Are you sure?
This action might not be possible to undo. Are you sure you want to continue?
LI BOR MARKET MODEL
Tim Xiao
1
Risk Analyt ics, Capit al Market s Risk Management , CI BC, Toront o, Canada
ABSTRACT
The LI BOR Market Model ( LMM or BGM) has become one of t he most popular
models for pricing int erest rat e product s. I t is commonly believed t hat Mont e Carlo
simulat ion is t he only viable met hod available for t he LI BOR Market Model. I n t his
art icle, however, we propose a lat t ice ( or t ree) approach t o price int erest rat e
product s wit hin t he LI BOR Market Model by i nt roducing a shift ed forward measure
and several novel fast drift approximat ion met hods. This model should achieve t he
best performance wit hout losing much accuracy. Moreover, t he calibrat ion is almost
aut omat ic and it is simple and easy t o implement . Addi ng t his model t o t he valuat ion
t oolkit is act ually quit e useful; especially for risk management or in t he case t here is
a need for a quick t urnaround.
Key Words: LI BOR Market Model ( LMM or BGM) , lat t ice model, t ree model, shift ed
forward measure, drift approximat ion, risk management , calibrat ion, callable exot ics,
callable bond, callable capped float er swap, callable inverse float er swap, callable
range accrual swap.
1
The views expressed here are of t he aut hor alone and not necessarily of his host inst it ut ion.
Address correspondence t o Tim Xiao, Risk Analyt ics, Capit al Market s Risk Management , CI BC,
161 Bay St reet , 12
t h
Floor, Toront o, ON M5J 2S8, Canada; email: Tim. Xiao@CI BC. com
1
The LI BOR Market Model ( LMM) is an int erest rat e model based on evolving
LI BOR market forward rat es under a riskneut ral forward probabilit y measure. I n
cont rast t o models t hat evolve t he inst ant aneous short rat es ( e.g., Hull Whit e, Black
Karasinski models) or inst ant aneous forward rat es ( e.g., Heat h Jarrow Mort on (HJM)
model) , which are not direct ly observable in t he market , t he obj ect s modeled using
t he LMM are market observable quant it ies. The explicit modeling of market forward
rat es allows for a nat ural formula for int erest rat e opt ion volat ilit y t hat is consist ent
wit h t he market pract ice of using t he formula of Black for caps. I t is generally
considered t o have more desirable t heoret ical calibrat ion propert ies t han short rat e
or inst ant aneous forward rat e models.
I n general, it is believed t hat Mont e Carlo simulat ion is t he only viable
numerical met hod available for t he LMM ( see Pit erbarg [ 2003] ) . The Mont e Carlo
simulat ion is comput at ionally expensive, slowly converging, and not oriously difficult
t o use for calculat ing sensit ivit ies and hedges. Anot her not able weakness is it s
inabilit y t o det ermine how far t he solut ion is from opt imalit y in any given problem.
I n t his paper, we propose a lat t ice approach wit hin t he LMM. The model has
similar accuracy t o t he current pricing models in t he market , but is much fast er.
Some ot her merit s of t he model are t hat calibrat ion is almost aut omat ic and t he
approach is less complex and easier t o implement t han ot her current approaches.
We int roduce a shift ed forward measure t hat uses a variable subst it ut ion t o
shift t he cent er of a forward rat e dist ribut ion t o zero. This ensures t hat t he
dist ribut ion is symmet ric and can be represent ed by a relat ively small number of
discret e point s. The shift t ransformat ion is t he key t o achieve high accuracy in
relat ively few discret e finit e nodes. I n addit ion, we present several fast and novel
drift approximat ion approaches. Ot her concept s used in t he model are probabilit y
dist ribut ion st ruct ure exploit at ion, numerical int egrat ion and t he long j ump t echnique
( we only posit ion nodes at t imes when decisions need t o be made) .
2
This model is act ually quit e useful for risk management because normally full 
revaluat ions of an ent ire port folio under hundreds of t housands of different fut ure
scenarios are required for a short t ime window. Wit hout an efficient algorit hm, one
cannot properly capt ure and manage t he risk exposed by t he port folio.
The rest of t his paper is organized as follows: The LMM is discussed in Sect ion
I . I n Sect ion I I , t he lat t ice model is elaborat ed. The calibrat ion is present ed in
Sect ion I I I . The numerical impl ement at ion is det ailed in Sect ion I V, which will
enhance t he reader’s underst anding of t he model and it s pract ical implement at ion.
The conclusions are provided in Sect ion V.
I . LI BOR MARKET MODEL
Let ( O , F , { }
0 > t t
F , P ) be a filt ered probabilit y space sat isfying t he usual
condit ions, where O denot es a sample space, F denot es a o  algebra, P denot es
a probabilit y measure, and { }
0 > t t
F denot es a filt rat ion. Consider an increasing
mat urit y st ruct ure
N
T T T < < < = ... 0
1 0
from which expiry mat urit y pairs of dat es
(
1 ÷ k
T ,
k
T ) for a family of spanning forward rat es are t aken. For any t ime
1 ÷
s
k
T t , we
define a right  cont inuous mapping funct ion ) (t n by
) ( 1 ) ( t n t n
T t T < s
÷
. The simply
compounded forward rat e reset at t for forward period (
1 ÷ k
T ,
k
T ) is defined by


.

\

÷ = =
÷
÷
1
) , (
) , ( 1
) , ; ( : ) (
1
1
k
k
k
k k k
T t P
T t P
T T t F t F
o
( 1)
where ) , ( T t P denot es t he t ime t price of a zero coupon bond mat uring at t ime T and
) , ( :
1 k k k
T T
÷
=o o is t he accrual fact or or day count fract ion for period (
1 ÷ k
T ,
k
T ) .
I nvert ing t his relat ionship ( 1) , we can express a zero coupon bond price in
t erms of forward rat es as:
[
=
+
=
k
t n j
j j
t n k
t F
T t P T t P
) (
) (
) ( 1
1
) , ( ) , (
o
( 2)
3
LI BOR Market Model Dynamics
Consider a zero coupon bond numeraire ) , (
i
T P  whose mat urit y coincides wit h
t he mat urit y of t he forward rat e. The measure
i
Q associat ed wit h ) , (
i
T P  is called
i
T
forward measure. Terminal measure
N
Q is a forward measure where t he mat urit y of
t he bond numeraire ) , (
N
T P  mat ches t he t erminal dat e
N
T .
For brevit y, we discuss t he one fact or LMM only. The one fact or LMM ( Brace
et al. [ 1997] ) under forward measure
i
Q can be expressed as
I f
i
T t k i s < , , t k k
k
i j
j j
j j j
k k k
dX t F t dt
t F
t F t
t F t t dF ) ( ) (
) ( 1
) ( ) (
) ( ) ( ) (
1
o
o
o o
o +
+
=
¿
+ =
( 3a)
I f
1
,
÷
s =
k
T t k i ,
t k k k
dX t F t t dF ) ( ) ( ) ( o = ( 3b)
I f
1
,
÷
s >
k
T t k i , t k k
i
k j
j j
j j j
k k k
dX t F t dt
t F
t F t
t F t t dF ) ( ) (
) ( 1
) ( ) (
) ( ) ( ) (
1
o
o
o o
o +
+
÷ =
¿
+ =
( 3c)
where
t
X is a Brownian mot ion.
There is no requirement for what kind of inst ant aneous volat ilit y st ruct ure
should be chosen during t he life of t he caplet . All t hat is required is (see Hull Whit e
[ 2000] ) :
( )
}
÷
÷
÷
= K =
1
0
2
1
2
1
2
) (
1
) , ( : ) (
k
T
k
k
k k k
du u
T
T o o o
( 4)
where
k
o
denot es t he market Black caplet volat ilit y and K denot es t he st rike. Given
t his equat ion, it is obviously not possible t o uniquely pin down t he inst ant aneous
volat ilit y funct ion. I n fact , t his specificat ion allows an infinit e number of choices.
People oft en assume t hat a forward rat e has a piecewise const ant inst ant aneous
volat ilit y. Here we choose t he forward rat e ) (t F
k
has const ant inst ant aneous volat ilit y
regardless of t ( see Brigo Mercurio [ 2006] ) .
4
Shift ed Forward Measure
The ) (t F
k
is a Mart ingale or drift less under it s own measure
k
Q . The solut ion
t o equat ion (3b) can be expressed as

.

\

+ ÷ =
} }
t
s k
t
k k k
dX s ds s F t F
0 0
2
) ( ) (
2
1
exp ) 0 ( ) ( o o
( 5)
where ) , ; 0 ( ) 0 (
1 k k k
T T F F
÷
= is t he current ( spot ) forward rat e. Under t he volat ilit y
assumpt ion described above, equat ion (5) can be furt her expressed as


.

