riskcourse lmm

LIBOR market model andits uses

Andrew Lesniewski, Ph.D.Managing Director

[email protected]

Ellington Management Group53 Forest Avenue

Old Greenwich, CT 06870

Libor market model p. 1

Overview

Dynamics of Libor forward rates and martingale measuresVolatility structures of Libor forwardsAsymptotic solution to the LMMThe vanilla systemValuation of caps and floorsAsymptotic valuation of swaptionsParametrization of instantaneous volatilities and correlations

Stable least square optimization


Overview

Discretization of the LMM and effective methods for generatingMC pathsAccurate and fast asymptotic calculation of the drift termsValuation of non-callable securities

Valuation of securities with embedded Bermudan optionsLMM and securities with uncertain time horizons: prepaymentrisk, credit risk

LMM and the SABR model of stochastic volatilityRisk management with LMM: delta, gamma, vega, etc.


Dynamics of LMM

We consider a sequence of approximately equally spaced dates

0 T0 < T1 < . . . < TN ,

which are called the standard tenors. A standard Libor forward rate

Lj , j = 0, 1, . . . , N 1,

is associated with a forward rate agreement which starts on Tj andends on Tj+1. Usually, we assume N = 120 and the Lj s are 3 monthLibor forward rates. These dates are the actual start and end dates ofthe contracts rather than the fixing dates. For simplicity, we disregardthis distinction. Proper implementation takes it into account.


Dynamics of LMM

We model Lj as a continuous time stochastic process Lj (t),0 t Tj1 (killed at t = Tj1!). The dynamics of the forward processis driven by an N -dimensional, correlated Wiener processW0 (t) , . . . ,WN1 (t). The probability measure associated with thisWiener process is denoted by P. We let jk denote the instantaneouscorrelation between Wj (t) and Wk (t), i.e.

EP [dWj (t) dWk (t)] = jkdt .

To motivate the form of the stochastic differential equations describingthe dynamics of the Lj s, consider the world in which there is novolatility of interest rates, i.e. for all js Lj (t) = Lj0, or

dLj (t) = 0.


Dynamics of LMM

The fact that the rates are stochastic leads us to replace this with asystem of stochastic differential equations:

dLj (t) = j (L (t) , t) dt+ Cj (L (t) , t) dWj (t) .

The first term on the right hand side is called the drift term, and thesecond term is called the diffusion term. The no arbitrage requirementforces a relationship between the drift and the diffusion terms. Theform of the drift term depends on the choice of numeraire.

Define : [0, TN ] Z by

(t) = m, if t [Tm1, Tm) .


Dynamics of LMM

We consider two types of numeraire:Forward. For k = 1, . . . , N , choose as numeraire the zerocoupon bond

Pk (t) = Pstub (t)

(t)ik

1

1 + iLi (t),

where Pstub (t) is the stub adjustment for the period [t, T(t)].Spot. Choose as numeraire the rolling bank account

P0 (t) =P(t)1 (t)

1i(t)1 Pi (Ti1).

Let Qk, k = 0, 1, . . . , N denote the appropriate equivalent martingalemeasure.


Dynamics of LMM

Under the forward measure Qk, k = 1, . . . , N , the dynamics of theforward rate Lk (t) is a martingale. Indeed,

Lk (t) =1

k

Pk1 (t) Pk (t)Pk (t)

,

i.e. it is the difference of two assets. Consequently, the dynamics ofLk (t) should be driftless:

dLk (t) = Ck(Lk (t) , t

)dWk (t) ,

where Ck(Lk (t) , t

)is an instantaneous volatility function.


Dynamics of LMM

This and the change of numeraire techniques allow us to determinethe dynamics for j 6= k. Changing numeraire from Pj (t) to Pk (t), wefind that:

dLj (t) = Cj(Lj (t) , t

)

j+1ik jiiCi

(Li (t) , t

)1 + iLi (t)

dt+ dWj (t) , if j < k,

k+1ij

jiiCi(Li (t) , t

)1 + iLi (t)

dt+ dWj (t) , if j > k .


Dynamics of LMM

Finally, under the spot measure (k = 0), the LMM dynamics reads:

dLj (t) = Cj(Lj (t) , t

) (t)ij

jiiCi(Li (t) , t

)1 + iLi (t)

dt+ dWj (t)

.

These equations have to be supplied with initial values for the Liborforwards:

Lj (0) = Lj0,

where Lj0 is the current value of the forward which is implied by thecurrent yield curve.


Factor reduction

In a market spanning 30 years, there are 120 quarterly Libor forwards(i.e. 120 stochastic factors). This poses severe problems with themodels implementation:

The curse of dimensionality kicks in, leading to unacceptablyslow performance.The parameters of the model are severely underdetermined andthe calibration of the model becomes unstable.

