Simona Svoboda - Libor Market Model With Stochastic Volatility PDF

LIBOR Market Model with Stochastic Volatility.
First Year Transfer Report

Simona Svoboda
Magdalen College, University of Oxford
November, 2005
Contents
Introduction 1
Chapter 1. Forward LIBOR Market Model 2
1. Model set up 2
2. Martingale Dynamics 2
3. Change of Measure 3
4. Drift Specications 7
5. Relationship between Brownian Motions under adjacent forward probability measures 8
6. Spot LIBOR Measure Dynamics 9
7. Swap Rate 10
Appendix 14
Chapter 2. Covariance Structure 15
1. Structure of the Forward Rate Dynamics 15
2. Degrees of Freedom 17
3. The Interplay Between Volatilities and Correlations 17
4. Term Structure of Volatilities and the Instantaneous Volatility 19
5. Instantaneous Correlation Function 24
Chapter 3. Deviations From Lognormality 26
1. Caplet Prices and Lognormality 26
2. Deviation from Lognormality 26
3. The Smile in Equity vs. Interest Rate Market 26
4. Alternate Interest Rate Dynamics 27
5. Alternate ways to introduce smiles 32
Chapter 4. Stochastic Volatility Approach 34
1. Introduction 34
2. Modelling techniques 34
3. Uncorrelated Asset and Variance Processes 35
4. Andersen, Brotherton-Ratclie Approach 36
5. Piterbarg Approach 43
6. Joshi and Rebonato Formulation 48
Appendix 51
Chapter 5. Two-Regime Extension of the LMM 53
1. Swaption Matrix Dynamics 53
i
CONTENTS ii
2. Two-Regime Dynamics 53
3. Modelling Approaches 55
Chapter 6. Future Work 61
Bibliography 62
Introduction
The LIBOR market model has become one of the most promising frameworks for modelling interest
rates and pricing of interest rate derivatives. This model is often attributed to Brace, Gatarek and
Musiela (BGM) [8] who were one of the rst to publish this methodology. Early papers also include
those by Miltersen, Sandmann and Sondermann [39] and Jamshidian [32].
This modelling framework makes a break with previous approaches (see [59] for a comprehensive
study) which were based on the evolution of the continuously compounded short rate (e.g. Vasicek
[60], CIR [12] and Hull-White [29] models) or instantaneous forward rates (HJM [27] approach).
None of these models were consistent with the market practice of using Blacks [6] formula to price
caps and swaptions and were fairly cumbersome to calibrate to market observables.
The market convention of pricing caps and swaptions using the Black formula is based on an
application of the Black and Scholes [7] formula for stock options with some simplications and
assumptions about the distribution of the underlying interest rates i.e. that they are lognormally
distributed.
The LIBOR market model takes as its basic units, a set of spanning forward rates. Placing these
in a lognormal framework naturally leads to the Black cap formula for the pricing of interest rate
caps. Similarly, using a set of lognormally distributed spanning swap rates as the basic building
blocks leads to the Black formula for the pricing of swaptions.
Unfortunately the lognormal specication of forward LIBOR rates is incompatible with the simul-
taneous lognormal specication of swap rates. Allowing each forward LIBOR rate to be lognormal
under its own measure, means that swap rates cannot be lognormal at the same time, even if each
is specied under its own measure (and vice versa). In practice, the forward swap rates derived
within the lognormal forward LIBOR framework do not deviate far from lognormality and suitable
approximations exist to allow consistent pricing of caps and swaption.
I look rst at the lognormal forward LIBOR framework and then discuss how lognormal swap rates
can be incorporated within it.
1
CHAPTER 1
Forward LIBOR Market Model
1. Model set up
Consider a trading horizon [0, T
] and a set of times {T

k
; k [0, n], k N} such that
0 T
0
< T
k
< . . . < T
n
T
. We form pairs of expiry-maturity times (T

k
, T
k+1
), k 0,
for a set of spanning forward rates f
k
. Additionally, set
k
= T
k+1
T
k
to be the year fraction
representing the tenor of forward rate f
k
.
Dene the simple forward rate over period [T
k
, T
k+1
], f
k
, as:
(1.1) 1 +
k
f
k
(t) =
P(t, T
k
)
P(t, T
k+1
)
, k = 0, . . . , n 1,
where P(t, T
k
) is the time t value of a risk-free zero coupon bond maturing at time T
k
with nominal
1.
The original derivation by BGM of the LMM was done within the HJM framework, making use of the
HJM result that no-arbitrage conditions impose a structure on the drift of the forward rate process.
Once the forward rate volatilities are fully specied, so are the forward rate drifts. This derivation
is under the risk-neutral measure, with a bank account as numeraire. Under this measure, none
of the forward rates are lognormal and one needs to change to a forward measure, corresponding
to the payout time of each forward rate, to obtain martingale dynamics and hence pricing of caps
via the Black formula. There are some products, such as Eurodollar futures, which do require the
risk-neutral dynamics of forward rate (for example see Brigo and Mercurio [10] for an analysis). In
6 I derive the forward rate dynamics under this risk-neutral measure, the spot LIBOR measure,
using a discretely compounded money market account as numeraire.
Elsewhere I use the forward measure approach since it is a natural framework for pricing of cap and
swaption based derivatives which constitute the foundation of the exotic interest rate derivatives
market.
For the original derivation of the LMM see [8] and [41]. I have examined this derivation in detail
in [59].
2. Martingale Dynamics
From equation (1.1) we have:
f
k
(t)P(t, T
k+1
) = (P(t, T
k
) P(t, T
k+1
))/
k
.
Since the right hand side is the price of a traded asset (dierence between two zero coupon bonds,
each with nominal value
1
k
), the left hand side must also be a traded asset and hence its value,
expressed with respect to numeraire P(t, T
k+1
), must be a martingale under the appropriate proba-
bility measure. Let Q
k
be the measure associated with numeraire P(t, T
k+1
), under which forward
2
3. CHANGE OF MEASURE 3
rate f
k
(t) is a martingale, that is, it is driftless. Hence:
(2.1) df
k
(t) =
k
(t)f
k
(t)dW
k
k
(t), t < T
k
,
where
k
(t) is the time t instantaneous volatility of forward rate f
k
, W
k
k
(t) is the k
th
element of the
n dimensional column vector Brownian motion associated with measure Q
k
. The vector Brownian
motion has correlation matrix , that is dW
k
dW
k
= dt, with element
ij
being the correlation
between Brownian motions W
k
i
and W
k
j
.
Expressed in terms of any other numeraire (and hence probability measure) the LIBOR rate ceases
to be a martingale and acquires a drift directly determined by the chosen numeraire. To determine
the form of this drift adjustment for the LIBOR rate, I rst examine the generic numeraire change
methodology.
3. Change of Measure
Consider an n-vector of assets X
t
with dynamics under probability measure Q
S
(probability measure
corresponding to numeraire S) dened by
1
:
(3.1) dX
t
=
S
t
(X
t
)dt +
t
(X
t
)CdZ
S
t
,
with
2
S
t
an (n 1) vector of instantaneous drifts,
t
an (n n) diagonal matrix of instantaneous volatilities,
Z
S
an n-dimensional standard Brownian motion under measure Q
S
,
C an (n n) matrix, such that CC
= is the instantaneous correlation matrix. That is

CdZ may be interpreted as an n-dimensional Brownian motion with correlation matrix .
We wish to express the dynamics of X
t
under probability measure Q
U
. The diusion coecient
remains unchanged under a change of measure, hence the dynamics take the form:
(3.2) dX
t
=
U
t
(X
t
)dt +
t
(X
t
)CdZ
U
t
,
with
U
t
as yet undetermined.
We use the Girsanov Theorem to dene the new measure and its associated dynamics.
1
Here, I follow the treatment in Brigo and Mercurio [10].
2
I acknowledge the somewhat inconsistent use of notation depicting time dependence, subscript and explicit
functional dependence on t (
t
(t)) are equivalent. This is done to ease the burden of notation.
Girsanov Theorem. Let Z
P
be an n-dimensional standard Brownian motion on the prob-
ability space (, F, P). Also let be any n-dimensional adapted column vector process. With T
xed we dene the process as:
(3.3)
t
= exp
_
1
2
_
t
0
|
s
|
2
ds +
_
t
0
s
dZ
P
s
_
.
Assume that
3
:
E
P
_
exp
_
1
2
_
T
0
|
t
|
2
dt
__
< ,
and dene a new probability measure Q on F
T
such that:
T
=
dQ
dP
.
Then Q is equivalent to P and Z
Q
, a new Q-Brownian motion, is dened as:
(3.4) dZ
Q
t
= dZ
P
t