\

+ ÷ =
t k
k
k k
X t F t F o
o
2
exp ) 0 ( ) (
2
( 6)
Alt ernat ively, we can reach t he same Mart ingale conclusion by direct ly deriving t he
expect at ion of t he forward rat e ( 6); t hat is
( )
) 0 (
2
exp
2
1
) 0 (
2
) (
exp
2
1
) 0 (
2
exp
2
exp
2
1
) 0 ( ) (
2 2
2 2
0
k t
t
k t
k t
k
t
t
t k
k
k k
F dY
t
Y
t
F dX
t
t X
t
F
dX
t
X
X t
t
F t F E
=


.

\

÷ =


.

\
 ÷
÷ =


.

\

÷


.

\

+ ÷ =
} }
}
·
· ÷
·
· ÷
·
· ÷
t
o
t
o
o
t
( 7)
where
t
X ,
t
Y are bot h Brownian mot ions wit h a normal dist ribut ion (0, t ) at t ime t ,
)  ( : ) (
t t
E E F  =  is t he expect at ion condit ional on t he
t
F , and t he variable subst it ut ion
used for derivat ion is
k t t
t X Y o ÷ = ( 8)
This variable subst it ut ion t hat ensures t hat t he dist ribut ion is cent ered on zero and
symmet ry is t he key t o achieve high accuracy when we express t he LMM in discret e
finit e form and use numerical int egrat ion t o calculat e t he expect at ion. As a mat t er of
fact , wit hout t his linear t ransformat ion, a lat t ice met hod in t he LMM eit her does not
exist or int roduces t oo much error for longer mat urit ies.
Aft er applying t his variable subst it ut ion (8) , equat ion ( 6) can be expressed as
5


.

\

+ =


.

\

+ ÷ =
t k
k
k t k
k
k k
Y t F X t F t F o
o
o
o
2
exp ) 0 (
2
exp ) 0 ( ) (
2 2
( 9)
Since t he LMM models t he complet e forward curve direct ly, it is essent ial t o
bring everyt hing under a common measure. The t erminal measure is a good choice
for t his purpose, alt hough t his is by no means t he only choice. The forward rat e
dynamic under t erminal measure
N
Q is given by
t k k
N
k j
j j
j j j
k k k
dX t F dt
t F
t F
t F t dF ) (
) ( 1
) (
) ( ) (
1
o
o
o o
o +
+
÷ =
¿
+ =
( 10)
The solut ion t o equat ion (10) can be expressed as


.

\

+ ÷ =


.

\

+ ÷ =
} }
t k
k
k k
t
s k
t
k
k k k
X t t F dX ds t F t F o
o
µ o
o
µ
2
) ( exp ) 0 (
2
) ( exp ) 0 ( ) (
2
0 0
2
( 11a)
where t he drift is given by
}
¿
}
¿
+ = + =
+
÷ = ÷ =
t
N
k j
j k
j j
j j
t
N
k j
j k j k
ds
s F
s F
ds s t
0
1
0
1
) ( 1
) (
) ( ) ( o o
o
o
o o ¢ µ
(11b)
where   ) ( 1 / ) ( ) ( s F s F s
j j j j j
o o ¢ + = is the drift term.
Applying ( 8) t o ( 11a) , we have t he forward rat e dynamic under t he shift ed
t erminal measure as


.

\

+ + =
t k
k
k k k
Y t t F t F o
o
µ
2
) ( exp ) 0 ( ) (
2
( 12)
Drift Approximat ion
Under t erminal measure, t he drift s of forward rat e dynamics are st at e
dependent , which gives rise t o sufficient ly complicat ed nonlognormal dist ribut ions.
This means t hat an explicit analyt ic solut ion t o t he forward rat e st ochast ic different ial
equat ions cannot be obt ained. Therefore, most work on t he t opic has focused on
6
ways t o approximat e t he drift , which is t he fundament al t rickiness in implement ing
t he Market Model.
Our model works backwards recursively from forward rat e N down t o forward
rat e k. The N t h forward rat e ) (t F
N
wit hout drift can be det ermined exact ly. By t he
t ime it t akes t o calculat e t he kt h forward rat e ) (t F
k
, all forward rat es from ) (
1
t F
k +
t o
) (t F
N
at t ime t are already known. Therefore, t he drift calcul at ion ( 11b) is t o
est imat e t he int egrals cont aining forward rat e dynamics ) (s F
j
, for j = k+ 1,…,N, wit h
known beginning and end point s given by ) 0 (
j
F and ) (t F
j
. For complet eness, we list
all possible solut ions below.
Frozen Drift ( FD) . Replace t he random forward rat es in t he drift by t heir
det erminist ic init ial values, i.e.,
¿
}
¿
+ = + =
+
÷ ~
+
÷ =
N
k j
j k
j j
j j
t
N
k j
j k
j j
j j
k
t
F
F
ds
s F
s F
t
1
0
1
) 0 ( 1
) 0 (
) ( 1
) (
) ( o o
o
o
o o
o
o
µ
( 13)
Arit hmet ic Average of t he Forward Rat es ( AAFR) . Apply t he midpoint
rule ( rect angle rule) t o t he random forward rat es in t he drift , i.e.,
( )
( )
¿
+ =
+ +
+
÷ ~
N
k j
j k
j j j
j j j
k
t
t F F
t F F
t
1
2
1
2
1
) ( ) 0 ( 1
) ( ) 0 (
) ( o o
o
o
µ
( 14)
Arit hmet ic Average of t he Drift Terms ( AADT) . Apply t he midpoint rule t o
t he random drift t erms, i.e.,
¿
+ = 

.

\

+
+
+
÷ ~
N
k j
k j
j j
j j
j j
j j
k
t
t F
t F
F
F
t
1
) ( 1
) (
) 0 ( 1
) 0 (
2
1
) ( o o
o
o
o
o
µ
( 15)
Geometric Average of t he Forward Rates ( GAFR) . Replace t he random
forward rat es in t he drift by t heir geomet ric averages, i.e.,
¿
+ =
× +
×
÷ ~
N
k j
k j
j j j
j j j
k
t
t F F
t F F
t
1
) ( ) 0 ( 1
) ( ) 0 (
) ( o o
o
o
µ
( 16)
7
Geometric Average of t he Drift Terms ( GADT) . Replace t he random drift
t erms by t heir geomet ric averages, i.e. ,
¿
+ =
+
×
+
÷ ~
N
k j
k j
j j
j j
j j
j j
k
t
t F
t F
F
F
t
1
) ( 1
) (
) 0 ( 1
) 0 (
) ( o o
o
o
o
o
µ
( 17)
Condit ional Expect at ion of t he Forward Rat e ( CEFR) . I n addit ion t o t he
t wo endpoint s, we can furt her enhance our est imat e based on t he dynamics of t he
forward rat es. The forward rat e ) (s F
j
follows t he dynamic ( 9) ( The drift t erm is
ignored) . We can derive t he expect at ion of t he forward rat e condit ional on t he t wo
endpoint s and replace t he random forward rat e in t he drift by t he condit ional
expect at ion of t he forward rat e.
Proposit ion 1. Assume t he forward rat e ) (s F
j
follows t he dynamic ( 9) , wit h
t he t wo known endpoint s given by ) 0 (
j
F and ) (t F
j
. Based on t he condit ional
expect at ion of t he forward rat e ) (s F
j
, t he drift of ) (t F
k
can be expressed as
¿
} + =
+
÷ ~
N
k j
t
k j
t F F j j
t F F j j
k
ds
s F E
s F E
t
j j
j j
1
0
) ( ), 0 ( 0
) ( ), 0 ( 0
]  ) ( [ 1
]  ) ( [
) ( o o
o
o
µ ( 18a)
where t he condit ional expect at ion of t he forward rat e is given by


.

\
 ÷


.

\

=
t
s t s
F
t F
F s F E
j
t
s
j
j
j t F F j
j j
2
) (
exp
) 0 (
) (
) 0 ( ]  ) ( [
2
) ( ), 0 ( 0
o
( 18b)
Proof. See Appendix A.
Condit ional Expect at ion of t he Drift Term ( CEDT) . Similarly, we can
calculat e t he condit ional expect at ion of t he drift t erm and replace t he random drift
t erm by t he condit ional expect at ion.
Proposit ion 2. Assume t he forward rat e ) (s F
j
follows t he dynamic ( 9) , wit h
t he t wo known endpoint s given by ) 0 (
j
F and ) (t F
j
. Based on t he condit ional
expect at ion of t he drift t erm
j
¢ , t he drift of ) (t F
k
can be expressed as
8
¿
} + =



.