We need a small number d of independent Brownian motions Za (t),a = 1, . . . , d,

E [dZa (t) dZb (t)] = ab dt ,

driving the process. Typically, d = 1, 2, 3, or 4.


Factor reduction

We express the true Brownian motions in terms of the Z s:

dWj (t) =

1ad

Uaj dZa (t) ,

where U is an N d matrix so that UU . We rewrite the dynamicsof the model in terms of the independent Brownian motions:

dLj (t) = j (L (t) , t) dt+

1ad

Bja(Lj (t) , t

)dZa (t) ,

whereBja

(Lj (t) , t

)= Uaj C

j(Lj (t) , t

).


Factor reduction

This system gives the factor reduced LMM dynamics. We interpretd UU as the correlation matrix corresponding to the factor reducedLMM dynamics. Clearly, its rank is equal to d, and

d =d

1ad

EaEa,

where Ea denotes the a-th column of the matrix U .


Low noise expansion

There is no known closed form solution to the LMM dynamics. We canconstruct an approximate solution by means of a low noise expansion:We introduce a smallness parameter in front of the diffusioncoefficients. This parameter is set to 1 at the end of the computation.Since the drift coefficients are quadratic in the diffusion coefficients, wemultiply them by 2. Expanding in powers of then yields:

Lj (t) = Lj0 +

1ad

t0

Bja (L0, s) dZa (s) +

t0

j (L0, s) ds

+

1a,bd1kN

0ust

Bka (L0, u)Bjb (L0, s)

LkdZa (u) dZb (s)

+ . . . .


Low noise expansion

The low noise solution implies the following asymptotic expansion forthe expected value of E

[Lj (t)

]:

E[Lj (t)

]= Lj0 +

t0

j (L0, s) ds

+

1a,bd1kN

ab

t0

Bka (L0, s)Bjb (L0, s)

Lkds+ . . . .

This formula shows that the naive expected value, namely todaysforward, has to be adjusted by a convexity correction which dependson the market volatility.


Low noise expansion

The covariance matrix Cov[Lj (t) , Lk (t)

]is asymptotically given by:

Cov[Lj (t) , Lk (t)

]=

1a,bd

ab

t0

Bja (L0, s)Bkb (L0, s) ds

+

1a,b,a,bd1i,iN

aabb

t0

t0

Bia (L0, s)Bia (L0, s

)

Bjb (L0, s)

LiBkb

(L0, s)

Lids ds + . . . .

The first term in the formula above is what one would naively expect,while the second term is a convexity correction to this quantity.


Optimization and Tikhonov regularization

In the following, we will face various multidimensional optimizationproblems, all of which are ill posed (i.e. the number of unknownparameters is smaller than the number of data points). Their solutionrequires minimizing a loss function L0 (x):

L0 (x) =i

ri (x)2 ,

with nonlinear residuals ri (x). Such problems are typically poorlyconditioned and numerically finicky. Instead, we will consider amodified loss function:

L (x) = L0 (x) + Sx2,

where S is a suitable smoothing operator.Libor market model p. 17

Vanilla system

Vanilla system consists of:Forward curve stripper and swap pricing model. For ourpurposes, the forward curve is represented as a sequence of NLIBOR forwards Lj0, j = 0, . . . , N . These forwards are used tocalibrate the model, and as the initial value to evolve the LIBORforwards.

Cap volatility stripper and cap / floor pricing model. The output ofthe cap vol stripper is a sequence of N caplet volatilities. Theyare used to calibrate the volatility structure of the model.Swaption pricing model. Swaption volatilities are also used tocalibrate the volatility structure of the model.


Stripping cap volatility

Caps and floors are baskets of calls and puts on Libor forwards struckat the same rate. Because of the complexity of their description (a 10year cap involves 39 caplets!), the market quotes them in terms of apremium or a single flat volatility. This flat volatility has the propertythat, when inserted in the pricing formula, it reproduces the optionpremium. In reality, caplet volatility exhibits a very pronounced termstructure. Typical of it is the persistence of a volatility hump whichusually peaks somewhere between 6 months and 2 years. Theprocess of constructing implied caplet volatility from market quotes issometimes called stripping.


Stripping cap volatility

We use a two step stripping algorithm.We fit the caplet volatilities to the hump function:

H (t) = (+ t) exp (t) + .

Once , , , and have been calibrated, we parameterize thecap volatility curve by means of cubic B-splines and optimize tonail down the fit to market prices.