t
dt.
The function
t
is known as the Radon-Nikodym derivative.
Returning to equation (3.1) we have:
dX
t
=
S
t
(X
t
)dt +
t
(X
t
)CdZ
S
t
=
U
t
(X
t
)dt +
t
(X
t
)CdZ
S
t
+
S
t
(X
t
)dt
U
t
(X
t
)dt
=
U
t
(X
t
)dt +
t
(X
t
)C
_
dZ
S
t
(
t
(X
t
)C)
1
_
U
t
(X
t
)
S
t
(X
t
)
_
dt
_
=
U
t
(X
t
)dt +
t
(X
t
)CdZ
U
t
where:
dZ
U
t
= dZ
S
t
(
t
(X
t
)C)
1
_
U
t
(X
t
)
S
t
(X
t
)
_
dt,
and by the Girsanov Theorem above, Z
U
t
is an n-dimensional Brownian motion under the equivalent
measure Q
U
.
Set
(3.5)
t
= (
t
(X
t
)C)
1
_
U
t
(X
t
)
S
t
(X
t
)
_
,
then the equivalent probability measure Q
U
is dened by its Radon-Nikodym derivative with respect
to Q
S
as:
(3.6)
t
=
dQ
U
dQ
S
F
t
= exp
_
1
2
_
t
0
|
s
|
2
ds +
_
t
0
s
dZ
S
s
_
.
By (3.6) is an exponential martingale under measure Q
S
and hence its dynamics are of the form:
(3.7) d
t
=
t
dZ
S
t
.
Geman et. al. (1995) [24] provide an invaluable tool for derivatives pricing by specifying the
Radon-Nikodym derivative in terms of the associated numeraires as:
(3.8)
dQ
U
dQ
S
=
U
T
S
0
U
0
S
T
,
3
This is the Novikov Condition (e.g. see [5]) which ensures is a martingale and E
P
[
T
] = 1.
hence:
(3.9)
T
=
dQ
U
dQ
S
F
T
=
U
T
S
0
U
0
S
T
.
But, since is a Q
S
martingale we have:
t
= E
Q
S
t
[
T
] = E
Q
S
t
_
U
T
S
0
U
0
S
T
_
=
U
t
S
0
U
0
S
t
, (3.10)
d
t
=
S
0
U
0
d
_
U
t
S
t
_
=
S
0
U
0
U/S
t
CdZ
S
t
(3.11)
since U/S is a martingale
4
under measure Q
S
.
Comparing (3.7) and (3.11) and making use of (3.10) and the denition of
t
, we derive
U
t
, the
drift under the new probability measure, Q
U
, as:
t
=
S
0
U
0
U/S
t
C
t
U
t
S
t
=
U/S
t
C
_
U
t
(X
t
)
S
t
(X
t
)
_
_
(
t
(X
t
)C)
1
_
U
t
S
t
=
U/S
t
C
_
U
t
(X
t
)
S
t
(X
t
)
_
=
S
t
U
t
U/S
t
CC
t
(X
t
)
U
t
(X
t
) =
S
t
(X
t
) +
S
t
U
t
t
(X
t
)
_
U/S
t
_
. (3.12)
All that remains is to determine
U/S
t
, the instantaneous volatility of the asset U/S. We assume
the two numeraire assets have dynamics
5
:
dS
t
= (. . .) dt +
S
t
CdZ
S
t
,
dU
t
= (. . .) dt +
U
t
CdZ
S
t
.
By the rules of stochastic dierentiation we have:
d
_
U
t
S
t
_
=
dU
t
S
t
+U
t
d
_
1
S
t
_
+dU
t
d
_
1
S
t
_
,
and by Itos Formula:
d
_
1
S
t
_
=
dS
t
S
2
t
+
1
S
3
t
dS
t
dS
t
= (. . .) dt

S
t
S
2
t
CdZ
S
t
,
4
An asset (U) in terms of its numeraire (S) is a martingale under the associated measure.
5
The dynamics are shown under measure Q
S
. However any equivalent measure could be used, since we are only
interested in the diusion coecient, which remains unchanged under change of measure.
hence:
d
_
U
t
S
t
_
= (. . .) dt +

U
t
S
t
CdZ
S
t

U
t
S
t
S
2
t
CdZ
S
t
= (. . .) dt +
_
U
t
S
t
U
t
S
t
S
t
S
t
_
CdZ
S
t
,
U/S
t
=

U
t
S
t
U
t
S
t
S
t
S
t
.
Substituting into (3.12) gives the nal form of the new drift coecient:
U
t
(X
t
) =
S
t
(X
t
) +
S
t
U
t
t
(X
t
)
_
U
t
S
t
U
t
S
t
S
t
S
t
_
=
S
t
(X
t
) +
t
(X
t
)
_
U
t
U
t

S
t
S
t
_
. (3.13)
Allowing the process for X to be fully lognormal under measure Q
S
, the drift and diusion coecient
take the form:
S
t
(X
t
) = diag(X
t
) m
S
t
,
t
(X
t
) = diag(X
t
) diag(v
X
t
),
where:
m
S
t
an (n 1) vector of instantaneous lognormal drift coecients,
diag(v
X
t
) an (n n) matrix with instantaneous lognormal volatility coecients along the
diagonal and zeros elsewhere,
diag(X
t
) an (n n) matrix with the elements of X
t
along the diagonal and zeros elsewhere.
Consequently equation (3.13) may be expressed as:
U
t
(X
t
) = diag(X
t
) m
S
t
+ diag(X
t
) diag(v
X
t
)
_
U
t
U
t

S
t
S
t
_
U
t
(X
t
) dt = diag(X
t
) m
S
t
dt + diag(X
t
) d lnX
t
(d lnU
t
d lnS
t
)
= diag(X
t
)
_
m
S
t
dt +d lnX
t
(d lnU
t
/S
t
)
_
,
hence X
t
remains fully lognormal under Q
U
and its drift takes the form
U
t
(X
t
) = diag(X
t
) m
U
t
with:
(3.14) m
U
t
dt = m
S
t
dt +d lnX
t
(d lnU
t
/S
t
)
.
No assumptions have been made about the processes followed by the two numeraires, S and U. If
S and U follow lognormal processes, then starting with deterministic drift m
S
t
, the resulting drift
m
U
t
will also be deterministic. For the case of more general processes describing the evolution of S
and U, a deterministic drift m
S
t
will give rise to a stochastic drift m
U
t
(since d lnX
t
(d lnU
t
/S
t
)
will
be a function of U
t
and S
t
.)
4. DRIFT SPECIFICATIONS 7
4. Drift Specications
As specied in (2.1), f
k
(t) is a martingale under measure Q
k
with associated numeraire P(t, T
k+1
),
hence:
(4.1) df
k
(t) =
k
(t)f
k
(t)dW
k
k
(t), t < T
k
.
To derive the dynamics under forward measure Q
i
, i < k (associated with numeraire P(t, T
i+1
)) we
apply (3.14) with
6
:
X
t
f
k
(t) = f(t, T
k
, T
k+1
),
S
t
P(t, T
k+1
),
U
t
P(t, T
i+1
),
hence:
m
S
t
m
k
k
(t) = 0; since f
k
(t) is driftless under Q
k
,
d lnX
t
d lnf
k
(t) = (. . .) dt +
k
(t)dW
k
k
(t),
d lnU/S d ln
_
P(t, T
i+1
)
P(t, T
k+1
)
_
,
By the denition of a zero-coupon bond price in terms of the discretely compounded forward rates,
we have:
ln
_
P(t, T
i+1
)
P(t, T
k+1
)
_
= ln
_
_
k
j=i+1
(1 +
j
f
j
(t))
_
_
=
k
j=i+1
ln(1 +
j
f
j
(t)).
So (3.14) becomes:
m
i
k
(t) dt = m
k
k
(t) dt +d lnf
k
(t)
_
d ln
_
P(t, T
i+1
)
P(t, T
k+1
)
__
=
k
j=i+1
d lnf
k
(t) d ln(1 +
j
f
j
(t))
=
k
j=i+1
j
1 +
j
f
j
(t)
d lnf
k
(t) df
j
(t)
=
k
j=i+1
j
f
j
(t)
j
(t)
k
(t)
jk
1 +
j
f
j
(t)
dt, t T
i+1
. (4.2)
Similarly, the dynamics under forward measure Q
i
, i > k are derived as follows:
ln
_
P(t, T
i+1
)
P(t, T
k+1
)
_
= ln
_
_
i
j=k+1
1
1 +
j
f
j
(t)
_
_
=
i
j=k+1
ln(1 +
j
f
j
(t)),
6
Here we reduce the asset vector process X
t
to a scalar valued process, being its k
th
element, the forward rate
f
k
(t) with reset time T
k
.
5. RELATIONSHIP BETWEEN BROWNIAN MOTIONS UNDER ADJACENT FORWARD PROBABILITY MEASURES8
and so:
m
i
k
(t) dt =
i
j=k+1
d lnf
k
(t) d ln(1 +
j
f
j
(t))
=
i
j=k+1
j
f
j
(t)
j
(t)
k
(t)
jk
1 +
j
f
j
(t)
dt, t T
k
. (4.3)
In summary, from (4.1), (4.2) and (4.3), the dynamics of f
k
(t) under the forward measure Q
i
with
associated numeraire P(t, T
i+1
), for t min(T
i+1
, T
k
) are:
df
k
(t) = m
i
k
(t)f
k
(t)dt +
k
(t)f
k
(t)dW
i
k
(t),
with
m
i
k
(t) =
k
j=i+1
j
f
j
(t)
j
(t)
k
(t)
jk
1 +
j
f
j
(t)
, i < k;
m
i
k
(t) = 0, i = k;
m
i
k
(t) =
i
j=k+1
j
f
j
(t)
j
(t)
k
(t)
jk
1 +
j
f
j
(t)
, i > k.
5. Relationship between Brownian Motions under adjacent forward probability
measures
By the Girsanov Theorem we have:
(5.1) CdZ
U
(t) = CdZ
S
(t) C
t
dt,
where Z
S
(t) and Z
U
(t) are Brownian motions under equivalent probability measures Q
S
and Q
U
respectively and
t
is dened in (3.5) as:
t
= (
t
(X
t
)C)
1
_
U
t
(X
t
)
S
t
(X
t
)
_
.
For lognormal asset X
t
we have:
t
dt =
_
diag(X
t
) diag(v
X
t
) C
_
1
diag(X
t
)(m
U
t
m
S
t
) dt
=
_
diag(v
X
t
) C
_
1
d lnX
t
(d lnU
t
/S
t
)
,
which follows from (3.14), and so:
CdZ
U
(t) = CdZ
S
(t) C
_
diag(v
X
t
) C
_
1
d lnX
t
(d lnU
t
/S
t
)
= CdZ
S
(t) diag(v
X
t
)
1
d lnX
t
(d lnU
t
/S
t
)
.
Applying this to the LMM case, CdZ
U
(t) dW
k+1
(t) and CdZ
S
(t) dW
k
(t) with correlation
7
matrix . Here, the asset vector X
t
, is reduced to a 1-dimensional asset, being its k
th
element f
k
(t),
7
dZ
U
(t) and dZ
S
(t) are standard Brownian motion vectors, premultiplication by C imposes the required corre-
lation structure, while dW
k+1
(t) and dW
k
(t) are specied as correlated Brownian motions.
6. SPOT LIBOR MEASURE DYNAMICS 9
and hence:
dW
k+1
k
(t) = dW
k
k
(t)
k
(t)
1
d lnf
k
(t)
_
d ln
P(t, T
k+2
)
P(t, T
k+1
)
_
= dW
k
k
(t) +
k
(t)
1
d lnf
k
(t) d ln(1 +
k+1
f
k+1
(t))
= dW
k
k
(t) +

k+1
k
(t)
1
1 +
k+1
f
k+1
(t)
d lnf
k
(t) df
k+1
(t)
= dW
k
k
(t) +

k+1
f
k+1
(t)
1 +
k+1
f
k+1
(t)

k+1
(t)
kk+1
dt.
The above specication allows some observations. The drift adjustment is a function of the forward
rate with natural payo at the maturity of the numeraire associated with the new probability
measure, but also the correlation between forward rates with natural payos at the maturity times of
the old and new numeraires. For non-adjacent forward measures, the drift adjustment is a function of
all forward rates spanning the interval between them, hence the further apart the forward measures,
the greater the drift adjustment.
6. Spot LIBOR Measure Dynamics
The numeraire associated with the risk-neutral measure is the continuously rebalanced bank account
B(t) dened in terms of the instantaneous short rate as:
B(t) = exp
__
t
0
r(s)ds
_
, dB(t) = r(t)B(t)dt.
This continuously rebalanced numeraire does not t naturally into the set-up of the LMM, as dened
in 1, where we have a preassigned maturity and tenor structure. Instead, we introduce a discretely
rebalanced bank account, where rebalancing only takes place at the predened maturity dates.
Dene (t) such that T
(t)1
t < T
(t)
, then the discretely rebalanced bank account is dened as:
(6.1)