\

+
÷ ~
N
k j
k j
t
t F F
j j
j j
k
ds
s F
s F
E t
j j
1
0
) ( ), 0 (
0
) ( 1
) (
) ( o o
o
o
µ
( 19a)
where t he condit ional expect at ion of t he drift t erm is given by
( )
) (
) ( / ) ( 1
1
) ( 1
) (
 ) (
2
) ( ), 0 (
0 ) ( ), 0 ( 0
s
s s
s F
s F
E s E
Cj
Cj Cj
t F F
j j
j j
t F F j
j j
j j
µ
µ v
o
o
¢
+
÷ =



.

\

+
=
( 19b)


.

\
 ÷


.

\

+ =
t
s t s
F
t F
F s
j
t
s
j
j
j j Cj
2
) (
exp
) 0 (
) (
) 0 ( 1 ) (
2
o
o µ
(19c)


.

\
 ÷


.

\

÷


.

\
 ÷


.

\

=
t
s t s
t
s t s
F
t F
F s
j j
t
s
j
j
j j Cj
) (
exp 1
) (
exp
) 0 (
) (
) 0 ( ) (
2 2
2
2 2
o o
o v
( 19d)
Proof. See Appendix A.
The accuracy and performance of t hese drift approximat ion met hods are
discussed in sect ion I V.
I I . THE LATTI CE PROCEDURE I N THE LMM
The “lat t ice” is t he generic t erm for any graph we build for t he pricing of
financial product s. Each lat t ice is a layered graph t hat at t empt s t o t ransform a
cont inuous t ime and cont inuousspace underlying process int o a discret et ime and
discret espace process, where t he nodes at each level represent t he possible values
of t he underlying process in t hat period.
There are t wo primary t ypes of lat t ices for pricing financial product s: t ree
lat t ices and grid lat t ices ( or rect angular lat t ices or Markov chain lat t ices) . The t ree
lat t ices, e.g., t radit ional binomial t ree, assume t hat t he underlying process has t wo
possible out comes at each st age. I n cont rast wit h t he binomial t ree lat t ice, t he grid
lat t ices (see Amin [ 1993] , GandhiHunt [ 1997] , Mart zoukos Trigeorgis [ 2002] ,
Hagan [ 2005] , and Das [ 2011] ) shown in Exhibit 1, which permit t he underlying
9
process t o change by mult iple st at es, are built in a rect angular finit e difference grid
( not t o be confused wit h finit e difference numerical met hods for solving part i al
different ial equat ions) . The grid lat t ices are more realist ic and convenient for t he
implement at ion of a Markov chain solut ion.
This art icle present s a grid lat t ice model for t he LMM. To illust rat e t he lat t ice
algorit hm, we use a callable exot ic as an example. Callable exot ics are a class of
int erest rat e derivat ives t hat have Bermudan st yle provisions t hat allow for early
exercise int o various underlying int erest rat e product s. I n general, a callable exot ic
can be decomposed int o an underlying inst rument and an embedded Bermudan
opt ion.
We will simplify some of t he definit ions of t he universe of inst rument s we will
be dealing wit h for brevit y. Assume t he payoff of a generic underlying inst rument is
a st ream of payment s  
i i i i i
C T F Z ÷ =
÷
) (
1
o for i= 1,…,N, where
i
C is t he st ruct ured
coupon. The callable exot ic is a Bermudan st yle opt ion t o ent er t he underlying
inst rument on any of a sequence of not ificat ion dat es
ex
M
ex ex
t t t ,..., ,
2 1
. For any
not ificat ion dat e
ex
j
t t = , we define a right  cont inuous mapping funct ion ) (t n by
) ( 1 ) ( t n t n
T t T < s
÷
. I f t he opt ion is exercised at t , t he reduced price of t he underlying
inst rument , from t he st ruct ured coupon payer’s perspect ive, is given by
( )
¿ ¿
=
÷
= 

.

\
 ÷
=


.

\

= =
N
t n i
N i
i i i i
t
N
t n i
N i
i
t
N
T T P
C T F
E
T T P
Z
E
T t P
t I
t I
) (
1
) (
) , (
) (
) , ( ) , (
) (
: ) (
~ o
( 20)
where t he rat io ) (
~
t I is usually called t he reduced value of t he underlying inst rument
or t he reduced exercise value or t he reduced int rinsic value.
Lat t ice approaches are ideal for pricing early exercise product s, given t heir
“ backward int ime” nat ure. Bermudan pricing is usually done by building a lat t ice t o
carry out a dynamic programming calculat ion via backward induct ion and is
10
st andard. The lat t ice model described below also uses backward induct ion but
exploit s t he Gaussian st ruct ure t o gain ext ra efficiencies.
First we need t o creat e t he lat t ice. The random process we are going t o model
in t he lat t ice is t he LMM ( 12) . Unlike t radit ional t rees, we only posit ion nodes at t he
det erminat ion dat es (t he payment and exercise dat es) . At each det erminat ion dat e,
t he cont inuoust ime st ochast ic equat ion (12) shall be discret ized int o a discret et ime
scheme. Such discret ized schemes basically convert t he Brownian mot ion int o
discret e variables. There is no rest rict ion on discret izat ion schemes. At any
det erminat ion dat e t , for inst ance, we discret ize t he Brownian mot ion t o be equally
spaced as a grid of nodes
t i
y
,
, for i = 1,…,
t
S . The number of nodes
t
S and t he space
bet ween nodes
t i t i t
y y
, 1 , ÷
÷ = ¢ at each det erminat ion dat e can vary depending on t he
lengt h of t ime and t he accuracy requirement . The nodes should cover a cert ain
number of st andard deviat ions of t he Gaussian dist ribut ion t o guarant ee a cert ain
level of accuracy. We have t he discret e form of t he forward rat e as


.

\

+ + =
t i k
k
t i k k t i k
y t y t F y t F
,
2
, ,
2
) , ( exp ) 0 ( ) ; ( o
o
µ
( 21)
The zero coupon bond (2) can be expressed in discret e form as
[
=
+
=
k
t n j
t i j j
t i t n t i k
y t F
y T t P y T t P
) (
,
, ) ( ,
) ; ( 1
1
) ; , ( ) ; , (
o
( 22)
We now have expressions for t he forward rat e (21) and discount bond (22) ,
condit ional on being in t he st at e
t i
y
,
at t ime t , and from t hese we can perform
valuat ion for t he underlying inst rument .
At t he mat urit y dat e, t he value of t he underlying inst rument is equal t o t he
payoff, i.e.,
) ( ) , (
, ,
N N
T i N T i N
y Z y T I = ( 23)
11
The underlying st at e process
t
X in t he LMM ( 11) is a Brownian mot ion. The
t ransit ion probabilit y densit y from st at e (
t i
x
,
, t ) t o st at e (
T j
x
,
, T ) is given by
(
(
¸
(
¸
÷
÷
÷
÷
=
) ( 2
) (
exp
) ( 2
1
) , ; , (
2
, ,
, ,
t T
x x
t T
T x t x p
t i T j
T j t i
t
( 24)
Applying t he variable subst it ut ion ( 8) , equat ion ( 24) can be expressed as
(
(
¸
(
¸
÷
÷ + ÷
÷
÷
=
) ( 2
) (
exp
) ( 2
1
) , ; , (
2
, ,
, ,
t T
t T y y
t T
T y t y p
t T t i T j
T j t i
o o
t
( 25)
Equat ion ( 20) can be furt her expressed as a condit ional value on any st at e
(
t i
y
,
, t ) as:
j
j j
j
j
T
N
t n j
j
t j T t i T
T N j
T j
j
t i N
t i
dy
t T
t T y y
y T T P
y Z
t T
y T t P
y t I
¿
} =
(
(
¸
(
¸
÷
÷ + ÷
÷
÷
=
) (
2
,
,
,
) ( 2
) (
exp
) ; , (
) (
) ( 2
1
) ; , (
) ; (
o o
t
(26)
This is a convolut ion int egral. Some fast int egrat ion algorit hms, e.g., Cubic
Spline I nt egrat ion, Fast Fourier Transform ( FFT) , et c., can be used for opt imizat ion.
We use t he Trapezoidal Rule I nt egrat ion in t his paper for ease of illust rat ion.
I ncomplete informat ion handling. Convolut ion is widely used in Elect rical
Engineering, part icularly in signal processing. The import ant part is t hat t he far left
and far right part s of t he out put are based on incomplet e informat ion. Any models
t hat t ry t o comput e t he t ransit ion values using int egrat ion will be inaccurat e if t his
problem is not solved, especially for longer mat urit ies and mult iple exercise dat es.
Our solut ion is t o ext end t he input nodes by padding t he far end values on each side
and only t ake t he original range of t he out put nodes.
Next , we det ermine t he opt ion values in each final not ificat ion node. On t he
last exercise dat e, if we have not already exercised, t he reduced opt ion value in any
st at e
M i
y
,
is given by


.

