8/17/22, 2:24 PM Differences between main classes of interest pricing derivatives models - Quantitative Finance Stack Exchange

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Differences between main classes of interest pricing derivatives models

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There seems to be 3 main classes of interest rate pricing models: 1) Short rate models, 2) Heath
Jarrow models and 3) Libor Market Model. My book doesnt seem to explain why we need all
11 these different models, when they are appriopriate for use and what the advantages and
disadvantages of these models are?

Could someone please summarise the difference between the various interest rate pricing models
7 and their advantages and disadvantages?

interest-rates derivatives pricing short-rate

Share Improve this question Follow asked Apr 30, 2021 at 18:35
Trajan
2,161 5 26 59

5 My 0.02 USD: The main problem with the short rate models was their inability to reproduce realistic yield
curves we see in real life. Both HJM and LMM were attempts to overcome this problem. It seems that LMM
has achieved greater acceptance, perhaps because of technical difficulties with HJM (non Markov
processes). – nbbo2 May 1, 2021 at 1:42

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I am not sure if you can classify it like that. Mind you, I never wrote a book. I'll write what I know
below and you can decide if the classification makes sense or not.
6
1 ) STIR: as the term indicates - short term like Eurodollar frequently modelled with Black or
Bachelier (normal) model. HW1F is also a short rate model.

2 ) HJM is a framework (M is not model but Morton): CIR, HW-1F and HW-2F can be shown to be
part of it @Gordon shows this for HW1f

It should be clear now, why I do not agree with the postulated classification.

Advantages vs disadvantages are similar to any other derivative model. If you price something
simple, do not overcomplicate things. Price a vanilla European call in FX with Garman Kohlhagen
Bl k A l h TARF i h SLV Id ll if lib i k
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or Black. A complex chooser TARF with SLV. Ideally, if calibration works, you price vanilla
instruments consistently but it is computationally a completely unnecessary task. In terms of
Greeks it becomes even more problematic if you use complex models for vanilla instruments.

In FI, anything including capped/floored floaters or digitals should be done by using vanilla
models in my opinion (normal, black, and via replication if needed).

3 ) LMM is the IR equivalent of what the SLV model is for FX - market standard generally (at least
very widely used).

Benefits?

it simulates genuinely quoted market rates of interest (LIBOR) as opposed to unobservable,

instantaneous rates of interest (HJM framework)
calibrates to the skew observed in OTM swaptions: especially shifted LMM (short rate models
cannot although strike dependent IVOL is backed out via Black - again a layover in
classification)

creates realistic correlation structure

...

Uses? complex products like (Bermudan) CMS spread options/caps/floors, step up callables etc.

Downside? It is complex; to implement but also to use. It is not like Black (or even SLV) where you
mainly input your terms (K,t,..) and you get your price. You need to select the appropriate
calibration instruments based on the structure you price. Typical choices range from Swaptions
(full spectrum, upper triangle etc), caps or caplets, CMSSO (single look and multilook) if you have
access to quotes, ...

Edit:

Generally, I would suspect that book should go through the model and the processes. If not, it is
probably just an intro that explains the intuition and the book is a bit too sketchy.

HJM:

unobservable rate (not desirable): LMM simulates genuine market rates

non-markovian makes estimation of model parameters difficult, also here

since it is a framework, lots of models fit into it

@ir7's comments: it is multi factor in it's generic framework (HW1F obviously is not).

Why I wrote it is like SLV?

First, what is the SLV? It combines LV (not really a model, just uses vanilla surface to get a
grid) with SV (in a nutshell, BSM with a separate stochastic process for vol, hence multiple
dynamic factors).
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Shortcomings SLV tries to address?: BS does not price exotic option well. LV calibrates nicely
to vanilla but the calibrated leverage surface is typically observed to flatten with maturity

which means the forward volatility smile will be less convex than on the initial pricing date
and you will not be pricing deals properly which are primarily sensitive to forward volatility
skew and smile (cliquets and co). SV prices for barriers and touches tend to be overvalued by
SV (undervalued by LV). In any case, Once calibrated to the vanilla market, LV and SV offer no
extra flexibility in matching the dynamics of implied volatility.

Why SLV solves this? Appropriate calibration of the mixing parameters will allow you to
closely match market quotes for exotic products.

Is it used? Yes, de facto the market standard for all exotic FX option pricing (there are many
flavours and ways to combine these, also how to construct local vol, stochastic vol etc, so this
is very sketchy and there are better and worse models).

(Shifted) LMM

Vanilla models (Black, Normal) and short term interest rate models will not price exotic
products properly.
What it does: attempts to match ATM/OTM-swaption/cap/caplet volatility and CMS spread
vol/correlation/option at calibration.

Why? This is needed to properly price derivatives depending on this market data. If you
ignore important aspects (skew, correlation etc) it will still price, just classic GIGO.

I like this tweet. If you use Local Vol Monte Carlo, you will get a price for essentially every
underlying that can be priced and any product you can define a payoff for. You will get expected
values from the MC runs, compute cashflows and discount. However, you can also model
something by simply assuming next days price will be equal to todays price. As silly as this
sounds, that is actually the way to forecast a random walk and works remarkably well in some
circumstances (see the section with Kenneth Rogoff and Richard Meese). Also, as mentioned by
@noob2, standard HJM is non-markovian, which may explain why it is not as popular as the LMM.

