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Swap pricing after the Lehman collapse & Continous rate models Christian Heggen, Nordea Markets

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Page 1: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Swap pricing after the Lehman

collapse &

Continous rate models Christian Heggen, Nordea Markets

Page 2: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

LIBOR

Page 3: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

How to calculate LIBOR payments

22,472.88360

91035,0000.000.10

360

actLNotR

LIBOR is quoted on an act/360 – basis. I.e. One

assumes 360 days in a year, but interest rates are paid

on actual days…

1, 3, 6, 9 eller 12 mnd

2 days

Interest rate

period LIBOR fixing

IR are paid

Page 4: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Basic swap pricing

%0.2%991.1

360

1820185.01

360

911

360

91017.01

),(),(1),(),(1),(),(1 313132322121

x

x

ttttLttttLttttL

• You have bought a house and you have been granted a mortgage in

a bank

• When you go to collect the mortgage and sign the papers, you are

given the opportunity to choose between 3 mths or 6mhts fixed rate

in the first period

• 3mths: 1.70

• 6mths: 1.85

• What do you choose? (and how should you think?)

Page 5: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Forward rates in USD and NOK

-

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

4.50

5.00

0 1.25 2.5 3.75 5 6.25 7.5 8.75 10 11.25 12.5 13.75

NOK USD

Page 6: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Loan in combination with an IRS

Company

Loan

Loan

agreement

IRS

Fixed rate

3 m Libor

3 m Libor

+ cm

Company pay 3mth Libor + cm (loan)

Company pay Fixed rate (IRS)

Company receive 3mth Libor (IRS)

Company pay Fixed rate + cm

Page 7: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

IRS in combination with a bond issue

Company

Bond

Loan

agreement

IRS

6m LIBOR+cm

Fixed coupon

Fixed

coupon

Company pay Coupon (Bond)

Company pay 6mL+cm (IRS)

Company receive Coupon (IRS)

Company pay 6mL + cm

Page 8: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Cross Currency swap

• Start (spot) • Maturity

Company Company

X

(EUR)

X*S

(USD)

S=FX spot rate

X=Notional

X

(EUR)

X*S

(USD)

• During the term

Company

EUR

3M

LIBOR

+/- B

USD

3M

LIBOR

EUR

3M

LIBOR

+/- B

USD

3M

LIBOR

B is the price of the currency swap

• Company can fund itself in USD but needs EUR

• Company delivers USD to Nordea in exchange of EUR in a currency swap

• Company pays EURIBOR to Nordea and recives LIBOR in currency swap

• At maturity the notionals are reversed at initial exchange rate

• A currency swap is basically an exchange of loans in different currencies

Page 9: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Credit Support Annex (CSA)

• A CSA is an agreement that regulates the maximum credit exposure between

two derivative counterparties

• If the mtm of the portfolio party A has against party B is negative, then party B

has implicitely granted party A a loan

• Under banking regulations, party B must then hold capital against credit losses

in case party A defaults before it has paid off the mtm of the derivatives

• In order to minimize the capital usage, party A can post collateral to party B in

order to reduce the credit risk party B bears

• How the collateral is calculated and posted is regulated in a CSA agreement

• Parameters in the agreement:

• Threshold

• Frequency of posting collateral

Page 10: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Agenda

The fundamental assumptions used when pricing up interest rate derivatives have

changed dramatically over the last years resulting in new methods for constructing

rate curves. This presentation describes the changes that have happened in the

market and the new interest rate curves needed to cope with the new market

situation.

• Brief historic overview → What happened to the market?

• How must curves be changed to adapt the new market conditions?

• Curve design in Nordea, before and after the crisis, focus on basis swaps.

Page 11: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Basic swap pricing

),(),(1),(),(1),(),(1 313132322121 ttttLttttLttttL

• Forward rates can be calculated using bootstrapping

• Discounting on forward rates

)(1)(),(),(1

11 m

m

i

iiiflii tDtDttttL

Page 12: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Standard yield curves, pre crisis

• It was plausible to construct one yield curve for pricing of all derivatives. Swap rates had next to

no dependency on the floating rate index. The reason for this was that the credit and liquidity

premium on 6m rates over 3m rates was negligible.