\

= 0 ,
) ; , (
) ; (
max
) ; , (
) , (
,
,
,
,
M i N
ex
M
M i
ex
M
M i N
ex
M
M i
ex
M
y T t P
y t I
y T t P
y t V
( 27)
12
Then, we conduct t he backward induct ion process t hat is performed by
it erat ively rolling back a series of long j umps from t he final exercise dat e
ex
M
t across
not ificat ion dat es and exercise opport unit ies unt il we reach t he valuat ion dat e.
Assume t hat in t he previous rollback st ep
ex
j
t , we calculat ed t he reduced opt ion
value: ) ; , ( / ) , (
, , j i N
ex
j j i
ex
j
y T t P y t V . Now, we go t o
ex
j
t
1 ÷
. The reduced opt ion value at
ex
j
t
1 ÷
is
¦
)
¦
`
¹
¦
¹
¦
´
¦
=
÷ ÷
÷ ÷
÷ ÷
÷ ÷
÷ ÷
÷ ÷
) ; , (
) , (
,
) ; , (
) , (
max
) ; , (
) , (
1 , 1
1 , 1
1 , 1
1 , 1
1 , 1
1 , 1
j i N
ex
j
j i
ex
j
c
j i N
ex
j
j i
ex
j
j i N
ex
j
j i
ex
j
y T t P
y t V
y T t P
y t I
y T t P
y t V
( 28a)
where t he reduced cont inuat ion value is given by
j ex
j
ex
j
ex
j j
ex
j j j i j
j N
ex
j
j
ex
j
ex
j
ex
j
j i N
ex
j
j i
ex
j
c
dy
t t
t t y y
y T t P
y t V
t t
y T t P
y t V
}
(
(
¸
(
¸
÷
÷ + ÷
÷
÷
=
÷
÷ ÷ ÷
÷
÷ ÷
÷ ÷
) ( 2
) (
exp
) ; , (
) , (
) ( 2
1
) ; , (
) , (
1
2
1 1 1 ,
1
1 , 1
1 , 1
o o
t
( 28b)
We repeat t he rollback procedure and event ually work our way t hrough t he
first exercise dat e. Then t he present value of t he Ber mudan opt ion is found by a final
int egrat ion given by
( )
1
1
2
1 1 1
1 1
1 1
1
2
exp
) ; , (
) , (
2
1
) , 0 ( ) 0 ( dy
t
t y
y T t P
y t V
t
T P pv
ex
ex
N
ex
ex
ex
N Bermudan
}
(
(
¸
(
¸
+
÷ =
o
t
( 29)
The present value or t he price of t he callable exot ic from t he coupon payer’s
perspect ive is:
) 0 ( ) 0 ( ) 0 (
_instrument underly Bermudan payer
pv pv pv ÷ = ( 30)
This framework can be used t o price any int erest rat e product s in t he LMM
set t ing and can be easily ext ended t o t he Swap Market Model (SMM) .
I I I . Calibrat ion
First , if we choose t he LMM as t he cent ral model, we need t o price int erest
rat e derivat ives t hat depend on eit her or bot h of cap and swapt ion market s. Second,
we will undoubt edly use various swapt ions t o hedge a callable exot ic. I t is a
13
reasonable expect at ion t hat t he calibrat ed model we int end t o use t o price our
exot ic, will at least correct ly price t he market inst rument s t hat we int end t o hedge
wit h. Therefore, in an exot ic derivat ive pricing sit uat ion, recovery of bot h cap and
swapt ion market s might be desired.
The calibrat ion of t he LMM t o caplet prices is quit e st raight forward. However,
it is very difficult , if not impossible, t o perfect ly recover bot h cap and swapt ion
market s. Fort unat ely for t he LMM, t here also exist ext remely accurat e approximat e
formulas for swapt ions implied volat ilit y, e.g., Rebonat o' s formula.
We int roduced a paramet er u and set
i i
o u o
=
where
i
o
denot es t he market
Black caplet volat ilit y. One can choose different u for different
i
o . For simplicit y we
describe one u sit uat ion here. By choosing 1 = u , we have perfect ly calibrat ed t he
LMM t o t he caplet prices in t he market . However, our goal is t o select a u t o
minimize t he sum of t he squared differences of t he volat ilit ies derived from t he
market and t he volat ilit ies implied by our model for bot h caps and swapt ions
combined.
I n t he opt imizat ion, we use Rebonat o’s formula for an efficient expression of
t he model swapt ion volat ilit ies, given by
( )
( )
2
Re
,
2
1 , 2
,
2
1 ,
0
2
,
2
,
) 0 (
) 0 ( ) 0 ( ) 0 ( ) 0 (
) ( ) (
) 0 (
) 0 ( ) 0 ( ) 0 ( ) 0 (
1
bonato
j i
j j j i j i
j i
T
j i
ij j i j i LMM
S
F F w w
dt t t
S
F F w w
T
 o

o
 o

o
 o o
 o
u u
u o o
o o
µ
u
o
= =
=
¿
¿
}
+ =
+ =
( 31a)
where
ij
µ = 1 under one fact or LMM. The swap rat e ) 0 (
, o
S is given by
¿
+ =
=

o
 o
1
,
) 0 ( ) 0 ( ) 0 (
i
i i
F w S
( 31b)
( )
( )
¿ [
[
+ = + =
÷
+ =
÷
+
+
=

o o

o
o o
o o
1 1
1
1
1
) 0 ( 1
) 0 ( 1
) 0 (
k
k
j
j j k
j
j j i
i
F
F
w
( 31c)
14
Assume t he calibrat ion cont aining M caplet s and G swapt ions. The error
minimizat ion is given by
( ) ( )
¿ ¿
= + + =
÷ + ÷
G
j
swn
N j
bonato
N j
M
i i i 1
2
,
Re
, 1
2
min
o o
o uu o o u
( 32)
where
swn
N j , + o
o denot es t he market Black swapt ion volat ilit y. The opt imizat ion can be
found at a st at ionary point where t he first derivat ive is zero; t hat is,
¿ ¿
¿ ¿
= + =
= + =
+
+
=
G
j
bonato
N j
M
i i
G
j
swn
N j
M
i i
1
Re
, 1
1 , 1
o
o
u o
o o
u
( 33)
I n t erms of forward volat ilit ies, we use t he t ime homogeneit y assumpt ion of
t he volat ilit y st ruct ure, where a forward volat ilit y for an opt ion is t he same or close
t o t he spot volat ilit y of t he opt ion wit h t he same t ime t o expiry. The t ime
homogeneous volat ilit y st ruct ure can avoid nonst at ionary behavior.
I n t he LMM, forward swap rat es are generally not lognormal. Such deviat ion
from t he lognormal paradigm however t urns out t o be ext remely small. Rebonat o
[ 1999] shows t hat t he pricing errors of swapt ions caused by t he lognormal
approximat ion are well wit hin t he market bid/ ask spread. For most short mat urit y
int erest rat e product s, we can use t he lat t ice model wit hout calibrat ion (33) .
However, for longer mat urit y or deeply in t he money (I TM) or out of t he money
( OTM) exot ics we may need t o use t he calibrat ion and even some specific skew/ smile
adj ust ment t echniques t o achieve high accuracy.
I V. NUMERI CAL I MPLEMENTATI ON
I n t his sect ion, we will elaborat e on more det ails of t he implement at ion. We
will st art wit h a simple callable bond for t he purpose of an easy illust rat ion and t hen
move on t o some t ypical callable exot ics, e.g., callable capped float er swap and
15
callable range accrual swap. The reader should be able t o implement and replicat e
t he model aft er reading t his sect ion.
Callable Bond
A callable bond is a bond wit h an opt ion t hat allows t he issuer t o ret ain t he
privilege of redeeming t he bond at some point s before t he bond reaches t he mat urit y
dat e. For ease of illust rat ion, we choose a very simple callable bond wit h a oneyear
mat urit y, a quart erly payment frequency, a $100 principal amount (A) , and a 4%
annual coupon rat e ( t he quart erly coupon 1 = C ) . The call dat es are 6 mont hs, 9
mont hs, and 12 mont hs. The call price (H) is 100% of t he principal. The bond spread
( ç ) is 0.002. Let t he valuat ion dat e be 0. A det ailed descript ion of t he callable bond
and current (spot ) market dat a is shown in Exhibit 2.
For a short  t erm mat urit y callable bond, our lat t ice model can reach high
accuracy even wit hout calibrat ion ( 33) and incomplet e informat ion handling.
Therefore, we set 1 = u and
i i
o o
= . The valuat ion procedure for a callable bond
consist s of 4 st eps:
St ep 1: Creat e t he lat t ice. Based on t he long j ump t echnique, we posit ion
nodes only at t he det erminat ion ( payment / exercise) dat es. The number of nodes and
t he space bet ween nodes at each det erminat ion dat e may vary depending on t he
lengt h of t ime and t he accuracy requirement . To simplify t he illust rat ion, we choose
t he same set t ings across t he lat t ice, wit h a grid space ( space bet ween nodes)
2 / 1 = ¢ , and a number of nodes S= 7. I t covers 3 ) 1 ( = ÷ S ¢ st andard deviat ions for a
st andard normal dist ribut ion. The nodes are equally spaced and symmet ric, as shown
in Exhibit 3.
St ep 2: Find t he opt ion value at each final node. At t he final mat urit y dat e
4
T , t he payoff of t he callable bond in any st at e
i
y is given by
16
( ) C A H y T V V
i i
+ = = , min ) , ( :
4 4 ,
( 34)
where A denot es t he principal amount , C denot es t he bond coupon, and H denot es
t he call price. The opt ion values at t he mat urit y are equal t o t he payoffs as shown in
Exhibit 3.
St ep 3: Find t he opt ion value at earlier nodes. Let us go t o t he penult imat e
not ificat ion dat e
3
T . The opt ion value in any st at e
i
y is given by
( ) C V H y T V V
c
i i i
+ = =
3 , 3 3 ,
, min ) , ( : ( 35)
Equat ion (35) can be furt her expressed in t he form of reduced value as