B(t) =
P(t, T
(t)
)
(t)1
j=0
P(T
j
, T
j+1
)
= P(t, T
(t)
)
(t)1
j=0
(1 +
j
f
j
(T
j
)).
At each time T
j
, starting at T
0
= 0, the bank account accrues interest at the currently resetting
forward rate f
j
(T
j
), paying at T
j+1
(once reset, this forward rate becomes the tenor
j
spot rate).
The accrued amount is then reinvested at the forward rate resetting at that time, f
j+1
(T
j+1
) and
so on. The nal rate f
(t)1
((t) 1) pays out at time T
(t)
> t, hence the nal discounting term
P(t, T
(t)
) gives the time t bank account value.
We determine the drift of f
k
under the spot LIBOR measure using (3.14) and the Q
k
forward
measure lognormal martingale dynamics in (2.1). Hence:
(6.2) m
k
(t)dt = m
k
k
(t)dt +d lnf
k
(t)(d ln

B(t)/P(t, T
k
)),
where m
k
(t) is the drift coecient under the spot measure

Q; m
k
k
(t) = 0, since the forward rate is
driftless under forward measure Q
k
;

B(t) and P(t, T
k
) are the numeraires associated with the spot
and forward measures respectively.
7. SWAP RATE 10
In terms of forward rates, P(t, T
k
) is dened as:
P(t, T
k
) = P(t, T
(t)
)
k1
j=(t)
1
1 +
j
f
j
(t)
,
hence using the denition of

B(t) in (6.1), we have:
ln

B(t)/P(t, T
k
) = ln
_
_
(t)1
j=0
(1 +
j
f
j
(T
j
))
k1
j=(t)
1
1+
j
f
j
(t)
_
_
= ln
_
_
(t)1
j=0
(1 +
j
f
j
(T
j
))
k1
j=(t)
(1 +
j
f
j
(t))
_
_
=
(t)1
j=0
ln(1 +
j
f
j
(T
j
)) +
k1
j=(t)
ln(1 +
j
f
j
(t)).
Hence
m
k
(t) dt = d lnf
k
(t)
_
d ln

B(t)/P(t, T
k
)
_
=
k1
j=(t)
d lnf
k
(t) (d ln(1 +
j
f
j
(t)))
=
k1
j=(t)
j
1 +
j
f
j
(t)
d lnf
k
(t) df
j
(t)
=
k1
j=(t)
j
1 +
j
f
j
(t)
f
j
(t)
j
(t)
k
(t)
jk
dt,
and the forward rate dynamics under the spot LIBOR measure are:
(6.3) df
k
(t) = f
k
(t)
k1
j=(t)
j
f
j
(t)
j
(t)
k
(t)
jk
1 +
j
f
j
(t)
dt +
k
(t)f
k
(t)d
W
k
(t),
where d
W
k
(t) is a Brownian motion under the spot LIBOR measure

Q.
7. Swap Rate
7.1. Denition. An interest rate swap is a contract to exchange a series of oating interest
payments in return for a series of xed rate payments. Hence, consider a series of payment dates
between T
+1
and T
, > . The xed leg of the swap pays

j
K at each time T
j+1
, j = , , 1
where
j
= T
j+1
T
j
. In return, the oating leg pays
j
f
j
(T
j
) at time T
j+1
where f
j
(T
j
) is the
tenor
j
rate, set at time T
j
for payment T
j+1
. Hence given the set of forward rate reset dates
T
j
, j = , , 1 and the series of payment dates T
j
, j = + 1, , , the time t, t T
value
7. SWAP RATE 11
of the interest rate swap is
8
:
1
j=
P(t, T
j+1
)
j
(f
j
(t) K) .
The par/fair forward swap rate S
,
(t) is the value of the xed rate K, such that the present value
of the contract is zero, hence:
(7.1) S
,
(t) =
1
j=
P(t, T
j+1
)
j
f
j
(t)
1
j=
P(t, T
j+1
)
j
=
P(t, T
) P(t, T
1
j=
P(t, T
j+1
)
j
,
where the second equality is due to the denition of the forward rate f
j
(t) in (1.1).
7.2. Dynamics. As mentioned in the introduction, the market convention is to price swaptions
by means of the Black formula. This implies the assumption that swap rates are driven by lognormal
dynamics. In an analysis closely matching that of forward rates in 2, we rearrange (7.1) to give:
S
,
(t)
1
j=
P(t, T
j+1
)
j
= P(t, T
) P(t, T
).
Since the right hand side is the price of a traded asset (the dierence between two dierent maturity
bonds), the left hand side is also the price of a traded asset and its value, expressed in terms of an
appropriate numeraire, is a martingale under the associated measure. Therefore we can write:
dS
,
(t) =
,
(t)S
,
(t)dW
,
(t),
where dW
,
(t) is a Brownian motion under probability measure Q
,
with associated numeraire
1
j=
P(t, T
j+1
)
j
, being the annuity stream with payment dates T
j
, j = + 1, , . Under this
annuity measure, Q
,
, the swap rate has a lognormal distribution, making it consistent with the
Black swaption pricing formula.
Despite this neat, concise set up, the incompatibility of the swap based LIBOR market model and
the forward LIBOR market model is problematic. Exotic interest rate derivatives tend to display
dependence on both forward and swap rates; hence we need a single coherent framework within
which both forward rates and swap rates can be expressed. Various approximations have been
developed to allow analytic swaption prices within the forward LIBOR model. See Rebonato [51]
and Brigo and Mercurio [10] on the relative merits of using either the forward or swap rate LIBOR
market model.
7.3. Swaption Volatilities in the Forward LIBOR Model. The swap rate is naturally
expressed in terms of forward rates, so in order to value swaptions in the forward LIBOR market
model we need to express the Black swaption volatility in terms of forward rate volatilities. As in the
case of forward rates and caplets, the Black swaption volatility is the square root of the integrated
swap rate variance over the life of the swaption, that is:
(7.2)
_
Black
,
(T
)
_
2
T
=
_
T
2
,
(t)dt =
_
T
0
_
dS
,
(t)
S
,
(t)
__
dS
,
(t)
S
,
(t)
_
.
8
See appendix for a derivation.
7. SWAP RATE 12
Rearranging (7.1), the swap rate may be expressed as a weighted sum of the constituent forwards
rates:
S
,
(t) =
1
j=
w
j
(t)f
j
(t),
with:
w
j
(t) =
P(t, T
j+1
)
j
1
j=
P(t, T
j+1
)
j
.
Applying Itos Lemma we obtain the swap rate dynamics in terms of the forward rate dynamics as
9
:
dS
,
(t) =
1
j=
S
,
(t)
f
j
(t)
df
j
(t) +
1
j=
1
i=
2
S
,
(t)
f
j
(t)f
i
(t)
df
j
(t) df
i
(t)
= ( ) dt +
1
j=
S
,
(t)
f
j
(t)

j
(t)f
j
(t)dW
j
(t),
and the swap rate variance becomes:
_
dS
,
(t)
S
,
(t)
__
dS
,
(t)
S
,
(t)
_
=
_
_
1
j=
S
,
(t)
f
j
(t)

j
(t)f
j
(t)dW
j
(t)
1
i=
S
,
(t)
f
i
(t)

i
(t)f
i
(t)dW
i
(t)
_
_
_
S
,
(t)
2
2
,
(t) =
_
_
1
j=
1
i=
S
,
(t)
f
j
(t)
S
,
(t)
f
i
(t)
f
j
(t)f
i
(t)
j
(t)
i
(t)
ij
(t)
_
_
_
S
,
(t)
2
.
The swap rate S
,
depends on each forward rate f
j
in two ways: explicitly, with weight w
j
and
more subtly through the dependence of w
j
on the forward rates. As a rst approximation, ignore
the forward rate dependence of the weights, hence:
S
,
(t)
f
j
(t)
w
j
(t),
(7.3)
2
,
(t) =
1
j=
1
i=
w
j
(t)w
i
(t)f
j
(t)f
i
(t)
j
(t)
i
(t)
ij
(t)
S
,
(t)
2
.
Jakel and Rebonato [31] and Hull and White [30] present a renement of this approximation which
is a simple extension allowing the weights to be functions of f
j
. Once notation is reconciled, their
approaches prove the same. Although conceptually simple, the notation is fairly messy so I do not
present this renement here.
The instantaneous swap rate variance in (7.3) is stochastic through its dependence on the future
realisations of the forward rates and the weights, which are stochastic quantities themselves. A
simple deterministic forward rate instantaneous volatility has produced a complex, stochastic swap
rate instantaneous volatility.
In order to evaluate a swaption corresponding to chosen forward rate volatilities, we need to evaluate
the integrated volatility as in (7.2). However the representation of the swap rate volatility in (7.3)
9
The measure under which these dynamics are specied is not relevant and so omitted.
7. SWAP RATE 13
shows the integrated volatility to be a path dependent integral
10
which must be evaluated by Monte
Carlo simulation.
By rewriting formula (7.3) as:
2
,
(t) =
1
j=
1
i=
ij
(t)
j
(t)
i
(t)
ij
(t),
with:
ij
(t) =
w
j
(t)w
i
(t)f
j
(t)f
i
(t)
_
1
i=
w
i
(t)f
i
(t)
_
2
,
we represent the swap rate volatility as a weighted sum of the covariance terms
j
(t)
i
(t)
ij
(t). As
a second approximation we set the values of these weights,
ij
(t), to their time t = 0 values. So in
eect, we set the forward rates f
j
, and the swap rate weights w
j
, to their initial values. Rebonato
[51] performs an extensive analysis as to the validity (and hence accuracy) of this approximation.
Therefore the swap rate instantaneous volatility is approximated as:
(7.4)
2
,
(t) =
1
j=
1
i=
w
j
(0)w
i
(0)f
j
(0)f
i
(0)
j
(t)
i
(t)
ij
(t)
S
,
(0)
2
,
and from (7.2) the Black swaption volatility becomes:
(7.5)
_
Black
,
(T
)
_
2
T
1
j=
1
i=
w
j
(0)w
i
(0)f
j
(0)f
i
(0)
S
,
(0)
2
_
T
i
(t)
j
(t)
ij
(t)dt.
This two-part approximation allows us to value swaptions analytically in the forward LIBOR market
model, making Monte Carlo superuous.
10
This is incompatible with the path independent Black implied volatility. This highlights the incompatibility
of simultaneously lognormal forward and swap rates.
Appendix
Given the set of forward rate reset dates T
j
, j = , , 1 and the series of payment dates
T
j
, j = + 1, , , the payo discounted to time t, t T
, of a swap paying xed and receiving