The outcome of stripping is a sequence j , j = 0, . . . , N 1 of N at themoney caplet volatilities. Specifically, j is the implied volatility of thecaplet expiring at Tj .


Approximate valuation of swaptions

A key ingredient of efficient calibration of the LMM is rapid andaccurate swaption valuation. This is hard, as:

A swap rate is a non-linear function of the underlying Liborforward rates.

The stochastic differential equation for the swap rate cannot besolved in closed form, and pricing swaptions requires MonteCarlo simulations.This poses a serious issue, as such simulations are costly.

We describe an approximation for rapid swaption valuation, based onthe low noise expansion, which we use to calibrate the model.



Since the purpose of the approximate formulas is to provide anefficient calibration tool, we focus on benchmark swaptions only.Consider a benchmark forward starting swap. The start date of theswap is denoted by Tm, and its end date is denoted by Tn. The levelfunction of the swap is defined by:

Amn (t) =

mjn1

jPj (t) ,

where j are the day count fractions for fixed rate payments. Typically,the payment frequency on the fixed leg is not the same as that on thefloating leg. This fact causes a bit of a notational nuisance but needs tobe taken properly into account for accurate pricing.



The forward swap rate is given by:

Smn (t) =Pm (t) Pn (t)

Amn (t)

=1

Amn (t)

mjn1

jLj (t)Pj (t) .

Incidentally, the formula above shows that the swap rate is amartingale under the measure associated with the level function.

The swap rate process in LMM can be written as:

dS (t) = (L, t) dt+

mjn1

j (L, t) dWj (t) .



Here

=

mjn1

S

Ljj +

1

2

mj,kn1

jk2S

LjLkCjCk ,

andj =

S

LjCj .

Explicitly, j is given by

j (L, t) = Cj(Lj , t

) (Rj (L, t) + j (L, t)

),

where the leading term is

Rj (L, t) =Pj (t)

A (t),



and the correction term is given by:

j =j

1 + jLj

S

jln1

lRl

jln1

lLlRl

.

To use this dynamics effectively, we approximate it by quantities withtractable analytic forms. The simplest approximation consists inreplacing the values of the stochastic forwards Lj (t) by their initialvalues Lj0. This amounts to freezing the curve at its current shape.



Within this approximation, the coefficients are deterministic:

j (L, t) j (L0, t) ,(L, t) (L0, t) .

The expected value of the swap rate is given by

E [S (t)] = S0 + t

0

(L0, s) ds,

and its variance is

Var [S (t)] =

mj,jn1

jj

t0

j (L0, s) j (L0, s) ds.



The normal volatility mn of a swaption with expiry Tm is

mn =

1

TmVar [Smn] .

Consequently, its frozen curve approximation 0,mn is given by

20,mn =1

Tm

mj,jn1

jj

t0

j (L0, s) j (L0, s) ds .

This formula is easy to implement in code, and leads to remarkablyaccurate results. One could, of course, go beyond this approximation,at the expense of producing a complicating and increasingly unwieldyanalytic expressions.


Structure of instantaneous correlations

An important input into the model calibration is determining theinstantaneous correlation matrix = {jk}0j,kN1. Thedimensionality of is N (N + 1) /2, posing an issue of finding a stablecalibration procedure. Possible strategies include:

Semi-definite programming. Try to imply the correlations fromthe cap / floor and swaption markets. This approach leads tonon-intuitive results and is prone to overfitting.Historical data. This approach, in conjunction with the principalcomponent analysis leads to stable correlation structure. It maynot reflect the current market correlations.

Parameterized correlations. May be the best choice.


Structure of instantaneous correlations

A realistic and flexible parametric form of instantaneous correlations isgiven by

jk = + (1 ) exp( |Tj Tk|

1 + min (Tj , Tk)

).

Caution: this parametrization produces a matrix that is onlyapproximately positive definite. It has some clear advantages:

It is intuitive: measures the overall level of correlations, isthe decay rate of correlations, and describes the short enddecorrelation.

It is easy to calibrate: only three parameters are involved.Perturbing the parameters , , leads to meaningful riskmeasures.


Parametrization of instantaneous volatilities

So far we have been working with a general instantaneous volatilityCj(Lj (t) , t

)for the forward Lj (t). In the implementation, we assume

Cj(Lj (t) , t

)to be one of the following standard models:

Cj(Lj (t) , t

)=

j (t) (normal model),j (t)Lj (t)j (CEV model),j (t)Lj (t) (lognormal model),j (t)Lj (t) + j (shifted lognormal model),

where the functions j (t) are deterministic, and where 0 j 1,j 0. These functions have to be suitably regularized at Lj 0 toprevent negative rates.