.

\
 +
= =
) ; , (
,
) ; , (
min
) ; , (
:
~
4 3
3 ,
4 3 4 3
3 ,
3 ,
i
c
i
i i
i
i
y T T P
C V
y T T P
H
y T T P
V
V
( 36a)
where ) ; , ( /
4 3 3 , i
C
i
y T T P V denot es t he reduced cont inuat ion value in st at e
i
y at
3
T given
by
( )
( )
( )
( )
( )
( )
( )
¦
)
¦
`
¹
(
(
¸
(
¸
÷
÷ + ÷
÷ +
¦
¹
¦
´
¦
(
(
¸
(
¸
÷
÷ + ÷
÷
÷
÷ ÷
=
(
¸
(
¸
÷
÷ + ÷
÷
÷
÷ ÷
=
÷
÷
=
¿
}
3 4
2
3 3 4 4 1
1 4
7
2
3 4
2
3 3 4 4
4
3 4
3 4
3 4
2
3 3 4 4
4
3 4
3 4
4 3
3 ,
2
) (
exp ) , (
2
) (
exp ) , (
2
2
) ( exp
2
) (
exp ) , (
2
) ( exp
) ; , (
T T
T T y y
y T V
T T
T T y y
y T V
T T
T T
dY
T T
T T y Y
Y T V
T T
T T
y T T P
V
i j
j
j
i j
j
i
i
c
i
o o
o o
¢
t
ç
o o
t
ç
(36b)
where ç denot es t he bond spread. Similarly we can comput e t he reduced callable
bond values at
2
T . All int ermediat e reduced values are shown in Exhibit 3.
St ep 4: Comput e t he final int egrat ion. The final int egral at valuat ion dat e 0 is
calculat ed as
17
( )
( )
399 . 80
2
) (
exp
) ; , (
) , (
2
) (
exp
) ; , (
) , (
2
2
exp
) , 0 (
2
) (
exp
) ; , (
) , (
2
exp
) , 0 ( ) 0 (
2
2
2 2 1
1 4 2
1 2
7
2
2
2
2 2
4 2
2
2
2
4
2
2
2 2
4 2
2
2
2
4
=
¦
)
¦
`
¹
(
(
¸
(
¸
+
÷ +
¦
¹
¦
´
¦
(
(
¸
(
¸
+
÷
÷
=
(
¸
(
¸
+
÷
÷
=
÷
÷
÷
=
¿
}
T
T y
y T T P
y T V
T
T y
y T T P
y T V
T
T
T P
dY
T
T Y
Y T T P
Y T V
T
T
T P V
j
j
j
j
j
j
j
o
o
¢
t
ç
o
t
ç
( 37)
Moreover, we need t o add t he present value of t he coupon at
1
T int o t he final
price. The final callable bond value is given by
398 . 81 ) , 0 ( ) exp( ) 0 ( ) 0 (
1 1
= ÷ + = C T P T V V ç ( 38)
The pseudo code is supplied in Appendix B for t he implement at ion program.
The convergence result s shown in Exhibit 4 indicat e what occurs for a given grid
space ¢ when we increase t he number of nodes S. The speed of convergence is very
fast , ensuring t hat a small number of grids are sufficient . All calculat ions are
converged t o 100.7518. One sanit y check is t hat t he callable bond price should be
close t o t he st raight bond price if t he call prices become very high. Bot h of t hem are
comput ed as 103.3536.
Callable capped float er swap
A callable capped float er swap has t wo legs: a regular float ing leg and a
st ruct ured coupon leg. The st ruct ured coupon rat e of t he j t h period (
j j
T T ,
1 ÷
) is given
by
} ], ), ( max{min[
1
F
j
C
j j j j j j j j
K K T F A C
÷
+ = ì q o
( 39)
where
j
A is t he not ional amount ,
C
j
K is t he rat e cap,
F
j
K is t he rat e floor,
j
q is t he
spread and
j
ì is t he scale fact or. For
j
ì > 0, it is called a callable capped float er
swap. For
j
ì < 0, it is called a callable inverse float er swap.
18
We choose a real middle life t rade wit h more t han 10 years remaining in it s
lifet ime. The float ing leg has a quart erly payment frequency wit h st ep down
not ionals and st epup spreads. The st ruct ured coupon leg has a semi annually
payment frequency wit h varying not ionals, spreads, scales, rat e caps, and rat e
floors. The call schedule is semi  annual.
Callable range accrual swap
A callable range accrual swap has t wo legs: a regular float ing leg and a
st ruct ured coupon leg. The st ruct ured coupon rat e of t he j t h period (
j j
T T ,
1 ÷
) is given
by
¿
+ =
÷
=
j
j i
T
T t
j
i j j
j
M
RI A
C
1
1
o
( 40a)
where
¹
´
¦ s + s
=
otherwise
K t t t F K if
I
j i i i j
i
0
) , ; ( 1
max min
ç
( 40b)
where R is t he fixed rat e,
min j
K and
max j
K are t he accrual range of t he j  t h period,
) , ; ( ç +
i i i
t t t F is t he LI BOR rat e, ç is t he range accrual index t erm,
j
M is t he t ot al
number of t he business days in t he j t h period.
We choose a real 10 years mat urit y t rade. The float ing leg has a quart erly
payment frequency and t he st ruct ur ed coupon leg has a semi annually payment
frequency wit h varying accrual ranges. I t st art s wit h t he first call opport unit y being
in 3 years from incept ion, and t hen every year unt il t he last possibilit y being 9 years
from incept ion. The range accrual index t erm is 6 mont hs.
The lat t ice implement at ion procedure for a callable capped float er swap or a
callable range accrual swap is quit e similar t o t he one for a callable bond except t he
valuat ion for t he underlying inst rument .
19
The convergence diagrams of pricing calculat ions are shown in Exhibit s 5 and
6. Each curve in t he diagrams represent s t he convergence behavior for a given grid
space as nodes are increased. All of t he lat t ice result s are well converged. I f t he grid
space is smaller, t he algorit hm has bet t er convergence accuracy but a slower
convergence rat e, and vice verse.
We benchmarked our model under different drift approximat ion met hods wit h
several st andard market approaches, e.g., t he regression based Mont e Carlo in t he
full LMM and t he HJM t rinomial t ree. The model comparisons for t he accuracy and
speed are shown in Exhibit s 7 and 8. Wit h regards t o accuracy, as expect ed, t he FD
performs very badly. AAFR and GAFR do a lit t le bet t er but errors go in different
direct ions. The same conclusions can be drawn for AADT and GADT. Bot h CEFR and
CEDT are t he best . I n t erms of CPU t imes, FD, AAFR, AADT, GAFR and GADT are t he
same. But CEFR and CEDT are slower, especially in t he callable range accrual swap
case.
V. CONCLUSI ON
I n t his paper, we proposed a lat t ice model in t he LMM t o price int erest rat e
product s. Conclusions can be drawn, support ed by t he previous sect ions. First , t he
model is quit e st able. The fast convergence behavior requires fewer discret izat ion
nodes. Second, t his model has almost equivalent accuracy t o t he current pricing
models in t he market . Third, t he implement at ion of t he model is relat ively easy. The
calibrat ion is very simple and st raight forward. Finally, t he performance of t he model
is probably t he best among all known approaches at t he t ime of writ ing.
We use t he following t echniques in our model: shift ed forward measure, drift
approximat ion, probabilit y dist ribut ion st ruct ure exploit at ion, long j ump, numerical
int egrat ion, incomplet e informat ion handling, and calibrat ion. Combining t hese
20
t echniques, t he model achieves sufficient accuracy in relat ively few t ime st eps and
discret e nodes, which makes it a very efficient met hod.
For ease of illust rat ion, we present t he lat t ice model based on t he Trapezoidal
Rule int egrat ion. A bet t er but slight ly more complicat ed solut ion is t o spline t he
payoff funct ions. The cubic spline of t he opt ion payoffs can achieve higher accuracy,
especially for Greeks calculat ions, and higher speed. Alt hough cubic spline t akes
some t ime, t he lat t ice will require much fewer nodes (23 ~ 28 nodes are good
enough) and can perform a much fast er int egrat ion. I n general, t he spline met hod
can provide a speedup fact or around 3 ~ 5 t imes.
We have implement ed t he lat t ice model t o price a variet y of int erest rat e
exot ics. The algorit hm can always achieve a fast convergence rat e. The accuracy,
however, is a bit t rickier, depending on many fact ors: drift approximat ion
approaches, numerical int egrat ion schemes, volat ilit y select ions, and calibrat ion, et c.
Some work, such as calibrat ion, is more of an art t han a science.
REFERENCE
Amin, K. “ Jump diffusion opt ion valuat ion in discret e t ime.” Journal of Finance, Vol.
48, No. 5 ( 1993) , pp. 1833 1863.
Brace, A., D. Gat arek, and M. Musiela. “ The market model of int erest rat e dynamics.”
Mat hemat ical Finance, Vol. 7, No. 4 (1997) , pp. 127 155.
Brigo, D., and F. Mercurio. “ I nt erest Rat e Models – Theory and Pract ice wit h Smiles,
I nflat ion and Credit .” Second Edit ion, Springer Finance, 2006.
21
Das, S. “ Random lat t ices for opt ion pricing problems in finance.” Journal of
I nvest ment Management , Vol. 9, No.2 ( 2011) , pp. 134 152.
Gandhi, S. and P. Hunt . “ Numerical opt ion pricing using condit ioned diffusions,”
Mat hemat ics of Derivat ive Securit ies, Cambridge Universit y Press, Cambridge, 1997.
Hagan, P. “ Accrual swaps and range not es.” Bloomberg Technical Report , 2005.
Hull. J., and A. Whit e. “ Forward rat e volat ilit ies, swap rat e volat ilit ies and t he
implement at ion of t he Libor Market Model.” Journal of Fixed I ncome, Vol. 10, No. 2
( 2000) , 46 62.
Mart zoukos, H., and L. Trigeorgis. “ Real (invest ment ) opt ions wit h mult iple sources
of rare event s.” European Journal of Operat ional Research, 136 (2002) , 696706.
Pit erbarg, V. “ A Pract it ioner’s guide t o pricing and hedging callable LI BOR exot ics in
LI BOR Market Models.” SSRN Working paper, 2003.
Rebonat o, R. “ Calibrat ing t he BGM model.” RI SK, March ( 1999) , 7479.
APPENDI X A:
Proof of Proposit ion 1. We rewrit e ( 9) as