So LMM achieves what SLV is doing. Try to model the underlying processes in a way that is
consistent with market prices. Both are the most widely used models for pricing exotic options in
their respective asset classes. SLV or LMM is not like BSM though. The latter is simple and there is
no variation (ignoring american option pricing and term structure BSM but my point is that
everyone uses the same formula). The complexity of SLV and LMM allow for numerous ways to
implement these.

Now, one could argue that it's a chicken or the egg dilemma but markets price products in a way
that whoever sells them does not constantly lose money. Complex structures have complex
problems that define what the "fair" price should be.

LMM is really a set of models combined together: correlation (frequently using a method
proposed by Rebonato) the vol model and shift model So it's a complex system of coupled
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proposed by Rebonato), the vol model and shift model. So it s a complex system of coupled
stochastic differential equations where Brownian motions exhibit a forward-forward correlation
structure.

In a super short summary. In my opinion, everything goes back to Bachelier. He just never got the
credit he would deserve in my opinion. No matter what model, if you turn all the additional
features off, you essentially end up with his ideas. The reason more complex models exist is to
overcome shortcomings.

You assume the forward (swap rate) obeys the stochastic differential equation of geometric
Brownian motion. Black assumes volatility is independent of the strike (usually not true, which is
why you have a vol skew/smile). CEV and SABR formulate ways to interpolate the vol smile (which
is needed to calibrate). For example, looking at SABR (not using LMM as it is so much more
nuanced and complex), setting vol parameter ν and correlation coefficient ρ to zero, it reduces to
CEV. If β = 1 in CEV it becomes regular Black SDE. Not using lognormal but normal -> Bachelier.

A quick attempt to explain some LMM dynamics. LMM tries to best match given smiles (market
quotes) using shifted-lognormal skew (skew between Black and Normal, again Bachelier). α = 0

implies Black skew and α = ∞ represents the Normal skew.

Bottom line, one book will never explain LMM, maybe The SABR/LIBOR Market Model: Pricing,
Calibration and Hedging for Complex Interest‐Rate Derivatives answers a lot of questions.
However, I use that model, but would never be able to implement this. Generally, these models
are constantly enhanced and refined and it takes a large number of very smart people
(predominantly, if not entirely with a non finance backgrounds like physics, computer science and
the like). Maybe there is someone in this forum who actually is contributing to developments who
is willing to outline how much time they spend(t) setting up LMM.

Share Improve this answer Follow edited May 2, 2021 at 0:14 answered May 1, 2021 at 0:15
AKdemy
4,798 1 4 26

Thanks for your answer but its much more sketchy than I was hoping for – Trajan May 1, 2021 at 10:20

It doesnt really explain the differences between the models. Moreover, I cant see why LMM is the equivalent
of Stochastic Local Vol for IR – Trajan May 1, 2021 at 10:28

The book Im reading is Stochastic Calculus for Finance II – Trajan May 1, 2021 at 16:44

1 OK; that book is not meant to explain the (practical) use of these models. It's a summary of mathematical
concepts for graduate students. Just like "Further Mathematics for Economic Analysis" does not teach you
any economics (quite literally in this case). The very end of the notes section (10.6) mentions books by
authors with practical experience. Rebonato, who I suggested above, is one of them. – AKdemy May 1, 2021
at 21:09

Just an addendum to the above answers and comments:

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4 The main decision is whether to use single or multiple factor dynamics.

LMM models term forward rates. HJM models instantaneous forward rates.

The main disadvantage of HJM, high-dimensional stochastic process as underlying, was

overcome by Cheyette, back in 1994, by restricting the general HJM model to a subset of
models with a specific parametrization of the volatility function. See for example Ingo Beyna's
book Interest Rate Derivatives Valuation, Calibration and Sensitivity Analysis for a
comprehensive review (and recent tractability improvements). Multifactor Gaussian
Markovian HJM models (including linear ones) are still used.

For current needs, risk free rates (RFR), see Mercurio and Lyashenko's Looking Forward to
Backward-Looking Rates: A Modeling Framework for Term Rates Replacing LIBOR, which is an
extension of LMM model providing additional information about the rate dynamics
(extended HJM, locally-equivalent Cheyette model) not accessible in the LMM.

Share Improve this answer Follow edited May 1, 2021 at 11:19 answered May 1, 2021 at 10:32
ir7
5,038 10 12

Is the HJM single or multiple factor? If it is multiple factor, how is it different to LMM? – Trajan May 1,
2021 at 11:00

HJM is multiple factor (but, of course, one can choose to use a single factor version). LMM models term
(1M, 3M) forward rate. HJM models instantaneous forward rate. – ir7 May 1, 2021 at 11:08

Also, LMM specifies log-normal or shifted log-normal dynamics for each term forward rate under its specific
T -forward measure, while HJM (with deterministic vol specification) dynamics for instantaneous forward

rate s normal. – ir7 May 1, 2021 at 11:35

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