• The various indices were assumed to be risk-free. Forecasting of any index and discounting

could be done on the same curve which represented the risk-free “time value of money”.

• A yield curve could therefore be constructed from a number of liquid different instruments

although these were linked to different indices. Example: deposits of various lengths, FRAs /

FUTs (typically 3m) and swaps (typically 6m).

• The value of collateral agreements (CSAs) were disregarded.

2.0

2.5

3.0

3.5

4.0

4.5

0 5 10 15 20 25 30

Tenor

Sw

ap

ra

te

EONIA 3M 6M

Example of pre-crisis EUR rates

(02-01-2007)

Page 13: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Crisis Start!

),(),(1),(),(1),(),(1 313132322121 ttttLttttLttttL

• Banks realize that they can loose money when lending to each other,

even the biggest players may go bust (Lehman Brothers).

• The longer the deposit time, the higher the credit add-on.

)(1)(),(),(1

11 m

m

i

iiiflii tDtDttttL

Page 14: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

The development of the 3v6 basis

0.0

1.0

2.0

3.0

4.0

5.0

6.0

Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10

%

0

10

20

30

40

50

60

Bp

3m EURIBOR 6m EURIBOR 3m3m FRA 3m6m basis (ra)

Pre credit crisis

Lehmann collapse

),()),((1),(),(1),(),(1 313132322121 ttBSttLttttLttttL

Page 15: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Post crisis, the standard yield curves break down

• Swaps linked against different indices trade with a significant basis, indicating that:

• Multiple curves representing different indices are needed.

• All instruments on one curve must be linked to the same index in order for the curve to be

consistent.

• Forecasting and discounting cannot always be done on the same curve.

• The value of CSAs are now being taken into account in derivatives pricing.

Example of post-crisis EUR rates

(06-09-2010)

0.5

1.0

1.5

2.0

2.5

3.0

0 5 10 15 20 25 30

Tenor

Sw

ap

ra

te

EONIA 1M 3M 6M

Page 16: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Four major changes due to the crisis

1. Forward curves are split up

2. Discount- and forward-curves separate

3. Discounting depends on the collateral

4. Forward rates are “OIS-based”

Page 17: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Crisis change 1 - forward curves are split up

• After the crisis trades against different indices

have different prices where they used to be the

same, e.g. the 3m vs. 6m Euribor spread used to

be zero’ish.

• Any pricing setup must incorporate this such that

the forecasting of future fixings is correct, i.e.

forward rate curves must be tenor dependent.

Before Crisis

All Euribor indices

on one forward

curve

After Crisis

Separate forward

curves for different

Euribor indices

Page 18: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Crisis change 2 – discount- and forward-curves separate

• In order to avoid arbitrage, all trades must be discounted on the

curve that most correctly reflect the time value of money.

• This means that forecasting and discounting are different for some

trades. A curve setup that allows for different forecast and

discounting curves is necessary: Two-Curves.

• The correct discount curve to use for non-collateralized trades is the

funding curve of any bank, but for practical reasons a Libor curve is

often used.

Before Crisis

One Euribor curve

After Crisis

Forecasting on one curve

– discounting on another.

Page 19: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Crisis change 3a – discounting depends on the collateral

• A collateral agreements will produce extra cash-flows

associated with a trade.

• The extra cash-flows can be seen as an “ad-on-trade”

to the actual trade.

• The extra cash-flows basically change the funding

costs involved. If the collateral earns the overnight rate

the trade should therefore be discounted on a

overnight rate.

Trade

Collateral

agreement

Part A Part B

cash

NPV

cash

Interest

With collateral

Trade Part A Part B

cash

NPV

Without collateral

Funding

source

Interest

cash

𝐷𝐹(1 + 𝑂𝐼𝑆 ∆𝑇) = 1

𝐷𝐹 =1

1 + 𝑂𝐼𝑆 ∆𝑇

Alternative argument:

One EUR received in the future. If

the trade is fully collateralized, the

collateral must be equal to the NPV.

This grown at the OIS rate must be

equal to the future cash.

Page 20: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

OIS swaps

• An Overnight Indexed Swap “OIS” is a swap where the floating leg

compounds daily rates.

m

i

i

o

k

k

n

j

jijfixn tDdrtDttO1 11

1 )(1)1(1)(),(

Page 21: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Crisis change 3b – collateral discounting depends on currency

• The CSAs typically specify that collateral can

be posted in different currencies.