.

\

÷


.

\

=
2 ) 0 (
) (
ln
1
) (
2
t
F
t F
t Y
j
j
j
j
o
o
( A1)
I n t he general Brownian Bridge case when t he Wiener process ) (t Y has ) (
1
t Y = a and
) (
2
t Y = b, t he dist ribut ion of ) (t Y at t ime ) , (
2 1
t t t e is normal given by
22


.

\

÷
÷ ÷
=
÷
÷ ÷
+ =
) (
) )( (
) ( ,
) (
) )( (
) ( ~ ) (
1 2
2 1
1 2
1
t t
t t t t
t
t t
a b t t
a t N t Y
Y Y
v µ
( A2)
I n our case: 0
1
= t , t t =
2
, a= 0, b= ) (t Y , ) , 0 ( t s e , t hus ( A2) can be expressed as

.

\
 ÷
= =
t
s t s
s t Y
t
s
s N s Y
Y Y
) (
) ( ), ( ) ( ~ ) ( v µ
( A3)
Let 2 / ) ( ) (
2
s s Y s A
j j j
o o + = . According t o t he linear t ransformat ion rule, ) (s A
j
is
a normal given by


.

\

÷
= =


.

\

= + = N
t
s t s
s s
F
t F
t
s
s
s s s A
j
Y j Aj
j
j j
Y j Aj j
) (
) ( ) ( ,
) 0 (
) (
ln
2
) ( ) ( ~ ) (
2
2
2
o
v o v
o
µ o µ
( A4)
Let ( ) ) ( exp ) ( s A s B
j j
= . By definit ion, ) (s B
j
is a lognormal given by
( ) ) ( ), ( ~ ) ( s s LogN s B
Aj Aj j
v µ . According t o t he charact erizat ions of t he lognormal
dist ribut ion, t he mean and variance of ) (s B
j
are
( )


.

\
 ÷


.

\

=


.

\

+ = =
t
s t s
F
t F s
s B E s
j
t
s
j
j Aj
Aj j Bj
2
) (
exp
) 0 (
) (
2
) (
exp ) ( ) (
2
0
o v
µ µ
( A5a)
( )   ( )


.

\
 ÷


.

\



.

\

÷


.

\
 ÷
= + ÷ =
t
s t s
F
t F
t
s t s
s s s s
j
t
s
j
j j
Aj Aj Aj Bj
) (
exp
) 0 (
) (
1
) (
exp ) ( ) ( 2 exp 1 ) ( exp ) (
2
2
2
o o
v µ v v
( A5b)
We have t he condit ional expect at ion of t he forward rat e ) (s F
j
as
( ) ( )


.

\
 ÷


.

\

= =
t
s t s
F
t F
F s B E F s F E
j
t
s
j
j
j j j t F F j
j j
2
) (
exp
) 0 (
) (
) 0 ( ) ( ) 0 (  ) (
2
0 ) ( ), 0 (
o
( A6)
Proof of Proposit ion 2 . Let ) ( ) 0 ( 1 ) ( 1 ) ( s B F s F s C
j j j j j j
o o + = + = where
) (s B
j
is
defined above. According t o t he linear t ransformat ion rule, ) (s C
j
is a lognormal
given by ( ) ) ( ), ( ~ ) ( s v s LogN s C
j
µ . The mean and variance of ) (s C
j
are
23


.

\

÷


.

\

+ = + =
t
s t s
F
t F
F s F s
j
t
s
j
j
j j Bj j j Cj
2
) (
exp
) 0 (
) (
) 0 ( 1 ) ( ) 0 ( 1 ) (
2
o
o µ o µ
(A7a)


.

\
 ÷


.

\



.

\

÷


.

\
 ÷
= =
t
s t s
F
t F
t
s t s
F s F s
j
t
s
j
j j
j j Bj j j Cj
) (
exp
) 0 (
) (
1
) (
exp ) 0 ( ) ( ) 0 ( ) (
2
2
2
2 2 2 2
o o
o v o v
( A7b)
On t he ot her hand, according t o t he charact erizat ions of t he lognormal
dist ribut ion, t he mean and variance of ) (s C
j
are

.

\

+ =
2
) (
) ( exp ) (
s
s s
Cj
v
µ µ
( A8a)
( )   ( ) ) ( ) ( 2 exp 1 ) ( exp ) ( s s s s
Cj
v µ v v
+ ÷ =
( A8b)
Solving t he equat ion (A8a) and ( A8b) , we get



.

\

+
=
) ( / ) ( 1
) (
ln ) (
2
s s
s
s
Cj Cj
Cj
µ v
µ
µ
( A9a)


.

\

+ =
) (
) (
1 ln ) (
2
s
s
s
Cj
Cj
µ
v
v
( A9b)
We know t he first negat ive moment of t he lognormal is ( ) ( ) 2 / ) ( ) ( exp ) (
1
s s s C E
j
v µ
+ ÷ =
÷
and have t he condit ional expect at ion of t he drift t erm as
) (
) ( / ) ( 1
1
2
) (
) ( exp 1
) (
1
1
) ( 1
1
1
) ( 1
) (
2
0 0
) ( ), 0 (
0
s
s s
s
s
s C
E
s F
E
s F
s F
E
Cj
Cj Cj
j j j
t F F
j j
j j
j j
µ
µ v
v
µ
o o
o
+
÷ = 
.

\

+ ÷ ÷ =


.

\

÷ =


.

\

+
÷ =



.