oating interest is:
1
j=
D(t, T
j+1
)
j
(f
j
(T
j
) K) ,
where D(t, T
j+1
) = B(t)/B(T
j+1
) is the stochastic discount factor. The time t value of this swap
contract can be evaluated by taking expectations:
Swap
,
(t, K) = E
t
_
_
1
j=
D(t, T
j+1
)
j
(f
j
(T
j
) K)
_
_
=
1
j=
E
t
[D(t, T
j+1
)
j
(f
j
(T
j
) K)]
=
1
j=
E
j
t
_
d
Q
dQ
j
F
t
D(t, T
j+1
)
j
(f
j
(T
j
) K)
_
=
1
j=
P(t, T
j+1
)
j
(f
j
(t) K) .
14
CHAPTER 2
Covariance Structure
1. Structure of the Forward Rate Dynamics
Consider the forward rate dynamics of Chapter 1 2 expressed in matrix notation and with respect
to some measure Q
U
:
(1.1) df(t) = (f, t)f(t)dt + (t)f(t)dW
U
(t),
where:
f(t) (n 1) column vector of forward rates,
(f, t) (n 1) column vector of drifts, which may be functions of the forward rates
themselves and time,
dW
U
(t) (n 1) column vector of correlated standard Brownian motions under a chosen
measure Q
U
. The Brownian motions have correlation matrix , that is,
dW
U
(dW
U
)
= dt,
(t) (n n) diagonal matrix, where the i
th
element,
i
is equal to the instantaneous
percentage volatility of the i
th
forward rate.
Within this specication, each forward rate is modelled via its own Brownian motion and associated
instantaneous volatility function. The Brownian motions are specied under a probability measure
Q
U
associated with numeraire U which uniquely determines the drift vector. If the correlation
matrix, , has full rank, the above equations provide a specication of dynamics of the term structure
with as many factors as forward rates.
A second specication proves more useful:
(1.2) df(t) = (f, t)f(t)dt +(t)f(t)dZ(t),
where f(t) and (f, t) are unchanged from above, but now dZ(t) is an (m1) vector of orthogonal
Brownian motions
1
and (t) is an (n m) real matrix where the
ij
, the (i, j)
th
element, is the
loading on the i
th
forward rate of the j
th
orthogonal Brownian motion (source of uncertainty).
The number of orthogonal (independent) sources of uncertainty, m, may now dier from the number
of forward rates, n. Preferably m << n. Each of the n forward rates is aected by each of
the m Brownian shocks. For each forward rate i, i = 0, . . . , n 1 the level of responsiveness to
Brownian shock j, j = 1, . . . , m is determined by factor
ij
. Hence the volatility of forward rate i,
i = 0, . . . , n 1 is decomposed among m Brownian motions.
1
Here I omit the specic reference to the pricing measure Q
U
and it should be taken as given, unless explicitly
indicated otherwise.
15
1. STRUCTURE OF THE FORWARD RATE DYNAMICS 16
For m = 1 we have a one-factor model where all forward rates are driven by a single source of
uncertainty and hence have perfect instantaneous correlation. Generally for m = n (specically
m < n) the resulting correlation matrix will dier from the full-rank correlation matrix above.
The rst formulation in (1.1) describes the yield curve evolution in terms of forward rate specic
Brownian shocks, while the second formulation makes use of shocks aecting the entire yield curve
and specifying the extent to which each forward rate is aected by each Brownian shock. The
relationship between the two formulations, that is the relationship between matrices and is:
(1.3)
2
i
(t) =
m
k=1
2
ik
,
where
i
is the i
th
diagonal element of matrix . Using this equality, the dynamics of the i
th
forward
rate in (1.2) may be expressed as:
df
i
f
i
=
i
dt +
m
k=1
ik
dZ
k
=
i
dt +
i
m
k=1
ik
_
m
j=1
2
ij
dZ
k
=
i
dt +
i
m
k=1
b
ik
dZ
k
, i = 0, . . . , n 1, (1.4)
where
b
ik
=

ik
_
m
j=1
2
ij
,
and element b
ik
is the proportion of total volatility of forward rate i attributable to Brownian shock
k. We have decomposed the responsiveness of the forward rates to the Brownian shocks into two
distinct components:
Instantaneous volatility component
i
, which gives the total level of volatility of forward
rate i. This is obtained from the Black implied volatility used to price caplets on the
forward rate with expiry T
i
via the relationship
(1.5)
2
Black
(T
i
)T
i
=
_
T
i
0
2
i
(u)du.
.
Correlation component. The components ({b
ik
}
m
k=1
), contain information about the cor-
relation structure. In fact bb
= , where b is the (n m) matrix of elements b

ik
and is
the correlation matrix of the Brownian motions specied in (1.1).
The two sets of components may be specied in a more-or-less independent manner.
For the case m < n, where the number of factors is smaller than the number of forward rates, we
need to ensure that the total volatility of each forward rate is fully recovered (this ensures correct
pricing of caplets). Hence we require:
(1.6)
m
k=1
b
2
ik
= 1, i = 0, . . . , n 1,
3. THE INTERPLAY BETWEEN VOLATILITIES AND CORRELATIONS 17
that is, each row vector comprising matrix b must have norm 1. Additionally, when the number of
factors is smaller than number of forward rates, an exogenously specied correlation matrix can no
longer be exactly recovered. Hence, we would like to determine the elements of b such that (1.6) is
satised and the resulting correlation matrix is optimised. For a detailed discussion on the problems
associated with correlation structures produced by low factor models see Rebonato, [49].
2. Degrees of Freedom
In Chapter 1, 4 I showed that for each choice of numeraire, the functional form of the forward rate
drift, (f, t), is fully determined by the exogenously specied volatility and correlation functions.
Each specic volatility and correlation function, gives rise to a dierent LMM implementation. We
have exibility in the specication of the following characteristics:
(1) Subject to the root-mean square constraint of equation (1.5), we need to assign a functional
form to the instantaneous volatility function
i
(t).
(2) The number of factors m.
(3) The proportion of each forward rates volatility attributable to each of the m orthogonal
sources of uncertainty, that is the specication of the {b
ik
}
m
k=1
coecients for each i =
0, . . . , n 1, subject to constraint (1.6).
Any choice of number of factors and admissible shape of instantaneous volatility function will
produce correct pricing of an exogenous set of vanilla caplets. Hence an innity of possible LMMs,
corresponding to dierent choices in factors (1) and (2), will calibrate exactly to vanilla caplets,
yet may dier signicantly in their correlation structure (factor (3)) and hence produce signicantly
dierent forward rate dynamics and exotic derivative prices. Therefore specication of the functional
form of
i
(t) and {b} becomes the core of a LMM implementation.
3. The Interplay Between Volatilities and Correlations
Valuation of simple European derivative products with payos determined by the realisation of
a single forward rate, requires knowledge of the unconditional terminal distribution of this rate.
For such a product, a single rate needs to be evolved under its martingale measure and hence
only a single volatility needs to be known. Few products fall into this category. Usually one
requires a multidimensional density function providing information about the probability of the
joint realisation of a series of forward rates at dierent times. That is, one requires the conditional
probability of occurrence of a certain yield curve at time T
n
, given (i.e. conditional on) realisations
of particular yield curves at previous times T
n1
, T
n2
, . . . , T
1
.
Let us consider the simplest of such products, the swaptions, where payo is determined by the
joint realisation of the forward rates constituting the underlying swap rate. Hence, one requires the
joint distribution of these forward rates at option expiry time. To evaluate such a distribution the
terminal correlation (the correlation which summarises the degree of dependence between forward
rates at a specic future time) is required, rather than the instantaneous correlation, which species
the degree of dependence between instantaneous changes in forward rates.
3. THE INTERPLAY BETWEEN VOLATILITIES AND CORRELATIONS 18
Say we require the terminal correlation between rates f
i
() and f
j
() at time T
, i < j. We need
to evaluate:
Corr
(f
i
(T
), f
j
(T
))
=
E
__
f
i
(T
) E
[f
i
(T
)]
_ _
f
j
(T
) E
[f
j
(T
)]
_
_
E
_
(f
i
(T
) E
[f
i
(T
)])
2
_
_
E
_
(f
j
(T
) E
[f
j
(T
)])
2
_
, (3.1)
where the expectations are taken under forward measure Q
, . Since the drifts of the forward

rates are functions of forward rates themselves, and hence stochastic, these expectations need to be
evaluated by means of a short stepped Monte Carlo simulation.
If we were able to obtain a closed form, exact expressions for the unconditional and conditional
distributions of the forward rates, we would not need to evolve the underlying process by means
of short stepped Monte Carlo to determine the terminal distribution. The distribution would be
known a priori and fully characterised by a small number of descriptive factors.
A generalised Brownian process, as used to model the forward rate process in (1.1) and (1.2), is
both Gaussian and conditionally Gaussian, however only in the case when the drift and volatility
vectors of the logarithm of the forward rates, () and (), respectively, are deterministic i.e. at
most functions of time.
Introducing approximations to the drift vector, such that it becomes deterministic (fully determined
by the volatilities and correlations), enables us to make use of the closed form solution for the
terminal distribution of the forward rates, thereby evaluating the terminal correlation.
Going back to Chapter 1, 4 we allow a partial freezing (with respect to time) of the drift in the
forward rate dynamics. Hence the dynamics of f
k
(t) under the forward measure Q
with associated
numeraire P(t, T
+1
), for t min(T
+1
, T
k
) are:
df
k
(t) = m
k
(t)f
k
(t)dt +
k
(t)f
k
(t)dW
k
(t),
with
m
k
(t) =
k
j=+1
j
f
j
(0)
j
(t)
k
(t)
jk
1 +
j
f
j
(0)
, < k;
m
k
(t) = 0, = k;
m
k
(t) =
j=k+1
j
f
j
(0)
j
(t)
k
(t)
jk
1 +
j
f
j
(0)
, > k;
where the dependence on time in the forward rate component of the drift has been eliminated by
freezing it at its time t = 0 value. This allows us to write:
f
k
(T
) = f
k
(0) exp
_
_
T
0
_
m
k
(t)