• Due to the cross currency basis spreads, the

value of the collateral depends on the

currency of the collateral.

• The correct rate to discount with is the

overnight rate plus the OIS basis spread (the

basis spread for a currency basis swap where

the floating legs exchanged are linked to the

OIS index).

• The OIS basis spread can be calculated from

“ordinary” basis swap discount curves

combined with OIS forward curves.

• A basis swap will always have at least one leg

where the collateral is in a different currency

than the payment currency.

Market

Trade

Collateral

agreement

Part A Part B

cash (EUR)

NPV (EUR)

cash USD

Interest (USD)

EUR trade with USD collateral

Pay cash USD

receive cash EUR

Receive USD interest

Pay EUR interest + basis spread

Basis swap

Page 22: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Crisis change 4 – Forward rates are “OIS-based”

• The interbank trades are almost always collateralized.

• Therefore, the observed market is collateralized.

• There can only be one correct forecast of the forward rate

for any given period, namely the implied forward rate

constructed with OIS discounting.

• When curves are constructed from swaps, which are OIS

discounted, the implied forward rates are different from

what they would be if the cash flows were discounted on

for example an Euribor curve.

Page 23: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Standard curve construction

• Choose a number of market observed instruments.

• Choose the basic object of the curve / the object in

which you want to do the interpolation – e.g. zero

coupon rates or forward rates. R(t).

• For each market observed instrument choose a time,

typically the latest payout of the instrument Tj .

• Choose an interpolation method – e.g. flat, linear, spline.

• Adjust the rates R(Tj) such that all instruments are

priced at par. There is one unique solution as long as all

market instruments contain different and non-

overlapping information and the set of {Ti} are chosen

wisely.

• The solution can be found either by bootstrapping or

global solving.

R

t

R(T1)

R(T2)

R(T3)

R(T4) R(T5)

Page 24: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Typical EUR curve, pre crisis

ON

TN

1W

2W

3W

1M

2M

3M

Mar2011F

Jun2011F

Sep2011F

Dec2011F

Mar2012F

Jun2012F

Sep2012F

Dec2012F

3Y

4Y

5Y

6Y

7Y

8Y

9Y

10Y

11Y

12Y

13Y

14Y

15Y

16Y

17Y

18Y

19Y

20Y

21Y

22Y

23Y

24Y

25Y

26Y

27Y

28Y

29Y

30Y

35Y

40Y

50Y

Deposits

1M, one month deposit

FRAs/FUTs

Jun2011F: June starting IMM-future

Swaps

10Y: 10Y swap using "correct" conventions

• Before the crisis, a standard yield curve could be

constructed from a number of different instruments

although these were linked to different indices.

Example: deposits of various lengths, FRAs / FUTs

(typically 3m) and swaps (typically 6m).

Page 25: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Curve construction with multiple curves

• For the forward and discount curve choose

instruments, interpolation object, interpolation

method and dates for curve points.

• Start by finding the solution for the discount curve.

This is done in the exact same way as the standard

curve.

• More than one discount curve may be constructed

to price trades under different collateral

agreements.

• Continue by finding the solution for the forward

curve. This is done by adjusting the points on the

forward curve until the instruments on the curve is

priced at par using the discount factors from the

discount curve.

• For advanced curve setups there may be multiple

forward curves that depend on each other. In such

cases all forward curves must be build together.

1d Fwd

1m Fwd

3m Fwd

6m Fwd

1y Fwd

OIS Disc

(1) Construct OIS disc curve.

(2) Use the OIS disc factors when

constructing all forward curves.