\

+
( A10)
where
) (s
Cj
µ
, ) (s
Cj
v are given by ( A7a) and (A7b) .
APPENDI X B:
24
The following pseudocode ( C+ + ) demonst rat es how t o implement t he model
t o price a callable bond. For t he purpose of an easy illust rat ion, we choose t he same
set t ings (t he number of nodes and t he grid space) across t he lat t ice and use t he
Trapezoidal Rule for numerical int egrat ion.
// 2*numNodes = 2*mNumNodes = the number of nodes (S); gap = mGap = the grid space (Phi)
double priceCallableBond (BondTrade* bd, CallableBond* cb, int numNodes, double gap) {
double pv;
cb>fillLattice();
// The last exercise
CallSchedule& cs = bd>callSch[numCallSch1];
if (cs.term == bd>cFlow[numCashFlow1].endDate) // The last exercise is at maturity
for (int i= numNodes; i <= numNodes; i++)
cs.reducedValue[i+numNodes] = min (cs.callPrice,
bd>cFlow[numCashFlow1].reducedPayoff[i+numNodes]);
else { // The last exercise is before maturity
for (int i= numNodes; i <= numNodes; i++) {
pv = 0;
for (int j = bd>numCF1; (bd>cFlow[j].endDate >= cs.term) && (j >= 0); j) {
CashFlow& cf = bd>cFlow[j];
(cf.endDate == cs.term) ? pv += cf.reducedPayoff[i+numNodes]
: pv += exp(bondSpread*(cf.endDatecs.term)) * cb>integral(i,
cs.vol, cf.vol, cf.endDate, cs.term, cf.reducedPayoff);
}
cs.reducedValue[i+numNodes] = min (cs.callPrice/cs.df[i+numNodes], pv);
}
}
if (numCallSch > 1) { // The remaining exercises
for (int i = numCallSch  2; i>=0; i) {
CallSchedule& cs = bd>callSch[i];
CallSchedule& preCs = bd>callSch[i+1];
for (int j = numNodes; j <= numNodes; j++) {
pv = exp(bondSpread * (preCs.term  cs.term))
* cb>integral (j, cs.vol, preCs.vol, preCs.term, cs.term, preCs.reducedValue);
for (int k=bd>numCF1; k >= 0; k) // Count intermediate coupons
if ((bd>cFlow[k].endDate < preCs.term) && (bd>cFlow[k].endDate >= cs.term))
pv += bd>cFlow[k].reducedPayoff[j+numNodes]
* exp (bondSpread*(bd>cFlow[k].endDate  cs.term));
cs.reducedValue[j+numNodes] = min (cs.callPrice/cs.df[j+numNodes], pv);
}
}
}
// The final integral
CallSchedule& preCs = bd>callSch[0];
pv = cb>integral (0, 0, preCs.vol, preCs.term, 0, preCs.reducedValue) *exp(bondSpread*(preCs.term));
pv *= bd>cFlow[bd>numCF1].endDf; // endDf: discount factor from 0 to the end date
for (int k=bd>numCF1; k >= 0; k) // Count intermediate coupons
if ((bd>cFlow[k].endDate < preCs.term))
pv += bd>cFlow[k].coupon * bd>cFlow[k].endDf * exp(bondSpread * bd>cFlow[k].endDate);
return pv;
}
25
void CallableBond::fillLattice() {
for (int i = mTrade>numCF1; i>=0; i) {
CashFlow& cf = mTrade>cFlow[i];
if (cf.endDate < mTrade>callSch[0].term) break;
for (int j = mNumNodes; j <= mNumNodes; j++)
fillNode(i, j, cf.startDate, mDrift);
}
}
void CallableBond::fillNode(int cI, int nI, double vT, DriftAppx flag) {
int numCF = mTrade>numCF;
double avgF, expon, fwdt, drift = 0;
CashFlow& fl = mTrade>cFlow[cI];
if (cI == numCF1) { // At maturity
fl.df[nI + mNumNodes] = 1.0;
fl.reducedPayoff[nI + mNumNodes] = fl.notional + fl.coupon;
}
else if (fl.startDate <= 0) // Starting before valuation date)
fl.reducedPayoff[nI + mNumNodes] = fl.coupon * fl.endDf / mTrade>cFlow[numCF1].endDf;
else {
fl.df[nI + mNumNodes] = 1.0;
for (int i = numCF  1; i > cI; i) {
CashFlow& cf = mTrade>cFlow[i];
expon = (cf.vol * cf.vol * vT / 2) + cf.vol * nI * mGap;
fwdt = cf.fwd0 * exp(drift + expon);
switch (flag) { // The other cases are similar to either AAFR or CEFR
case AAFR: // Arithemic Average Fwd Rate
avgF = 0.5 * (cf.fwd0 + fwdt);
drift += vT * fl.vol * cf.vol * cf.delta * avgF / (1 + cf.delta * avgF);
break;
case CEFR: // Conditional Expectation of Fwd Rate
drift += fl.vol * cf.vol * integralFwd(cf.fwd0, fwdt, 0, vT, cf.vol, cf.delta);
break;
default:
break;
}
fl.df[nI + mNumNodes] /= (1 + fwdt * cf.delta); // df: discount factor maturing at maturity
}
fl.reducedPayoff[nI + mNumNodes] = fl.coupon / fl.df[nI + mNumNodes];
}
}
// GaussLegendre integration for drift
const double xArray[] = {0, 0.1488743389, 0.4333953941, 0.6794095682, 0.8650633666, 0.9739065285};
const double wArray[] = {0, 0.2955242247, 0.2692667193, 0.2190863625, 0.1494513491, 0.0666713443};
double CallableBond::integralFwd(double F0, double Ft, double a, double b, double vol, double delta) {
double xm = 0.5 * (b + a);
double xr = 0.5 * (b  a);
double ss = 0, dx = 0;
for (int j = 1; j <= 5; j++) {
dx = xr * xArray[j];
ss += wArray[j] * (expectFwd(F0, Ft, (xm + dx), b, vol, delta)
+ expectFwd(F0, Ft, (xm  dx), b, vol, delta));
}
return ss * xr;
}
double CallableBond::expectFwd(double F0, double Ft, double s, double t, double vol, double delta) {
double mean = F0 * pow ((Ft / F0), (s / t)) * exp(0.5 * vol * vol * s * (t  s) / t);
return delta * mean / (1 + delta * mean);
}
26
// Trapezoidal Rule Integration
double CallableBond::integral (int curPos, double curVol, double preVol, double preTerm,
double curTerm, double* value){
double diffPos, tmpV, sum = 0;
for (int k = mNumNodes; k <= mNumNodes; k++) {
diffPos = k*mGap  curPos*mGap + preVol * preTerm  curVol * curTerm;
tmpV = value[k+mNumNodes] * exp (diffPos * diffPos/(2*(preTerm  curTerm)));
((k == mNumNodes)  (k == mNumNodes)) ? sum += 0.5 * tmpV : sum += tmpV;
}
return sum * mGap / sqrt(2 * PI * (preTerm  curTerm));
}
EXHI BI T 1. The Grid/ Rect angular Lat t ice
This exhibit defines t he st at e space for t he underlying process
t
Y over t he first t wo discret e
t ime periods. The st art ing st at e
0
y at valuat ion dat e 0 is t he single root of t he lat t ice. At each
dat e
i
t t he underlying process
i
t
Y is discret ized int o a number of vert ical nodes/ st at es indexed
by j . The value
i
t j
y
,
denot es t he underlying process in st at e j at dat e
i
t . The node
1
, 1 t
y , for
inst ance, can evolve t o any discret e st at e in
2
t wit h cert ain t ransit ion probabilit ies. For a
Brownian mot ion, t he t ransit ion probabilit y can be easily det ermined by ( 25) .
EXHI BI T 2: The Callable Bond and Associated Spot Market Dat a
The callable bond has a one year mat urit y, a $100 principal, a quart erly payment frequency,
and a 4% annual coupon rat e. Delt a = (end dat e – st art dat e) / 365 (day count : ACT/ 365). The
discount bond ) , 0 (
i
T P mat ures at t he end dat e
i
T . The call dat es are 6, 9, and 12 mont hs.
Cash flow index 1 2 3 4
St art dat e ( days) 0 92 181 273
1
t
1
, 2 t
y
1
, 3 t
y
1
, 4 t
y
1
, 5 t
y
2
, 1 t
y
2
, 2 t
y
2
, 3 t
y
2
, 4 t
y
2
, 5 t
y
0
y
1
, 1 t
y
2
t
27