For the purpose of calibration we require that the deterministic volatilitycomponents j (t) are piecewise constant. That leads to the followingparametrization of the instantaneous volatility:

j (t) t [T0, T1) [T1, T2) [T2, T3) . . . [TN1, TN )0 (t) 0 0 0 . . . 0

1 (t) 1,0 0 0 . . . 0

2 (t) 2,0 2,1 0 . . . 0

3 (t) 3,0 3,1 3,2 . . . 0

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

N1 (t) N1,0 N1,1 N1,2 . . . 0



The table above contains 7140 parameters (assuming N = 120), andthe problem is vastly overparametrized !A natural remedy to the overparameterization problem is to assumethat the instantaneous volatility is stationary, i.e.,

j,i = ji,0

ji ,

for all i < j. This assumption appears natural and intuitive, as it impliesthat the structure of cap volatility will look in the future exactly the sameway as it does currently. Consequently, the forward volatility problemplaguing the traditional terms structure models would disappear.



With the stationary volatility assumption we have the followingparametrization of the instantaneous volatility structure:

j (t) t [T0, T1) [T1, T2) [T2, T3) . . . [TN1, TN )0 (t) 0 0 0 . . . 0

1 (t) 1 0 0 . . . 0

2 (t) 2 1 0 . . . 0

3 (t) 3 2 1 . . . 0

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

N1 (t) N1 N2 N3 . . . 0



This assumption is unsuitable for accurate calibration of the model.The financial reason is the phenomenon of mean reversion of longterm rates. One cannot take it into account by adding anOrnstein-Uhlenbeck style drift term to the LMM dynamics as this wouldviolate the arbitrage freeness of the model. One can, however, achievea similar effect by modifying the instantaneous volatility function.We introduce a volatility kernel function K (, ) to account for thedeviation from the purely stationary model. A convenient form of thevolatility kernel is

K (, ) = exp () .For each maturity Tj we choose a parameter j , and set

Kj,i = K (Tj Ti, j) .Libor market model p. 34


We are thus led to assume the following structure of the instantaneousvolatility:

j (t) t [T0, T1) [T1, T2) . . . [TN1, TN )0 (t) 0 0 . . . 0

1 (t) 1K1,0 0 . . . 0

2 (t) 2K2,0 1K2,1 . . . 0

3 (t) 3K3,0 2K3,1 . . . 0

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

N1 (t) N1KN1,0 N2KN1,1 . . . 0



The lower triangular matrix above, LMMs internal representation ofvolatility, is referred to as the LMM volatility surface.The structure above may still overparameterize the instantaneousvolatility, depending on the number of benchmark options used tocalibrate the model. To further reduce the number of parameters weexpress the j s and j s as linear interpolations of a smaller numberof auxiliary parameters.


Least square optimization

In order to calibrate the model we seek instantaneous volatilityparameters i so that to fit the at the money caplet and swaptionvolatilities. These can be expressed in terms of the instantaneousvolatilities are as follows. The at the money volatility of the capletexpiring at Tm is given by:

m (1, . . . , m, m)2=

1

Tm

0im1

2mi

Ti+1Ti

K (Tm t, m)2 dt

1Tm

0im1

2miK2m,i (Ti+1 Ti) .



The at the money volatility of the swaption expiring at Tm into a swapmaturing at Tn is approximately equal to

m,n (, m, . . . , n1)2 =

1

Tm

mj,kn1

jkjm,n

km,n

m1i=0

jikiKj,iKk,i (Ti+1 Ti) .

Here, j are simply rescaled versions of the corresponding functionswhich were defined and calculated asymptotically.



We calibrate the model by means of the Levenberg-Marquardtoptimization. The loss function is given by:

L (, ) = 12

m

wm(m (, ) m

)2+

1

2

m,n

wm,n(m,n (, ) m,n

)2

+1

2j

()2j ,

where m and m,n are the market observed caplet and swaptionvolatilities. The coefficients wm and wm,n are weights which allow oneselect the accuracy of calibration of each of the instruments. The lastterm is a Tikhonov regularizer.


Approximation schemes for LMM

For the purpose of asset pricing we solve numerically the SDEsdefining the LMM dynamics. Such a solution is a collection of MonteCarlo paths, each of which represents a future forward rate scenario.

We choose a sequence of event dates t0, t1, . . . , tm, and denote byLjn Lj (tn) the approximate solution. We also use

jn = j (Ln, tn) ,

Cjan = Cja (Ln, tn) ,

to denote the values of the drift and diffusion terms at time tn.