k
(t)
2
2
_
dt +
_
T
k
(t)dW
k
(t)
_
.
So evaluating (3.1) as the correlation coecient of bivariate lognormal variables produces:
(3.2) Corr
(f
i
(T
), f
j
(T
)) =
exp
_
_
T
0

i
(t)
j
(t)
ij
dt
_
1
_
exp
_
_
T
0

i
(t)
2
dt
_
1
_
exp
_
_
T
0

j
(t)
2
dt
_
1
.
4. TERM STRUCTURE OF VOLATILITIES AND THE INSTANTANEOUS VOLATILITY 19
Alternatively, as in Rebonato [51], [54] consider the correlation coecient of the logarithm of the
forward rates as
2
:
(3.3) Corr
(lnf
i
(T
), lnf
j
(T
)) =
_
T
0

i
(t)
j
(t)
ij
dt
_
_
T
0

i
(t)
2
dt
_
_
T
0

j
(t)
2
dt
.
By the Cauchy-Schwarz inequality
3
we know:
Corr
(lnf
i
(T
), lnf
j
(T
))
ij
,
ij
0,
Corr
(lnf
i
(T
), lnf
j
(T
))
ij
,
ij
< 0.
That is, the terminal correlation is always lower than, or equal to the (constant) instantaneous cor-
relation. This is because the terminal decorrelation
4
is inuenced by the instantaneous correlation,
ij
, as well as the time dependence of the instantaneous volatility functions,
i
(). As long as the
instantaneous volatilities are not constant, a signicant amount of decorrelation can occur, even if
the instantaneous correlation is perfect.
The success of a LMM implementation depends on the quality of the volatility specication, hence
the choice of input volatility function is central. The form of the volatility and correlation func-
tions should be nancially intuitive, provide sucient exibility, but not allow too many degrees of
freedom (free parameters) which could result in over tting.
4. Term Structure of Volatilities and the Instantaneous Volatility
The term structure of volatilities refers to the function
Black
(T), being the implied volatility
associated with caplet of expiry T. Having dened our interest rate term structure as a discrete set
of n spanning forward rates over a horizon subdivided by expiry-maturity times T
k
, k = 0, . . . , n,
we express the term structure of volatilities in terms of the instantaneous volatilities as
5
:
(4.1)
_
T
k
0
2
inst
(u, T
k
)du =
2
Black
(T
k
)T
k
, 0 k n 1.
While ensuring that the above pricing relationship is satised, we need to specify an instantaneous
volatility function that is nancially satisfactory (i.e. the resulting evolution through time is nan-
cially plausible and justiable).
2
This may also be interpreted as a rst order approximation of the correlation in (3.2).
3
The Cauchy-Schwarz inequality (for example see [61]) states:
__
b
a
1
(x)
2
(x)dx
_
2
_
b
a
2
1
(x)dx
_
b
a
2
2
(x)dx.
4
The term decorrelation refers to less than perfect correlation (among say, forward rates). Most of the early
short rate models were one factor models, implying perfect instantaneous correlation among forward rates. This is
unrealistically high and much work was done to modify these models to lower the level of correlation among forward
rates i.e. to achieve decorrelation.
5
Here, to clearly distinguish between implied Black volatility and instantaneous volatility, I have made the
instantaneous volatility an explicit function of expiry time, where previously this was depicted by a subscript.
4.1. Functional Form. The instantaneous volatility can be either piecewise constant or of
some parametric form.
Piecewise constant. The piecewise constant specication implies that the volatility of for-
ward rate f
k
has a constant value between each pair of expiry-maturity dates (T
i
, T
i+1
), i =
0, , k 1.
Parametric form. The instantaneous volatility is specied as some function of current time
t, expiry time T
k
and some set of parameters {
i
}.
Within these two basic specications we can assign an underlying structure on the resulting volatil-
ities to reduce the degrees of freedom and impose a desirable future evolution on the volatility term
structure.
Let m(t) be such that m(t) = i for T
i
< t T
i+1
, m(0) = 0 and dene
m(t)
R for t [0, T
];
k
R for k = 0, . . . , n 1;
km(t)
R for k = 0, . . . , n 1, t [0, T
]. Also dene functions

h : R R, g : R R, f : R R.
4.1.1.
inst
(t, T
k
) =
m(t)
,
inst
(t, T
k
) = h(t). The instantaneous volatility is a function of
current time only. This specication implies that all forward rates exhibit the same responsiveness
to random shocks. Although popular at times, mainly for numerical reasons, this functional form
does not have a very sound nancial justication nor does it allow the exact recovery of all possible
market observed term structures.
4.1.2.
inst
(t, T
k
) =
k
,
inst
(t, T
k
) = g(T
k
). The instantaneous volatility is purely forward
rate specic. Although this specication allows us to t any exogenously specied volatility term
structure
6
, it is not nancially appealing since it implies each forward rate has the same (constant)
volatility over its life, regardless of its term to maturity. Forward rates with the same remaining term
to maturity will display dierent volatilities, and so the term structure of volatilities will change
shape over time.
4.1.3.
inst
(t, T
k
) =
k
m(t)
,
inst
(t, T
k
) = g(T
k
)h(t). Responsiveness to the random shocks
is split into a time dependent part and a forward rate dependent component. To ensure correct
pricing of a set of market caplets we require:
2
Black
(T
k
)T
k
= g(T
k
)
2
_
T
k
0
h(u)
2
du.
Hence for any chosen function h(t), we can always nd a g(T
k
) such that the caplets are correctly
priced by setting
7
:
g(T
k
)
2
=

2
Black
(T
k
)T
k
_
T
k
0
h(u)
2
du
.
The functional dependence on the specic forward rate introduces the same characteristic observed
in specication 4.1.2, the shape of the volatility term structure changes through time.
6
In the simplest case, by setting
inst
(t, T
k
) =
k
= g(T
k
) =
Black
(T
k
).
7
Equivalently in the piecewise continuous case, the caplet pricing requirement is:
2
Black
(T
k
)T
k
=
2
k
_
T
k
0
2
m(u)
du =
2
k
n1
i=0
2
i
i
,
and constant
k
can be found as:
2
k
=
2
Black
(T
k
)T
k
n1
i=0

2
i
i
.
4.1.4.
inst
(t, T
k
) =
km(t)
,
inst
(t, T
k
) = f(T
k
t). The instantaneous volatility is purely
a function of the residual term to maturity. This functional form is nancially appealing since the
volatility term structure will maintain its shape through time; this is easily demonstrated by the
equality
_
T
0
2
inst
(u, T)du =
_
T+
2
inst
(u, T +)du.
However, it is no longer possible to t any exogenous set of caplet implied volatilities. The time
homogeneous structure of the instantaneous volatility function requires that
2
Black
(T
k
)T
k
, as ob-
tained from todays term structure of volatilities, must be a strictly increasing function of T
k
. So
if
2
Black
(T
k
)T
k
is not monotonically increasing in T
k
, we will be not be able to exactly recover
observed caplet prices with a purely time homogenous instantaneous volatility function. Therefore,
only if we observe
2
Black
(T
k
)T
k
to be a strictly increasing function are we always able to nd an
instantaneous volatility function of the form f(T
k
t) such that all caplets are correctly priced.
The market observed
2
Black
(T
k
)T
k
, is usually not strictly increasing and hence a time homogenous
solution cannot be found. Since empirical evidence suggests time homogeneity to be a desirable
characteristic, the subsequent functional forms use a time homogenous specications, with a multi-
plicative augmentation that is either time or forward rate dependent.
4.1.5.
inst
(t, T
k
) =
k
km(t)
,
inst
(t, T
k
) = g(T
k
)f(T
k
t). This functional specication
comprises a forward rate specic component g(T
k
) (similarly
k
) and a component depending on
the residual term to maturity T
k
t. As in 4.1.3 above, we can impose correct pricing of todays
market observed caplets, for any function f(T
k
t) (similarly
km(t)
), by setting:
g(T
k
)
2
=