Page 26: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

EUR

"build as if the build-date was jan 1 2012"

OIS Disc Curve LIBOR Disc Curve Fwd Curves-Build from OIS Disc

BASE

Explanations / Examples 1d 3m 1d 1m 3m 6m 1y OIS Basis swaps Libor Basis swaps

Deposits ON ON ON RFR0M:1M RFR0M:3M RFR0M:6M RFR0M:12M

1M, one month deposit TN TN TN

FRAs/FUTs 1W 1W 1W

RFR0M:3M: 3M fixing 2w 2w 2w

Jun2011F: June starting IMM-future 3w 3w 3w

Swaps 1M 1M 1M

10Y: 10Y swap using "correct" conventions 2M 2M 2M 2M

Float spreads 3M 3M 3M 3M Mar2012F Mar2012:6M:3M Mar2012:12M:3M 3M 3M

4M 4M 4M

Fixed spreads 5M 5M 5M

Dec2011:6M:3M: IMM-dated spread 3v6, 6M long 6M 6M 6M 6M Jun2012F Jun2012:6M:3M Jun2012:12M:3M 6M 6M

5Y:6M: spot starting spread, 5Y long. 7M 7M 7M

Basis swaps 8M 8M 8M

9M 9M 9M 9M Sep2012F Sep2012:6M:3M Sep2012:12M:3M 9M 9M

Fx swaps 10M 10M 10M

11M 11M 11M

1Y 1Y 1Y 1Y Dec2012F Dec2012:6M:3M Dec2012:12M:3M 1Y 1Y

Mar2013F Mar2013:6M:3M Mar2013:12M:3M

18M 18M 18M 18M Jun2013F Jun2013:6M:3M Jun2013:12M:3M

Sep2013F Sep2013:6M:3M Sep2013:12M:3M

2Y 2Y 2Y 2Y Dec2013F Dec2013:6M:3M 2Y 2Y

Mar2014F Mar2014:6M:3M

Jun2014F

3Y 3Y 3Y 3Y:6M 3Y:6M 3Y 3Y:6M 3Y 3Y

4Y 4Y 4Y 4Y:6M 4Y:6M 4Y 4Y:6M 4Y 4Y

5Y 5Y 5Y 5Y:6M 5Y:6M 5Y 5Y:6M 5Y 5Y

6Y 6Y 6Y 6Y:6M 6Y:6M 6Y 6Y:6M 6Y 6Y

7Y 7Y 7Y 7Y:6M 7Y:6M 7Y 7Y:6M 7Y 7Y

8Y 8Y 8Y 8Y:6M 8Y:6M 8Y 8Y:6M 8Y 8Y

9Y 9Y 9Y 9Y:6M 9Y:6M 9Y 9Y:6M 9Y 9Y

10Y 10Y 10Y 10Y:6M 10Y:6M 10Y 10Y:6M 10Y 10Y

11Y 11Y 11Y 11Y:6M 11Y:6M 11Y 11Y:6M

12Y 12Y 12Y 12Y:6M 12Y:6M 12Y 12Y:6M 12Y 12Y

13Y 13Y 13Y 13Y:6M 13Y:6M 13Y 13Y:6M

14Y 14Y 14Y 14Y:6M 14Y:6M 14Y 14Y:6M

15Y 15Y 15Y 15Y:6M 15Y:6M 15Y 15Y:6M 15Y 15Y

16Y 16Y 16Y 16Y:6M 16Y:6M 16Y 16Y:6M

17Y 17Y 17Y 17Y:6M 17Y:6M 17Y 17Y:6M

18Y 18Y 18Y 18Y:6M 18Y:6M 18Y 18Y:6M

19Y 19Y 19Y 19Y:6M 19Y:6M 19Y 19Y:6M

20Y 20Y 20Y 20Y:6M 20Y:6M 20Y 20Y:6M 20Y 20Y

21Y 21Y 21Y 21Y:6M 21Y:6M 21Y 21Y:6M

22Y 22Y 22Y 22Y:6M 22Y:6M 22Y 22Y:6M

23Y 23Y 23Y 23Y:6M 23Y:6M 23Y 23Y:6M

24Y 24Y 24Y 24Y:6M 24Y:6M 24Y 24Y:6M

25Y 25Y 25Y 25Y:6M 25Y:6M 25Y 25Y:6M

26Y 26Y 26Y 26Y:6M 26Y:6M 26Y 26Y:6M

27Y 27Y 27Y 27Y:6M 27Y:6M 27Y 27Y:6M

28Y 28Y 28Y 28Y:6M 28Y:6M 28Y 28Y:6M

29Y 29Y 29Y 29Y:6M 29Y:6M 29Y 29Y:6M

30Y 30Y 30Y 30Y:6M 30Y:6M 30Y 30Y:6M 30Y 30Y

35Y 35Y 35Y 35Y:6M 35Y:6M 35Y 35Y:6M

40Y 40Y 40Y 40Y:6M 40Y:6M 40Y 40Y:6M

50Y 50Y 50Y 50Y:6M 50Y:6M 50Y 50Y:6M

Nordea EUR curve, post crisis

• Multiple forward curves

with consistent

instruments.