The simplest numerical scheme is Eulers scheme. It consists inreplacing the differentials by finite differences. For n = 1, . . . ,m, we let

tn = tn tn1,dWna =Wa (tn)Wa (tn1) ,

denote the time and Wiener process increments,respectively. Note thatdWna N

(0,tn). Then, Eulers solution scheme reads:

Ljn+1 = Ljn +

jntn +

1ad

Uaj Cjn dWna .

Eulers scheme converges at the rate of maxtn, as m.



A somewhat more accurate method is Milsteins scheme. It is arefinement of Eulers scheme which converges at the rate of max tn,as m. We set

jabn = Uaj U

bj C

j(Ljn, tn

) CjLj

(Ljn, tn

).

Then, Milsteins scheme for the LMM reads:

Ljn+1 = Ljn +

jn 12

1ad

jaan

tn

+

1ad

Uaj Cjn dWna +

1

2

1a,bd

jabn dWna dWnb .



Having discretized the dynamics, we have to select a method forsimulating the Wiener process. An efficient method relies on thespectral decomposition of the covariance matrix of W (t) sampled att0, t1, . . . , tm. The covariance matrix is explicitly given by:

Cij = E [W (ti)W (tj)]= min (ti, tj) .

Consider the eigenvalue problem for C:

CEj = jEj , j = 0, . . . , m,

with orthonormal eigenvectors Ej s and eigenvalues

0 . . . m 0.Libor market model p. 43


We let Ej (tn) denote the n-th component of Ej , and represent thediscretized Wiener process as

W (tn) =

0jm

j Ej (tn) j ,

where j are i.i.d. random variables with j N (0, 1). These numbersare best calculated by applying the inverse cumulative normal functionto a sequence of Sobol numbers. In practice, we may want to use onlya certain portion of the spectral representation by truncating it at somep < m. This eliminates the high frequencies from W (tn), and lowersthe sampling variance. The price for this is lower accuracy.


Computing the drift terms

Evaluating the drift terms along each Monte Carlo path is timeconsuming and accounts for over 50% of total simulation time.Typically they are small compare to the initial values of the Liborforwards, and it is desirable to develop an efficient methodology foraccurate approximate evaluation of the drift terms.The first and simplest approach consist in freezing the values ofLj (t) at the initial value Lj0 Lj (0). We precompute the values

j0 j (L0, 0) ,

and use them for the drift terms throughout the simulation. Thisapproximation, the frozen curve approximation, is rather crude, anddoes not perform very well for long dated instruments.



The order 3/4 approximation, uses the next order term in the low noiseexpansion:

j1/2 (t) j0 (L0, 0) + a,j (L0, 0)Za (t) + j (L0, 0) t.

Under the forward measure Qk, the coefficients a,j are given by:

a,j =

Cj j+1ik

jiiCi

1+iLi

[Uaj

Cj

Lj + Uai

(Ci

Li iCi

1+iLi

)], if j < k,

0, if j = k,Cj

k+1ij

jiiCi

1+iLi

[Uaj

Cj

Lj + Uai

(Ci

Li iCi

1+iLi

)], if j > k,



and the coefficients j are given by:

j =

j+1ik

jii1+iLi

[j0C

i Cj

Lj +i0C

j(Ci

Li iCi

1+iLi

)], if j < k,

0, if j = k,k+1ij

jii1+iLi

[j0C

i Cj

Lj +i0C

j(Ci

Li iCi

1+iLi

)], if j > k.

Under the spot measure,

a,j = Cj

(t)ij

jiiCi

1 + iLi

[Uaj

Cj

Lj+ Uai

(Ci

Li iC

i

1 + iLi

)],



and

j =

(t)ij

jii1 + iLi

[j0C

i Cj

Lj+i0C

j

(Ci

Li iC

i

1 + iLi

)].

The order 3/4 approximation leads to excellent accuracy.

On might easily refine this approach by computing terms of higherorder in stochastic Taylors expansion. This leads, however, to morecomplex and computationally expensive formulas, and the benefit ofusing an asymptotic expansion disappears. The order 1/2approximation appears to offer the best performance versus accuracyprofile.


Valuation of non-callable securities

Valuations within the LMM are based on the arbitrage free pricing law.For our purposes, the equivalent martingale measure Q is either one ofthe forward measures or the spot measure. The conditional expectedvalue is calculated by means of Monte Carlo simulations. A convenientchoice of the numeraire for all valuations is the spot numeraire. Thesample paths generation method described above produces lowvariance estimates of the expected value. In addition, one might use ageneric variance reduction method (such as antithetic variables) inorder to further reduce the sampling variance. For most instruments, arelatively small number of Monte Carlo paths leads to accurate andstable valuations. As few as 1000 paths are sufficient to producereliable prices.