2
Black
(T
k
)T
k
_
T
k
0
f(T
k
u)
2
du
.
If g(T
k
) = , constant for all T
k
, k = 0, . . . , n 1 (similarly
k
=
i
for all k, i), we have a time
homogeneous term structure of volatilities. By rst determining f() (similarly {}) such that we
have as close a t as possible to caplet prices and then determining g() (similarly {}) to ne tune
the t, we allow the instantaneous volatility to be as time homogenous as possible (see [51]). Ideally
g() (similarly {}) should be as close to constant as possible, across forward rate maturities.
4.1.6.
inst
(t, T
k
) =
m(t)
km(t)
,
inst
(t, T
k
) = h(t)f(T
k
t). The time homogenous instan-
taneous volatility component is augmented by a purely time dependent one. The relative respon-
siveness of equal maturity forward rates remains the same over time, but is augmented by the time
dependent function h(t) (similarly
m(t)
). While this specication is nancially appealing, it is more
demanding from a numerical/computational perspective. As before, the correct pricing of caplets
is ensured by
8
:
2
Black
(T)T =
_
T
0
g(u)
2
h(T u)
2
du.
8
In the piecewise constant case, by:
2
Black
(T)T =
n1
i=0
2
i
2
ki
i
.
We are unable to split the integral as in 4.1.3 and 4.1.5 making it more dicult to jointly specify
the two functions. Introducing simplications, such as allowing h() to be piecewise constant
9
could
produce unexpected results when calculating the covariance terms.
4.1.7.
inst
(t, T
k
) =
m(t)
km(t)
,
inst
(t, T
k
) = h(t)g(T
k
)f(T
k
t). One could implement
this hybrid function which contains features of all the approaches described above. Rebonato [51]
recommends a three stage procedure where a best t optimisation is rst implemented for h(T
k
t)
and any residual mispricing of todays caplets is eliminated by the time dependent and forward rate
dependent components, g() and f() respectively (equivalently for
km(t)
, {} and {}.).
The choice of volatility function and its specic form it should be nancially intuitive, with associated
parameters having a transparent econometric interpretation. Therefore we discuss some empirical
observations of the qualitative shape of the volatility term structure.
4.2. Qualitative Shape of the Volatility Term Structure. In general, the volatility term
structure displays a humped shape, with relatively low volatility on the short end, a peak around the
18 month maturity and then decreasing volatility towards the long end of the maturity spectrum,
with a possible attening out of volatilities. The general shape of the volatility term structure
remains the same through time, that is volatilities of caps with dierent terms to maturity maintain
the same relative magnitudes through time. There may, however be short periods when the term
structure displays anomalous behaviour, taking on a generally monotonically decreasing shape.
Rebonato [51] posits a nancial explanation for these observations. In major nancial markets (US,
UK and Euro area) monetary authorities set the level of the short term rate. Under normal market
conditions, their actions are fairly transparent to market players and unexpected actions are not
common, hence the instantaneous volatilities of rates with short term to maturity tend to be fairly
low. There may, however, be periods of market turmoil when uncertainty is high regarding the
actions of monetary authorities. Rebonato refers to this as excited conditions, characterised by
high uncertainty regarding the future level of the short rates; and hence high volatility of the short
maturity forward rates.
By contrast, the long end of the maturity spectrum is aected mainly by expectations regarding
ination and the level of real rates. Day to day economic news has a limited impact, hence volatilities
tend to be fairly low and stable.
It is the intermediate maturities that tend to be most inuenced by the arrival of new economic
information regarding the state of the economy and the actions of the monetary authorities; leading
to higher volatilities in the area of 6 to 18 months maturity.
A note on time dependence of the instantaneous volatility and the terminal decorre-
lation. The above description indicates the strong time dependence of the instantaneous volatility
function. As discussed in 3 the covariance (correlation) elements dened in (3.3) are central to
the evolution of forward rates as well as prices of LIBOR products. The observed time dependence
plays a central role in achieving terminal decorrelation among forward rates. The greater the time
dependence of the instantaneous volatility function, the lower the terminal correlation, even in the
presence of perfect instantaneous correlation. This time dependence becomes increasingly important
in determining the level of terminal correlation when instantaneous correlation is high, as is usually
the case between same currency forward rates.
9
This amounts to using a hybrid instantaneous volatility specication with both a continuous and piecewise
constant component.
4.3. Specic Functional Form. Here we focus on the parametric versions of the functions
assessed in 4.1. Two general functional forms stand out as being nancially and computationally
feasible, allowing the term structure to maintain its general shape through time, yet having enough
exibility to calibrate to exogenous caplet prices:
inst
= h(t)g(T
k
)f(T
k
t),
inst
= g(T
k
)f(T
k
t).
We need to assign a specic parametric form to functions f(), g() and h().
4.3.1. f(T
k
t). Since we could like the term structure of volatilities to be as time-homogenous
as possible, the time-homogenous component dominates in determining the instantaneous volatili-
ties. We would like this function to allow both the empirically observed humped and monotonically
decreasing shapes.
Pricing of caplets (via the variance) and the evaluation of covariance terms requires integration of
the square of this function; we would like a parametric form that allows a simple analytic solution
for the integral of its square.
Additionally the specic parametric form should also be nancially intuitive with parameters that
can be related to market observables. Rebonato [51], [54] argues that the functional form:
(4.2) f(T
k
t) = (a +b(T
k
t)) exp(c(T
k
t)) +d
satises these criteria
10
. It is able to produce both a monotonically decreasing and a humped
instantaneous volatility curve, providing a fair degree of exibility as to the exact shape of the
humped curve. The parameters {a, b, c, d} have the following nancial interpretation:
As = T
k
t , f(T
k
t) d, hence d is associated with the volatility at very long
maturities. Therefore we require d > 0.
Similarly, = T
k
t 0, f(T
k
t) a + d and hence a + d should be approximately
equal to the shortest maturity implied volatilities
11
. Again a +d > 0.
The location (on the term to maturity axis) of the hump is determined by evaluating
f
() = 0. The hump is therefore at =

bca
cb
, which is a local maximum for b > 0. For
b < 0 no maximum occurs. Additionally, empirical evidence shows that the hump in the
volatility curve is found around 1-year, hence
bca
cb
1.
In the light of the above observation, consider the curve in the normal state. At the
short maturity end, we require a positive slope i.e. f
(0) > 0. This is satised by the joint

constraints a < b/c and b > 0, where the second constraint is the same one that guarantees
the presence of a local maximum.
4.3.2. h(t). The choice of this function is more subjective, since empirical observations of cal-
endar time dependence are dicult to isolate. Rebonato [51] recommends a function of the type:
(4.3) h(t) =
_
N
i=1
i
sin
_
ti
M
+
i+1
_
_
exp(
N+1
t),
where N is the number of free parameters (recommended to be as small as 2 or 3) and M is the
maturity of the longest caplet. This function is a linear combination of sine waves, (where the
10
This same functional form is supported and analysed by Brigo and Mercurio [10].
11
For 0 the time interval over which one integrates to get from instantaneous to implied (average) volatility
also tends to zero and so the two quantities will converge. Hence the instantaneous and implied volatilities are equal.
5. INSTANTANEOUS CORRELATION FUNCTION 24
phases and amplitudes are optimised) multiplied by a decay factor (with optimised decay constant).
The intuition behind this functional form is to allow a sucient number of frequencies to pick
up the localised time dependence, but not too many so that excessive market noise obscures the
specication.
4.3.3. g(T
k
). The forward rate dependent function is the nal smoothing function ensuring
perfect pricing of todays market caplets (perfect tting to todays volatility term structure). If we
set:
(4.4) g(T
k
) = 1 +
k
, 0 k n 1,
where n is the total number of forward rate maturities, we should not nd any
i
s signicantly
dierent from zero.
5. Instantaneous Correlation Function
As with the instantaneous volatility function, we may allow a parametric or non-parametric speci-
cation of the instantaneous correlation. The correlation is a long-run characteristic of forward rates
and is not expected to change signicantly over time. This leads to a time independent specica-
tion of correlation between each pair of forward rates of maturity T
i
and T
j
respectively, making
the correlation matrix stationary through time. The non-parametric form involves determining the
1
2
n(n 1) unique elements of the (n n) correlation matrix from market prices. Alternatively,
having decided on a parametric form, the free parameters are determined to best t market prices.
A general functional form for the instantaneous correlation function between forward rates with
maturity T
i
and T
j
is:
(5.1)
ij
= (t, T
i
, T
j
).
Since the instantaneous correlation enters the evaluation of the covariance elements specied in (3.3)
we require (together with a square-integrable volatility function) that
ij
(t) should be integrable
over time interval [T
k
, T
k+1
]. Additionally to be a valid correlation function we require 1
ij
1.
Rebonato [51] proposes the time-homogeneous correlation functions:
ij
= (T
i
t, T
j
t) or
ij
= (T
i
T
j
).
Determining the correlations (regardless of having chosen a non-parametric or parametric specica-
tion) from market prices is a particularly dicult task. Rebonato [51] discusses three main reasons
for this diculty. While caplet prices depend directly on the instantaneous volatility (via the root
mean square) of individual forward rates, there are no vanilla instruments depending purely on the
correlation between forward rates. In fact the only vanilla instruments depending on the instanta-
neous correlation are European swaptions, where the price depends on the covariance over the life
of the swaption:
_
T
exp
0
i
(u)
j
(u)
ij
(u)du.
Since the instantaneous correlation always appears coupled to the (only partially known) instan-
taneous volatility functions, it is particularly dicult to estimate the correlation functions based
on swaption prices. Secondly, it is not the instantaneous correlation directly that determines the
swaption prices but rather the terminal correlation (as shown in (3.3)). This is determined by both
the time dependence of the instantaneous volatility and the instantaneous correlation. Dierent
5. INSTANTANEOUS CORRELATION FUNCTION 25
combinations of these two factors can produce the same terminal decorrelation and hence the same
covariance element and swaption price. It is dicult to disentangle the inuence of the two factors.
Thirdly, for a given average correlation among forward rates making up a swap rate, the instanta-
neous swap rate volatility is very weakly dependent on the specic shape of the correlation function.
Time dependent instantaneous forward rate volatilities lower the terminal correlation (relative to
constant instantaneous forward rates). This has the eect of lowering the root-mean-square swap
rate volatility. In conclusion, swaption prices are weakly dependent on the shape of the instanta-
neous correlation function and aected to the same degree by the time dependence of the forward
rate instantaneous volatility and the instantaneous correlation. This makes it dicult to extract
information about the instantaneous correlation matrix from European swaption prices.
Standard market practice is to use a historical, econometric correlation matrix and only calibrate
the time dependent instantaneous volatility functions to market observables.
CHAPTER 3
Deviations From Lognormality
1. Caplet Prices and Lognormality
In the model set-up of Chapter 1 forward rates are assumed to follow a lognormal process. We
determine a terminal probability measure, for each forward rate, such that it becomes an exponential
martingale with deterministic volatility. The caplet prices obtained from these forward rates are
consistent with the lognormal distribution (under the terminal measure) so using the Black formula
to calculate implied volatilities corresponding to these prices, results in, for each maturity, a at
curve as a function of caplet strike.
However, it is only under the terminal measure that full lognormality
1
is a prerequisite for obtaining
Black consistent prices. Under other measures, the forward rate process obtains a non-deterministic
drift term and is no longer lognormal. Under this new measure, the value of the discounting term
in the caplet pricing formula (no longer the zero coupon bond maturing at time of caplet payout)
takes on dierent values in dierent states of the world (hence for dierent values of caplet payo).
The additional drift term in the forward rate dynamics compensates for the covariation between
caplet payout and discounting factor.
2. Deviation from Lognormality
In the mid 1990s, the caplet market started to exhibit implied volatilities that were monotonically
decreasing as a function of strike, i.e. a skew. The reason for this observation was posited to be a
deviation from lognormality of the forward rate process. In the late 1990s the skew started to assume
an upward sloping prole for higher strike values taking on a hockey stick shape. The reason for
this additional feature is seen to be an additional deviation from lognormality superimposed on that
producing the monotonically decreasing smile.
3. The Smile in Equity vs. Interest Rate Market
Rebonato [51] proposes that the interest rate skew has arisen for dierent reasons to those explaining
the appearance and persistence of a skew in the equity and foreign exchange markets. Hence, it
would not be correct to apply the modelling methodologies applied in the equity markets, where
both the skew and smile eects are explained using one mechanism. This view is supported by
Gatarek [23].
In the equity markets, a negative correlation is observed between changes in share prices and changes
in volatilities. That is, as share prices fall, the volatility increases and vice versa. This negative
1
By full lognormality I refer to both drift and volatility terms taking on the lognormal form. Under alternate
measures the diusion coecient remains unchanged (hence lognormal), however the drift becomes a function of the
forward rates and hence we are no longer able to nd a closed form solution for the distribution of the forward rate
at caplet expiry. This is the prerequisite for Black prices under the terminal measure.
26
4. ALTERNATE INTEREST RATE DYNAMICS 27
correlation and resulting presence of a smile is usually explained by the leverage eect, rather than
a deviation from lognormality of the stock price process. The total value of a company comprises
both equity capital and debt. For a xed level of debt, a fall in share price causes the value of the
rm to decline; the debt:equity ratio increases i.e. the rms leverage increases causing an increase
in volatility.
A similar eect is observed in interest rate markets, for very low interest rates, the percentage
volatility is signicantly higher than for higher levels of interest rates. While the absolute change in
rates in response to market shocks does seem to depend on the level of rates, a perfectly proportional
move is too restrictive. It would appear that a dependence somewhere between proportionality
(lognormal process) and independence (normal process) is more appropriate. See analysis of market
data in [52], [53].
4. Alternate Interest Rate Dynamics
As mentioned above, the presence of a caplet volatility surface (a caplet volatility curve for each
caplet expiry) is an indication that forward rates follow alternate dynamics, such that when the
resulting caplet prices are represented via (lognormal) implied volatilities obtained through the
Black formula, they exhibit a curve that deviates from the at structure consistent with lognormal
dynamics.
Alternate dynamics were rst proposed by Cox and Ross [13] (constant-elasticity of variance - CEV
process) and by Rubinstein [57] (displaced diusion). An approach developed for the equity markets
by Dupire [17], [18] and Derman and Kani [14], [15] has become known as the local volatility
approach. Specically, information contained in the skew is used to determine a unique diusion
coecient giving rise to an alternate process for the underlying. This approach has lost popularity
since one needs a twice dierentiable volatility smile (therefore a very smooth interpolation technique
is required); additionally the volatility surface dynamics predicted by this approach tend to be
contradictory to those observed in the market.
For the case of forward rate dynamics, we examine the displaced diusion and CEV dynamics in
turn.
4.1. Displaced Diusion.
4.1.1. Model Set-Up. Here the quantity f
k
(t) + is modelled as a lognormally distributed
variable, hence:
(4.1) d(f
k
(t) +) = df
k
(t) =
,k
(t)(f
k
(t) +)dW
k
k
(t), > 0.
The displaced diusion process was rst proposed by Rubinstein [57] for pricing equity options
by considering the stock price based on the underlying debt structure of the rm. Marris [38]
reparameterises this process as:
(4.2) df
k
(t) = (f
k
(t) + (1 )f
k
(0))
,k
(t)dW
k
k
(t),
where f
k
(0) is todays value of the forward rate. These two parameterisations coincide for:
,k
(t) =
,k
(t) and
f
k
(t) + = f
k
(t) +
1
f
k
(0) =
1
f
k
(0).
Rewriting (4.2) as:
(4.3) df
k
(t) =
_
f
k
(t) +
1
f
k
(0)
_
,k
(t)dW
k
k
(t),
the diusion coecient may be interpreted as a weighted sum of lognormal and normal components,
with the lognormal process recovered for = 1 (or = 0) and the normal process for = 0.
From (4.1) we may write a closed form solution for the value of f
k
(t
), t < t
T
k
as
2
:
f
k
(t
) = (f
k
(t) +) exp
_
1
2
_
t
,k
(u)
2
du +
_
t
,k
(u)dW
k
k
(u)
_
,
hence:
E
k
t
[ln(f
k
(t
) +)] = ln(f
k
(t) +)
1
2
_
t
,k
(u)
2
du;
and we express the distribution of f
k
(t
), conditional on f
k
(t), as a shifted lognormal distribution
with density function:
(4.4) P
k
(f
k
(t
)|f
k
(t)) =
1
(f
k
(t
) +)
(t, t
2
exp
_
_
_
1
2
_
_
ln
_
f
k
(t
)+
f
k
(t)+
_
+
1
2

