at t
Value at time t of this is:
PT − Pfwd (t, T, T + ∆)
" #
Value of Forward at t ∗
= ETt =0
Z(t, T) Z(T, T)
where the last 0 comes from the definition of a forward at its writing!
Hence,
∗
Pfwd (t, T, T + ∆) = ETt [PT ]
And in particular if PT = Z(T, T + ∆)
∗
F(t, T, T + ∆) = ETt [Z(T, T + ∆)]

And this observation justifies systematic replacement of random future

values by their forward values.

14 / 14