Valuation of Bermudan options

Valuation of securities with embedded American (or Bermudan)options is more difficult, as the traditional Monte Carlo approach isinefficient. The problem is that while optimal exercise of a Bermudanoption requires solving a backward induction problem, Monte Carlopaths evolve forward in time. Recently, a number of efficientapproximate Monte Carlo algorithms for pricing Bermudan andAmerican options have been proposed. The approach we outline isinspired by the Longstaff - Schwarz approach. It is based on asequence of nested chaos expansions of the continuation values ateach exercise date. As few as 5000 Monte Carlo paths lead to reliablepricing.



We fix a measure Qk and consider a Bermudan swaption which can beexercised on dates t1, . . . , tM . If exercised on tj , it allows the holder toenter into a swap starting on (or about) tj . We let p (t) = p (L (t) , t)denote the payoff function. For a stopping time , we letp (t) = p (t ). Then its value at time t0 (today) equals

V (t0) = supT (t1,...,tM )

E [p |Ft0 ] ,

where T (t1, . . . , tM ) denotes the set of stopping times taking values inthe set {t1, . . . , tM}. The stopping time at which the maximum isattained is called the optimal stopping time.



In order to simplify the notation, we assume one factor only, d = 1(nothing gets lost). We introduce the notation:

Xj =W (tj)

tj, j = 1, . . . ,M,

so that Xj N (0, 1). From the properties of a Wiener process,

Xj =

tj1tj

Xj1 +

1 tj1

tjj , with j N (0, 1) .

We denote by gj (Xj) = p (L (tj) , tj) the payoff function at time tj , i.e.the present value (at time tj) of the corresponding swap.



Let Vj (Xj) denote the value of the option at time tj . Then,

VM (XM ) = gM (XM ) .

For j =M 1, . . . , 1, the value of the option is the greater of theimmediate payoff and the continuation value of the option:

Vj (Xj) = max (gj (Xj) , D (tj , tj+1)E [Vj+1 (Xj+1) |Xj ]) ,

where D (tj , tj+1) = Pk (tj+1) /Pk (tj). Todays value of the option is

V0 (X0) = D (t0, t1)E [V1 (X1) |X0] .



The continuation value of the option at time tj is

Cj (Xj) = D (tj , tj+1)E [Vj+1 (Xj+1) |Xj ] ,

i.e.Vj (Xj) = max (gj (Xj) , Cj (Xj)) .

We also have a recursion for the continuation values:

CM (XM ) = 0,

Cj (Xj) = D (tj , tj+1)E [max (gj+1 (Xj+1) , Cj+1 (Xj+1)) |Xj ] ,

for j =M 1, . . . , 1. Todays option price is

V0 (X0) = C0 (X0) .



We now would like to write

Vj (Xj) =

0k


The expansions with respect to the Hermite polynomials are truncatedat some finite order , i.e.:

Vj (Xj)

0k

ajk Hk (Xj) ,

E [Vj (Xj) |Xj1]

0k

(tj1 t0tj t0

)k/2ajk Hk (Xj1) .

Relatively low values of , 5, lead to good numerical results.



The Fourier coefficients ak are replaced by their Monte Carloestimates. We shall choose the coefficients so as to minimize thesquare error:

1

2

1iN

Vj (X(i)j )

0k

ajkHk

(X

(i)j

)2

.

This leads to the following estimate for the Fourier coefficients:

aj G1j vj ,

where Gj is a matrix whose components are:



(Gj)kl =1

N

1iN

Hk

(X

(i)j

)Hl

(X

(i)j

),

and where vj is a vector with the components:

(vj)k =1

N

1iN

Vj

(X

(i)j

)Hk

(X

(i)j

).

From the performance point of view, is worthwhile to accelerate theconvergence of this series. Payoff functions of options are, typically,not smooth. This causes slowdowns of the rate of convergence at thepoints where the payoff has kinks (as in the usual calls or puts) ordiscontinuities (as in digital options).



Having estimated the conditional expected values (and thus calculatedthe consecutive continuation values), we construct the optimalstopping time as follows.

Along a Monte Carlo path, find the earliest of the dates tj , wherethe immediate exercise outweighs the continuation value.Assign this date to the optimal stopping time along the path.Calculate the average over all Monte Carlo paths.


Securities with uncertain horizons

It is important to extent LMM so that instruments with risks other thaninterest rate risk can be valued. Certain classes of such instruments,such as mortgage backed securities (MBS) or credit sensitiveinstruments are characterized by the uncertainty of their time horizon.It is caused by an event such as prepayment in case of MBS, ordefault in case of credit sensitive instruments. Unlike the callableLIBOR exotics, where the termination decision is made optimally andconsistently with the rates process, these risks are largely exogenousto the rates process. Below we formulate some basic assumptionsabout modeling these instruments.