End dat e ( days)
92 (
1
T ) 181 (
2
T ) 273 (
3
T ) 365 (
4
T )
Delt a ( years) 0.252055 0.243836 0.252055 0.252055
Payoff ( $) 1 1 1 101
Call Schedule ( days)  181 273 365
Discount bond ) , 0 (
i
T P 0.999313 0.998557 0.997293 0.995667
Black Volat ilit y
i
o
 0.337631 0.344218 0.350878
EXHI BI T 3: The LMM Lat t ice St ructure of t he Callable Bond.
The callable bond is defined in Exhibit 2. ) , (
~
:
~
, i j j i
y T V V = denot es t he reduced value of t he
callable bond at any node ( i, j ).
1
V denot es t he coupon at
1
T . ) 0 ( V is t he value calculat ed by
t he final int egrat ion. ) 0 ( V is t he final callable bond value t hat is equal t o ) 0 ( V plus t he present
value of
1
V . The grid space is 5 . 0 = ¢ and t he number of nodes is 7 = S . This lat t ice has 3
st eps and 7 nodes.
EXHI BI T 4: The Convergence Result s for t he Callable Bond.
The callable bond is defined in Exhibit 2. 1 = u and drift approximat ion is AADT. Each curve
represent s t he convergence behavior for a given grid space ( phi) as nodes are added. All
calculat ions are converged t o 100. 7518.
0
) 6 (
2
m T ) 12 (
4
m T ) 9 (
3
m T
5 . 1
1 4 , 1 3 , 1 2 , 1
÷ = = = = y y y y
1
2 4 , 2 3 , 2 2 , 2
÷ = = = = y y y y
) 3 (
1
m T
07 . 29
~
2 , 1
= V
99 . 66
~
2 , 2
= V
398 . 81 ) 0 ( = V
5 . 0
3 4 , 3 3 , 3 2 , 3
÷ = = = = y y y y
0
4 4 , 4 3 , 4 2 , 4
= = = = y y y y
5 . 0
5 4 , 5 3 , 5 2 , 5
= = = = y y y y
100
4 , 1
= V
100
4 , 2
= V
100
4 , 3
= V
100
4 , 4
= V
100
4 , 5
= V
24 . 44
~
3 , 1
= V
05 . 78
~
3 , 2
= V
24 . 96
~
3 , 3
= V
17 . 100
~
3 , 4
= V
82 . 98
~
3 , 5
= V
41 . 86
~
2 , 3
= V
72 . 96
~
2 , 4
= V
55 . 94
~
2 , 5
= V
7
5 . 0
=
=
S
¢
1
1
= V
399 . 80 ) 0 ( = V
100
4 , 6
= V
100
4 , 7
= V
1
6 4 , 6 3 , 6 2 , 6
= = = = y y y y
5 . 1
7 4 , 7 3 , 7 2 , 7
= = = = y y y y
11 . 87
~
3 , 6
= V
72 . 57
~
3 , 7
= V
36 . 77
~
2 , 6
= V
46 . 45
~
2 , 7
= V
28
Convergence of a callable bond
70
80
90
100
110
11 15 19 23 27 31 35 39 43 47
Number of nodes N
P
r
i
c
e
s
phi=1/2
phi=1/3
phi=1/4
.
EXHI BI T 5: The Convergence Result s for t he Callable Capped Float er Swap
The callable capped float er swap has more t han 10 years remaining in it s lifet ime. The float ing
leg has a quart erly payment frequency. The st ruct ural leg has a semi annually payment
frequency. The call schedule is semi annual. u = 1 and drift approximat ion is CEDT. Each curve
represent s t he convergence behavior for a given grid space ( phi) as nodes ( N) are added.
Convergence of a callable capped floater swap
9.0%
8.0%
7.0%
6.0%
5.0%
4.0%
3.0%
2.0%
1.0%
0.0%
1.0%
2.0%
140 150 160 170 180 190 200 210 220 230 240 250 260 270 280 290 300
Number of nodes N
R
e
l
a
t
i
v
e
p
r
i
c
e
e
r
r
o
r
phi=1/4
phi=1/6
phi=1/8
phi=1/10
EXHI BI T 6: The Convergence Result s for t he Callable Range Accrual Swap
29
The callable range accrual swap has 10 years mat urit y. The float ing leg has a quart erly
payment frequency. The st ruct ural leg has a semi annually payment frequency. There are 7
call opport unit ies. u = 1 and drift approximat ion is CEDT. Each curve represent s t he
convergence behavior for a given grid space (phi) as nodes are added.
Convergence of a callable range accrual swap
5.0%
4.0%
3.0%
2.0%
1.0%
0.0%
1.0%
2.0%
140 150 160 170 180 190 200 210 220 230 240 250 260 270 280 290 300
Number of nodes N
R
e
l
a
t
i
v
e
p
r
i
c
e
e
r
r
o
r
s
phi=1/4
phi=1/6
phi=1/8
phi=1/10
EXHI BI T 7: The Benchmark Result s for t he Callable Capped Float er Swap
This exhibit present s t he result s for model comparison. We benchmark t he lat t ice model under
different drift approximat ion met hods wit h several st andard market approaches, e. g. , t he
regressionbased Mont e Carlo in t he full LMM and t he HJM t rinomial t ree, for bot h accuracy
and speed. The t rade is t he same as t he one in Exhibit 5. The grid space is ¢ = 1/ 8 and t he
number of nodes is S= 200. PC denot es Predict orCorrect or. The column ‘Dif from MC’ = 1 –
( current row price) / (price of MC in LMM). All comput at ional t imes are denot ed in seconds on
a comput er wit h a 2. 33 GHz Duo Core CPU.
Model u Drift Steps n Calls Nodes/Paths Price Err from MC Run time
MC in LMM  PC 40 20 1 million 4,546,863.3 0 290.32
HJM tritree   1979 20 2n+1 4,602,136.3 1.22% 15.01
1 FD 40 20 200 4,822,728.4 6.07% 0.32
1 AAFR 40 20 200 4,637,263.2 1.99% 0.32
1 AADT 40 20 200 4,637,718.1 2.00% 0.32
1 GAFR 40 20 200 4,698,215.6 3.33% 0.32
1 GADT 40 20 200 4,698,441.3 3.33% 0.32
Our Model
1 CEFR 40 20 200 4,665,210.3 2.60% 0.38
30
1 CEDT 40 20 200 4,665,552.4 2.61% 0.39
0.99 FD 40 20 200 4,708,768.9 3.56% 0.32
0.99 AAFR 40 20 200 4,504,989.2 0.92% 0.32
0.99 AADT 40 20 200 4,505,426.3 0.91% 0.32
0.99 GAFR 40 20 200 4,609,779.5 1.38% 0.32
0.99 GADT 40 20 200 4,609,996.6 1.39% 0.32
0.99 CEFR 40 20 200 4,563,689.2 0.37% 0.38
0.99 CEDT 40 20 200 4,563,730.9 0.37% 0.39
EXHI BI T 8: The Benchmark Result s for t he Callable Range Accrual Swap
This exhibit present s t he result s for model comparison. We benchmark t he lat t ice model under
different drift approximat ion met hods wit h several st andard market approaches, e. g. , t he
regressionbased Mont e Carlo in t he full LMM and t he HJM t rinomial t ree, for bot h accuracy
and speed. The t rade is t he same as t he one in Exhibit 6. The grid space is ¢ = 1/ 8 and t he
number of nodes is S= 200. The column ‘Dif from MC’ = 1 – (current row price) / ( price of MC
in LMM). All comput at ional t imes are denot ed in seconds on a comput er wit h a 2. 33 GHz Duo
Core CPU.
Model u Drift Steps n Calls Nodes/Paths Price Dif from MC Run time
MC in LMM  Euler 1801 7 1 million 585793.2 0.00% 2372.21
HJM tritree   1801 7 2n+1 582167.8 0.62% 15.62
1 FD 1801 7 200 648365.4 10.68% 0.21
1 AAFR 1801 7 200 602482.2 2.85% 0.21
1 AADT 1801 7 200 602742.1 2.89% 0.21
1 GAFR 1801 7 200 616318.6 5.21% 0.21
1 GADT 1801 7 200 616425.3 5.23% 0.21
1 CEFR 1801 7 200 598253.3 2.13% 2.21
1 CEDT 1801 7 200 598372.4 2.15% 2.35
0.99 FD 1801 7 200 609373.9 4.03% 0.21
0.99 AAFR 1801 7 200 579337.2 1.10% 0.21
0.99 AADT 1801 7 200 579386.3 1.09% 0.21
0.99 GAFR 1801 7 200 591981.5 1.06% 0.21
0.99 GADT 1801 7 200 591917.6 1.05% 0.21
0.99 CEFR 1801 7 200 588918.9 0.53% 2.21
Our Model
0.99 CEDT 1801 7 200 588935.7 0.54% 2.35
This action might not be possible to undo. Are you sure you want to continue?
Use one of your book credits to continue reading from where you left off, or restart the preview.