• Two discount curves

depending for pricing of

trades with and without

collateral.

Page 27: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

• Continous time interest rate models

• Short rate models

• Hull-White

• Libor Market Models

Page 28: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Introduction

• In Norway the general perception is that floating rate mortgages is the best in the

long run with the least risk

• In USA (and Denmark) the general perception is that fixed rate mortgages is the

best in the long run

• Why?

• One possible explanation is that fixed rate mortgages in USA can always be

refinanced at par

• Fixed rate mortgages in Norway have to be refinanced over par if rates have fallen

• How can banks in USA and Denmark offer fixed rate mortgages where the

borrower always can refinance at par?

Page 29: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Cap

1. fix 2.fix 3.fix 4.fix 5.fix 6.fix 7.fix 8.fix 1

1,5

2

2,5

3

3,5

4

4,5

5

No No Yes Yes No No No Yes Exercise

Option?

Cap:3,5 %

Page 30: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Cap - pricing

n

i

iiiii dNKdNFTDNotCap1

211,0

• Market practice is to price caps and floors with Black 76

• Hence market prices on caps and floors are quoted in volatility terms with the

assumption that one is using Black 76 to calculate the actual price

• All other parameters are assumed to be exogenous variables

• All intuition around option prices is gained and communicated with the

assumption that you are in a Black & Scholes world

• The price of a cap is therefore

• Where F is the forward rate starting at time i, K is the strike, D is the 0-coupon

bond maturing at time i+1 and delta is the time fraction for period i

Page 31: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Swaptions and Bermudas

• A Swaption is an option where the owner has the right but not the obligation to

pay fixed rate (payer swaption, call) or receive fixed rate (receiver swaption, put)

in an IRS at the maturity of the option period

• The market practice is to price swaptions using Black 76

• Note: A cap is the sum of options on forward rates while a swaption is an option

on the sum of forward rates

• Price of cap >= Price of swpation

• Why?

• In an American swaption the holder has the right to exercise the option any time

before expiry

n

i

ii dKNdNFTPHPayer1

2101,0

Page 32: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Swaptions and Bermudas

• In a Bermuda option, the holder has the right to exercise the option on specific

dates before expiry.

• The tenor on the underlying swap becomes shorter for each exercise

• Hence a 5 yrs Bermudan swaption is the sum of exercises:

• 0->5yrs swap, 1->4yrs swap, 2->3yrs swap, 3->2yrs swap, 4->1yr swap

• BUT each exercise contingent upon the latter not being exercised

• How to price such a swaption?

• Black & Scholes world?

• Sum of the values of each exercise

Page 33: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Short rate models – Hull White

• Models the short rate and the whole yield curve is decribed in terms of the

instantanious short rate

• The Hull White model is an Ohrnstein Uhlenbeck process

• It has a drift along the initial yield curve and a mean reversion back to the initial yield

curve at a rate a

• Zero coupon bonds (or discount factors) are described analytically as:

• Where:

tttt dWdtardr

trTtBeTtATtD

,,,

14

1,

,0

,0lnln 222

3

atataT

tt eeeta

FTtBtD

TDA

a

eTtB

tTa )(1),(

at

t ea

taFtFt

22

12

,0,0

Page 34: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Short rate models – Hull White

Page 35: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Dynamics in a H-W model

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

4.00%

4.50%

0.2

5

0.5

0.7

5 1

1.2

5

1.5

1.7

5 2

2.2

5

2.5

2.7

5 3

3.2

5

3.5

3.7

5 4

4.2

5

4.5

4.7

5 5

Initial forward curve One path for r Remaining forward curve

Page 36: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Short rate models – Hull White

• The Hull White model can be solved analytically for caps (and swpations)

• This makes it easy to calibrate the model to market observed option prices

• When the model is calibrated to the market, one can price more complex

structures

• Note:

• Cannot calibrate to swaptions and caps simultaniously

• May be large errors on some caplets due to low number of parameters

],1,[1

1 iii

n

i

i

Pii hNTtDKhNTtDNotCap

ii

ii

P TTBa

aT,

2

2exp11

1

2),0(

),0(ln

1 1

i

P

i

i

i

P

iTDK

TDNoth

Page 37: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Short rate models – Hull White

• Pros

• Markov property – possible to implement in tree or PDE

• Ensures fast and accurate pricing and hedging

• Fast Monte Carlo simulation

• Easy to implement and easy to calibrate due to closed form solutions for swaptions

and caps/floors

• Cons

• Parameters not intuitive as caps/floors and swaptions priced with B & S

• Not possible to calibrate to caps/floors and swaptions simultaniously

• No yield curve dynamics

• Not possible to obtain forward volatilites or correlations

• Normal distribution of the short rate gives a positive probability of negative rates

Page 38: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

LIBOR market model (BGM)

• Since a and σ in the HW model have a difficult intuitive interpretation, market

practitioners have been asking for a new and more intutitive model

• The market has been pricing caps with B&S for years:

• 𝐶𝑎𝑝𝑙𝑒𝑡 = 𝐸 exp (− 𝑟𝑡𝑑𝑡)𝑇

0∆ 𝐿 𝑆, 𝑇 − 𝐾 + =D 0, 𝑇 𝐸𝑄 ∆ 𝐹 𝑆; 𝑆, 𝑇 − 𝐾 +

• With a lognormal distribution for F. The dynamics of F(t;S,T) under the measure

associated with D(t,T) is chosen as:

• Where v is the instantanious volatility and W is a standard Brownian motion

under the Q(T) measure.

Q

tdWTStvFTStdF ),;(),;(

Page 39: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

LIBOR market model (BGM)

• Let B be the discretely balanced bank account when investing 1 at time 0

• Choose B as numeraire and use Girsanov’s theorem starting from the dynamics

𝑑𝐹𝑘 = 𝜎𝑘𝐹𝑘𝑑𝑊𝑘 under 𝑄𝑘 to obtain the dynamics under B

• The measure 𝑄𝐵 associated with B is called the spot LIBOR measure. Then we

have the following:

k

tj

B

kkk

jj

jjkjj

kkk tdWtFtdttF

tFttFttdF

)(

,)()()(

)(1

)()(

Page 40: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Libor Market Model (BGM)

• The LMM for F’s allows for:

• Immidiate and intuitive calibration of caplets (better than any short rate models)

• Easy calibration to swaptions through algebraic approximation (better than most short

rate models)

• Can virtually calibrate a high number of market products exactly or with a precision

impossible to short rate models

• Clear correlation parameters since these are instantatious correlations of forward rates

• Powerful diagnostics: can check future volatility and terminal correlations strucutres

• Can be used for Monte Carlo simulation

• High dimensionality (many F’s are evolving jointly)

• Unknown joint distribution of the F’s (although each is lognormal under its canonical

measure)

• Difficult to use with PDEs or trees, but «recent» Monte Carlo approaches such as

Least Square MC make trees and PDEs less necessary

Page 41: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

How do we choose between models?

• The picture below shows yield curves from 2006 until today in NOK swaps

• We see three different shifts in the yield curves

• Parallell (absolute level)

• Tilt (upward or downward sloping)

• Curvature (convex or concave)

1

2

3

4

5

6

7

1 2 3 4 5 6 7 8 9 10

Page 42: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Bermudan swaption

• What are the underlying dynamics?

• The model of choice needs to be able to capture the dynamics of the 1->4 swap, the 2-

>3 swap …. For each exercise.

• Calibration to swaptions

• No exposure to cap prices

• Exposure to curvature or tilt in yield curve?

• A Berumdan is an option with an early exercise feature

• Easiest to price in a tree or with finite difference grid

• Points to a short – rate model

• Hull – White or the 2-factor HW model would be the prefered model

Page 43: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Autocap

• In a 5 year cap with 3mth LIBOR as underlying, there are 20 caplets

• 20 individual options to price

• Often a cap might seem expensive

• In a 5 year auto cap against 3mth LIBOR, the holder can choose how many

caplets he wants to buy. A caplet is automatically exercised if it is ITM at any

fixing (exercise) date.