(t, t
)
2

(t, t
)
_
_
2
_
_
_,
where x > and
(t, t
)
2
=
_
t
t

,k
(u)
2
du.
The density function in (4.4) indicates one of the great advantages of the displaced diusion ap-
proach. Analytical tractability is maintained since we have
P(t, T
k+1
) E
k
_
[f
k
(T
k
) K]
+
|F
t
_
= P(t, T
k+1
) E
k
_
[(f
k
(T
k
) +) (K +)]
+
|F
t
_
,
and so we may evaluate a caplet on forward rate f
k
(), with strike K, using the Black caplet formula
with input spot f
k
() + , strike K + and volatility parameter
(t, t
). Repeating this process

for a series of strikes {K}
i
and using the Black caplet formula a second time to retrieve the Black
volatility implied by these prices, will produce a series of caplet implied volatilities with a dependence
on K i.e.
imp

imp
(, K).
A note of caution is required when dealing with displaced diusion dynamics. Since f
k
(t) + is an
exponential martingale (see (4.1), we have f
k
(t) + > 0 and hence f
k
(t) > , and the forward
rate can take on negative values.
4.1.2. Determining
. Although we are able to use the Black formula to price caplets within the
displaced diusion framework, we need to determine the correct input volatility,
(0, t
). Speci-
cally we observe the lognormal implied volatility,
imp
from the market and need to determine the
corresponding
for the choice of , such that the caplet prices match. Marris [38] applies numer-
ical methods to solve this for any level of moneyness by inversion of the Black pricing formula. To
2
Alternatively, in terms of the parameterisation in (4.2) the value of f
k
(t
), 0 < t
T
k
is expressed as:
f
k
(t
) =
f
k
(0)
exp
_
1
2
_
t
,k
(u)
2
du +
_
t
,k
(u)dW
k
k
(u) (1 )
_
, = 0.
obtain an analytic approximation, he matches caplet prices that are close-to-the-money, specically
with strike K = f
k
(0) exp
_
1
2
2
t
_
(which gives =
1
2
). A rst order approximation yields:

(0, T
k
) =
f
k
(0)
f
k
(0) +

imp
(T
k
).
An analysis by Rebonato [54] follows a similar methodology, matching at-the-money caplets (K =
f
k
(0)), and using a Taylor Series expansion of the cumulative normal distribution to obtain the
same rst order approximation and a further renement of the form:

imp
f(0)
f(0)+
_
1
1
24
2
imp
T
_
1
1
24
_
f(0)
f(0)+
imp
_
2
T
.
This extra degree of accuracy proves necessary for longer maturities (see the analysis in Rebonato
[54]).
4.2. CEV Dynamics. CEV dynamics refers to a general family of diusions of the form:
(4.5) df
k
(t) =
,k
(t)f
k
(t)dW
k
k
(t), 0 1,
where the lognormal and normal diusions may be seen as limiting cases for = 1 and = 0
respectively. This formulation may be classed as a local volatility model since the percentage
volatility is a function of the forward rate itself, specically
,k
(t)f
1
k
(t) and hence for < 1 the
percentage volatility increases as forward rates fall and vice versa. This characteristic is consistent
with market observations, for example see [51], [52], [53].
4.2.1. Application to LMM. Andersen and Andreasen [2] generalise the LMM by allowing the
forward rate dynamics to take the form:
(4.6) df
k
(t) = (f
k
(t))
k
(t)dW
k
k
(t),
where W
k
k
(t) is a Brownian motion
3
under probability measure Q
k
,
k
(t) is a bounded deterministic
function and : [0, ) [0, ) is some, possibly non-linear, function. They apply a deterministic
time change of the form:
k
(t, T) =
_
T
t
k
(u)
2
du,

W
k
k
(
k
(0, t)) =
_
t
0
k
(u)dW
k
k
(u),
where

W
k
k
is a Brownian motion under the deterministic time change
k
(0, t) and so the dynamics
of f
k
() can be represented as
(4.7) d
f
k
(
k
(0, t)) = (

f
k
(
k
(0, t)))d
W
k
k
(
k
(0, t)),
where

f
k
(
k
(0, t)) = f
k
(t). Specialising to the CEV case by setting (x) = x
, > 0, (4.7) becomes:

(4.8) d
f
k
(
k
(0, t)) =

f
k
(
k
(0, t)))d
W
k
k
(
k
(0, t)).
Andersen and Andreasen make the following observations:
For 0 < <
1
2
SDE (4.8) does not have a unique solution unless a boundary condition is
specied at

f
k
= 0 (equivalently f
k
= 0) i.e.