In order to make the framework consistent with LMM we make thefollowing assumptions.

Assumption 1. The underlying uncertainty is modeled by theLIBOR market model.Assumption 2. Additional uncertainty (prepayment, default, ...)is modeled by a random time T . T is not required to be astopping time with respect to Ft. However, we assume that

P ({T > t} |F) = P ({T > t} |Ft) .

The second assumption means that the probability of event occurringdepends only on the information up to time t



Assumption 3. There exist a process (t) 0, the intensityprocess, so that

P ({T > t} |Ft) = exp( t

0

(s) ds

).

In the context of prepayment, (t) is the (continuous time versionof) SMM. In the context of credit, it is the hazard rate.Assumption 4. The event will occur almost surely,

P ({T


Valuation of securities with uncertain time horizons is done by meansof Monte Carlo simulations. The stochastic process

S (t) = exp

( t

0

(s) ds

)

is called the survival probability, while

F (t) = 1 S (t)

is the event probability.



A cashflow of a security with event risk is given by:j

(cjP (tj)S (tj) + rjP (tj)

(Fj (t) F (tj1)

)),

where cj are the known cash amounts, and rj are the recovery rates incase an event occurs. The intensity process defining the survivalprobability is modeled outside of LMM. The price of the security iscalculated by taking the appropriate expected value of the cashflowsabove.


LMM and the SABR model

The SABR model describes the dynamics of a single forward withstochastic volatility. Its dynamics is given by:

dL (t) = C (L (t)) dW (t) ,

d (t) = (t) dZ (t) ,

whereE [dW (t) dZ (t)] = r dt.

One usually chooses C (L) to be of the CEV type

C (L) = L .

SABR captures volatility smile on vanilla options. In order to model thesmile of more complex instruments, we need to suitably extend LMM.



We consider an extension of the LIBOR market model with stochasticvolatility parameters denoted by 1t , . . . , Nt :

dLj (t) = j(L (t) , (t) , t)dt+ Cj(Lj (t) , j (t) , t)dW j (t) ,

dj (t) = j(L (t) , (t) , t)dt+Dj(Lj (t) , j (t) , t)dZj (t) ,

with

E[dW i (t) dW j (t)] = ijdt,

E[dW i (t) dZj (t)] = rijdt,

E[dZi (t) dZj (t)] = piijdt.

Choose the drifts so that this dynamics is arbitrage free!



Under the forward measure Qk, the arbitrage free dynamics is:

dLjt = Cj(Ljt ,

jt , t)

j+1ik jiiCi(Lit, it, t)1 + iLit dt+ dW jt , if j < k,dW jt , if j = k,k+1ij

jiiCi(Lit,

it, t)

1 + iLitdt+ dW jt , if j > k ,

djt = Dj(Ljt ,

jt , t)

j+1ik rjiiCi(Lit, it, t)1 + iLit dt+ dZjt , if j < k,dZjt , if j = k,k+1ij

rjiiCi(Lit,

it, t)

1 + iLitdt+ dZjt , if j > k .



Under the spot measure, the dynamics reads:

dLj (t) = Cj(Lj (t) , j (t) , t

) (t)ij

jiiCi(Li (t) , i (t) , t

)1 + iLi (t)

dt

+ Cj(Lj (t) , j (t) , t

)dWj (t) ,

dj (t) = Dj(j (t) , t

) (t)ij

jiiCi(Li (t) , i (t) , t

)1 + iLi (t)

dt

+Dj(j (t) , t

)dZj (t) .

Note that the model involves a large number of parameters. Judiciouschoices have to be made in order to produce a stable framework.


Risk management: delta

This is the most important risk factor (and the easiest to hedge).Choose a hedging portfolio consisting of vanilla instrumentssuch as swaps, Eurodollar futures, forward rate agreements, etc:

hedge = {B1, . . . , Bn} .

Let C0 denote the current forward curve (the base scenario).Choose a number of new micro scenarios

C1, . . . , Cp

by perturbing a segment of C0. For example, C1 could result fromC0 by shifting the first 3 month segment down by 1 bp.



The vector of portfolios sensitivities to these scenarios is

i = (Ci)(C0) , i = 1, . . . , p,

where by (Ci) we denote the value of the portfolio given theforward curve Ci.The matrix B of sensitivities of the hedging instruments to thesescenarios is

iBj = Bj (Ci)Bj (C0) .To avoid accidental colinearities between its rows or columns,one should always use more scenario than hedging instruments.