• If LIBOR rises above the strike immidiately and stays there throughout the tenor of the

cap, the holder will exercise all caplets after the 10 first fixings and he will have no

protection against higher LIBOR for the last 2,5 years

• Clearly the price of the auto cap is less or equal to a regular cap

• But which model should one use to price an auto cap?

Page 44: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Auto cap

• Underlying dynamics?

• Only against LIBOR -> Calibration to caps

• No simultanious yield curve dynamics at exercise times

• Automatic exercise and start from time 0

• Forward simulation -> Monte Carlo

• Could use both LMM and HW

• HW is sufficient as there is no yield curve dynamics in the product

• Mean reversion parameter might be an issue

Page 45: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Knock – In swap

• A knock – in swap is an interest swap that comes to live if LIBOR breaches a

barrier

• Example: Tenor 5 years. If 3mth LIBOR breaks 3,50% then it knocks into a swap at

3,75% for the remaining maturity

• Product for liability managers who are exposed to rising LIBOR

• Which model to price and risk manage this product?

• Dynamics:

• Clearly exposure to LIBOR which calls for calibration to caps

• Exposure to correlation between LIBOR and the swap you get knocked into

• Automatic knock – in -> Forward simulation -> Monte Carlo model

• Exposure to different points on the yield curve simultaniously calls for a multi

factor model

Page 46: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Rate expectations in a historical perspective

46

0

1

2

3

4

5

6

7

04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 21 22

USD LIBOR 3m

Page 47: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

30y – 10y CMS spread range accrual

• The CMS Spread Range Accrual was originally an invstor product designed to

give investors a substantial pick-up in yield by taking a view on the shape of the

yield-curve. The product was usually structured as a note (bond).

• The payoff in the product was: 𝑃𝑎𝑦𝑜𝑓𝑓 = 10% ∙𝑛

𝑁∙30

360

• Where n=number of days CMS30-CMS10 > 0 and N is total number of days in period

• In many cases, the bank had the options to call the bond every year

• Which model should we choose?

• Need for a model which models the whole yield curve simultaniously

• One option to price every day in the structure (often 10 years) -> need for a fast model

• Preferably a model solved in a tree due to speed

• LMM first choice for pricing but very slow

• Multi dimensional short rate model a possibility but very difficult to estimate

parameters

• Model the spread directly

Page 48: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Nordea set – up

• Model development

• Nordea employs 10 model developers to continiously develop new models and

improve implementation

• Recent focus has been to adjust models for multi – curve set up

• E.g. Is the volatility on products priced against 3m LIBOR different from 6m

LIBOR?

• Model set – up

• All models are programmed in C++

• In-house scripting language for programming of pay – off structures and cash flows

gives great flexibility to price almost any option or swap

• Excel is used as GUI for developers and strucutrers

• All models added as functions in Excel

• Nordea has bought a 3rd party system and replaced all models with its own, but

kept the database and other functionalities

Page 49: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Linear Rate Linear rate instruments,

vanilla swaps etc.

Linear Inflation linear inflation

instruments, e.g.

inflation swaps.

Linear Credit

linear credit, e.g.

cds, correlation

credit products

cdo’s, n to default,

etc.

Stochastic Volatility

European options with

one underlying. E.g.

swaptions, caps, CMS’s,

arrears swaps, quantos,

Linear

Equity linear equity

instruments.

BGM model

Path dependent

interest rate

options, e.g.

bermudans,

ratchet, range

accruals, …

Cheyette model

Monte-Carlo and

finite difference

models. Path

dependent interest

rate options.

Equity model

Monte-Carlo jump

diffusion model for

European and

path dependent

equity

instruments.

Page 50: Swap pricing after the Lehman collapse & Continous …folk.uio.no/fredb/UiO_skolepresentasjon_2014.pdfSwap pricing after the Lehman collapse & Continous rate models Christian Heggen,

Thank you!

Nordea Markets is the name of the Markets departments of Nordea Bank Norge ASA, Nordea Bank AB (publ), Nordea Bank Finland Plc and Nordea Bank Danmark A/S.

The information provided herein is intended for background information only and for the sole use of the intended recipient. The views and other information provided herein are the

current views of Nordea Markets as of the date of this document and are subject to change without notice. This notice is not an exhaustive description of the described product or the

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