The vector of hedge ratios is calculated by minimizing

L () = 12B 2 + 1

2Q2.

Here, is an appropriately chosen small smoothness parameter,and Q is the smoothing operator. Explicitly,

=((B)

tB + QtQ

)1(B)

t.

One can think of the component j as the sensitivity of the portfolio tothe hedging instrument Bj . This method of calculating portfoliosensitivities is called the ridge regression.


Risk management: gamma

The gamma of a portfolio is sometimes calculated as its globalconvexity characteristic. This is a rather crude measure, as portfoliostypically exhibit complex convexity behaviors. A better way is toconstruct the portfolio gamma as the change in its delta underspecified macro scenarios:

0,1, . . . ,r,

with 0 base scenario (no change in rates). For example:+50 All rates up 50 basis points.+25 All rates up 25 basis points.25 All rates down 25 basis points.50 All rates down 50 basis points.


Risk management: gamma

For each of the macro scenarios, we calculate the deltas

1, . . . ,r.

The quantities:

1 = 1 0,.

.

.

r = r 0,

are the portfolio gammas under the corresponding scenarios. Forintermediate market moves, the portfolio gamma can be calculated bylinearly interpolating the macro scenarios.


Risk management: vega

In order to quantify the vega risk we have to first design appropriatevolatility scenarios.

Perturb vol inputs. Shift selected swaption and/or capvolatilities.

Perturb internal parameters. As explained before, LMM buildsits internal volatility surface S. We construct volatility microscenarios by accessing S and shifting selected non-overlappingsegments. Let us call these scenarios

S0,S1, . . . ,Sq,

with S0 = S being the base scenario.


Risk management: vega

We choose a hedging portfolio hedge which may consist of liquidinstruments such as swaptions, caps and floors, Eurodollaroptions, or other instruments (Bermudan options?).The rest is a verbatim repeat of the delta story. We calculate thesensitivities of the portfolio to the volatility scenarios. Wecalculate the sensitivities of the hedging portfolio to the volatilityscenarios. Finally, we use ridge regression to find the hedgeratios.

This method of managing the vega risk works remarkably well andallows one, in particular, to separate the exposure to swaptions fromthe exposure to caps / floors.


head {Overview}head {Overview}head {Dynamics of LMM}head {Dynamics of LMM}head {Dynamics of LMM}head {Dynamics of LMM}head {Dynamics of LMM}head {Dynamics of LMM}head {Dynamics of LMM}head {Factor reduction}head {Factor reduction}head {Factor reduction}head {Low noise expansion}head {Low noise expansion}head {Low noise expansion}head {Optimization and Tikhonov regularization}head {Vanilla system}head {Stripping cap volatility}head {Stripping cap volatility}head {Approximate valuation of swaptions}head {Approximate valuation of swaptions}head {Approximate valuation of swaptions}head {Approximate valuation of swaptions}head {Approximate valuation of swaptions}head {Approximate valuation of swaptions}head {Approximate valuation of swaptions}head {Structure of instantaneous correlations}head {Structure of instantaneous correlations}head {Parametrization of instantaneous volatilities}head {Parametrization of instantaneous volatilities}head {Parametrization of instantaneous volatilities}head {Parametrization of instantaneous volatilities}head {Parametrization of instantaneous volatilities}head {Parametrization of instantaneous volatilities}head {Parametrization of instantaneous volatilities}head {Least square optimization}head {Least square optimization}head {Least square optimization}head {Approximation schemes for LMM}head {Approximation schemes for LMM}head {Approximation schemes for LMM}head {Approximation schemes for LMM}head {Approximation schemes for LMM}head {Computing the drift terms}head {Computing the drift terms}head {Computing the drift terms}head {Computing the drift terms}head {Valuation of non-callable securities}head {Valuation of Bermudan options}head {Valuation of Bermudan options}head {Valuation of Bermudan options}head {Valuation of Bermudan options}head {Valuation of Bermudan options}head {Valuation of Bermudan options}head {Valuation of Bermudan options}head {Valuation of Bermudan options}head {Valuation of Bermudan options}head {Valuation of Bermudan options}head {Securities with uncertain horizons}head {Securities with uncertain horizons}head {Securities with uncertain horizons}head {Securities with uncertain horizons}head {Securities with uncertain horizons}head {LMM and the SABR model}head {LMM and the SABR model}head {LMM and the SABR model}head {LMM and the SABR model}head {Risk management: delta}head {Risk management: delta}head {Risk management: delta}head {Risk management: gamma}head {Risk management: gamma}head {Risk management: vega}head {Risk management: vega}

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