f
k
= 0 is set to be an absorbing boundary,
For
1
2
, (4.8) has a unique solution,
For 0 < < 1

f
k
= 0 is an attainable boundary; while for 1 it becomes unattainable.
3
Andersen and Andreasen consider the more general case of W
k
(t) an m-dimensional Brownian Motion.
Additionally, by transforming variables as:
x
k
(t) =
f
k
(t)
2(1)
(1 )
2
and dening x
k
(
k
(0, t)) = x
k
(t), the resulting SDE for x
k
(
k
(0, t)) is a squared Bessel process and
hence Andersen and Andreasen nd the conditional density of x
k
(T), given x
k
(t), t T as:
(4.9) P
k
(x
k
(T)|x
k
(t)) =
1
2
k
(t, T)
exp
_
x
k
(T) +x
k
(t)
2
k
(t, T)
__
x
k
(t)
x
k
(T)
_
/2
I
||
_
_
x
k
(t)x
k
(T)
k
(t, T)
_
,
where P
k
(|) is the conditional probability under measure Q
k
, = 1/(2(1 )) and I
q
() is the
modied Bessel function of the rst kind
4
of order q. Brigo and Mercurio [10] express this density
in terms of the original variables f
k
(T) and f
k
(t) using a slightly dierent parameterisation.
Making use of this conditional probability density, Andersen and Andreasen are then able to nd
closed form solutions for caplet prices in terms of the non-central
2
distribution
5
for all values of
> 0. See [2] for the detailed formulae.
For values of > 1, the caplet Black implied volatilities are a monotonically increasing function
of strike, = 1 corresponds to the lognormal case hence producing equal volatilities across strikes,
while < 1 produces a monotonically decreasing volatility curve as a function of strike. For the
case > 1 there is the possibility of exploding forward rate paths under measures other than the
terminal probability measure (since the forward rate drift coecient becomes non-zero). Andersen
and Andreasen explore a limited CEV (LCEV) to overcome the possibility of explosive rates for
> 1 and to mitigate the negative eects of the absorbing boundary at f
k
= 0 for 0 < < 1. See
[2] for details.
4.3. Link between CEV and displaced diusion processes. CEV processes have appeal-
ing theoretical properties. Chief among these is that f
k
() remains positive if its starting value is
positive i.e. if f
k
(0) > 0. It does however have signicant numerical drawbacks. The analytic solu-
tion for caplets derived by Andersen and Andresen [2] requires the evaluation of the non-central
2
distribution. This is fairly demanding involving an innite sum of gamma functions. The transition
density (see (4.9) above) only provides a semi-analytic solution, again involving an innite sum of
gamma functions. This makes fast numerical implementation dicult.
On the other hand, the displaced diusion process maintains the analytical simplicity of the log-
normal framework, allowing for closed form solutions via the Black formula. However, for < 0,
the value of the displacement parameter required for a downward sloping volatility curve, it admits
negative interest rates. While this may not be problematic for typical values of interest rates, very
low rates, such as those observed in the Japanese market, result in too much of the probability
distribution falling below zero.
Marris [38] nds a remarkable consistency between caplet prices resulting from the two processes,
given a certain pairing of parameters. Specically, consider formulation (4.2) of the displaced
4
The modied Bessel function of the rst kind of order q may be expressed as:
I
q
(x) =
j=0
(x/2)
q+2j
j! (q +j + 1)
,
with () the gamma function dened as (x) =
_
0
u
x1
e
u
du.
5
For the case = 1 the solution simplies to the Black caplet formula.
diusion dynamics:
df
k
(t) = (f
k
(t) + (1 )f
k
(0))
,k
(t)dW
k
k
(t)
and the CEV dynamics of (4.5):
df
k
(t) =
,k
(t)f
k
(t)dW
k
k
(t), 0 1.
By letting = , the displaced diusion process may be used as a numerical/computational proxy
for the CEV dynamics
6
.
Surprisingly, the evidence as to why this agreement in prices is found is somewhat sketchy. Marris
provides graphical evidence of the coincidence of caplet implied volatilities over a range of strikes,
but does not provide a concrete analytical proof. He comments that the somewhat unnatural
parameterisation of the displaced diusion in (4.2) was reverse engineered to yield the coincidence
with the CEV dynamics
7
.
Muck [40] notes the lack of proof of the admissibility of this approximation, especially for the
case of derivatives depending on joint distributions of forward rates, rather than just the terminal
distribution of a single rate as is the case for the caplets (and to some extent Barrier Options)
considered by Marris. He provides an analysis of swaptions and barrier swaptions, nding good
agreement between prices obtained in the two frameworks.
As a starting point to obtaining some clarity as to why the two processes yield coincident caplet
prices for a specic parameterisation, we note that for = and
,k
() =
,k
()f
1
k
(0), the
instantaneous volatilities, quadratic variations and slopes of the quadratic variations
8
match for
f
k
() = f
k
(0). Hence, at-the-money, we match both the level and slope of the implied volatility
curve.
Consider the instantaneous volatility in (4.2) for = :
(f
k
(t) + (1 )f
k
(0))
,k
|
f
k
(t)=f
k
(0)
= (f
k
(t) + (1 )f
k
(0))
,k
f
1
k
(0)|
f
k
(t)=f
k
(0)
= f
k
(0)
,k
= f
k
(t)
,k
|
f
k
(t)=f
k
(0)
which is the instantaneous volatility in (4.5).
6
In terms of the displaced diusion parameterised by , this implies =
1
f
k
(0).
7
Unfortunately he does not provide any details of these calculations.
8
This was also note by Muck [40].
5. ALTERNATE WAYS TO INTRODUCE SMILES 32
The slope, with respect to f
k
(t) of the quadratic variation (alternatively consider the slope of the
instantaneous volatility function) is expressed as:
The displaced diusion case:
(f
k
(t) + (1 )f
k
(0))
2
2
,k
f
k
(t)
f
k
(t)=f
k
(0)
= 2 (f
k
(t) + (1 )f
k
(0))
2
,k
|
f
k
(t)=f
k
(0)
= 2 f
(21)
k
(0)
2
,k
.
The CEV case:
_
f
k
(t)
,k
_
2
f
k
(t)
f
k
(t)=f
k
(0)
= 2 f
(21)
k
(0)
2
,k
.
Earlier in this chapter, I noted that a strong dependence between the level of forward rates and
the (lognormal) Black implied volatilities may be observed in the market. If we switch from a
lognormal process to CEV or displaced diusion dynamics, hence expressing the implied volatility
in the appropriate co-ordinates, much of this dependence is eliminated. See Rebonato [54] for the
CEV case and [52], [53] for the displaced diusion case.
5. Alternate ways to introduce smiles
5.1. Jumps. Another way of introducing skew and smile characteristics to the volatility curve
is via jumps in the dynamics of the underlying. An application of this approach to the LMM was
developed by Glasserman and Kou [25] and Glasserman and Merener [26]. This model has not
gained much acceptance for several reasons. It presents some technical complications, requiring
strongly time dependent parameters of the jump process (specically the jump frequency and jump
distribution) which gives rise to non-time-homogenous volatility term structures. Additionally the
jump component needs to be improbably high to calibrate to observed smiles.
5.2. Uncertain Volatility and Mixture of Models. Another method introduced in the past
few years involves prices obtained as a weighted average of prices from dierent simple models.
Supporters suggest this to be an easy way to add stochastic volatility to a pricing approach and
incorporate a market observed smile. Gatarek [23] and Johnson and Lee [33], among others, propose
using a conventional model for each of a predetermined set of input volatilities
i
, i = 1, , N.
The nal instrument price then becomes a weighted average of these prices, where the weights are
chosen so as to calibrate to some market instruments. In fact this general approach is based on an
early result by Hull and White [28], see Chapter 4, 3 for a discussion of this result. Additionally
Johnson and Lee [33] propose to use this to calibrate to volatility smile dynamics contained in exotic
options such as barriers and cliquets.
Piterbarg [44] opposes this modelling approach, claiming it to be under-specied and self-inconsistent.
He does not dispute its applicability and validity for European options, where only the average
volatility (term volatility) over the term to expiry has a bearing on the option price; the actual path
taken is immaterial. The problem arises when pricing exotics (which depend on the volatility path).
There may be multiple dynamics capable of producing the same mixture, yet giving rise to dierent
derivative prices.
5. ALTERNATE WAYS TO INTRODUCE SMILES 33
An alternate mixture of models approach taken by Brigo and Mercurio [9], [10] is more thorough
and avoids the problems highlighted by Piterbarg. Brigo and Mercurio propose a LMM where each
forward rate follows a diusion process uniquely determined by a mixture of lognormal density
functions. Specically they determine a local volatility function (, f
j
()) such that the SDE
9
:
df
j
(t) = (t, f
j
(t)) f
j
(t)dW
j
(t)
has a unique, strong solution with marginal density given by a mixture of lognormals as:
p
t
(y) =
d
dy
Q
j
{f
j
(t) y} =
N
i=1
i
p
i
t
(y), t T
j
,
with
N
i=1
i
= 1 and p
i
t
(y) being lognormal densities associated with a deterministic volatility
i
(t)
of the i
th
lognormal dynamics:
df
j,i
(t) =
i
(t)f
j,i
(t)dW
j
(t), i = 1, , N.
9
As before dW
j
is a Brownian motion under the Q
j
forward measure.
CHAPTER 4
Stochastic Volatility Approach
1. Introduction
The approaches discussed in the previous two chapters go a long way to accounting for the variability
observed in time series of implied volatilities. Additionally they incorporate a skew generating
mechanism within the pricing framework. However, as noted by Andersen and Andreasen [1], they
are unlikely to account for all the pertinent dynamics. Rebonato [50], [54] discusses empirical data
of implied volatility dynamics, nding support for the inclusion of stochastic volatility to improve
LMM realism.
Once a stochastic volatility model has been specied, the pricing of derivative instruments (especially
in the LMM framework) is almost exclusively by Monte Carlo. This is due to the additional source
of uncertainty introduced by the stochasticity of the volatility, as well as the complexity of the payo
function that characterises the types of derivatives for which such a model is required. In general
no closed-form solutions exist, even for the simple vanilla instruments used for calibration (caps,
swaptions). Calibration by means of Monte Carlo is prohibitively time consuming, so the main work
in developing a stochastic volatility model is nding computationally ecient approximations for
pricing of vanilla instruments to facilitate calibration.
2. Modelling techniques
Lewis [37] is an extensive text detailing an array of volatility modelling approaches with reference
to equity and FX. Many of these approaches have subsequently been applied, by the authors listed
below, to the LMM case. Among others, Lewis deals with transform based solutions (Fourier and
Laplace transforms), asymptotic expansions - specically volatility of volatility expansions and the
mixture approach, already mentioned in the previous chapter.
In another recent text by Fouque et. al. [21], volatility is assumed to follow a fast mean-reverting
process and call prices are approximated by expansion of this fast mean reversion parameter. The
literature on asymptotics expansions for stochastic volatility is extensive including many papers
by Fouque et. al. such as [19], [22], [20], Sircar and Papanicolaou [58], Lee [36] (who compares
slow-variation, small-variation and Fouque et. al.s fast-variation asymptotics) and Rasmussen and
Wilmott [48].
Three main published approaches to the inclusion of stochastic volatility in the LMM are: Joshi
and Rebonato [35], [34], [50]; Andersen and Brotherton-Ratclie [3] and Andersen and Andreasen
[1]; and Piterbarg [45], [46], [47]. Piterbarg builds on the work by Andersen, Brotherton-Ratclie
and Andreasen, I discuss their approach rst.
However, before looking at stochastic volatility extensions of the LMM, I make a short detour
to examine a result by Hull and White [28] which has become prevalent in stochastic volatility
applications.
34
3. UNCORRELATED ASSET AND VARIANCE PROCESSES 35
3. Uncorrelated Asset and Variance Processes
Here we consider pricing problem as in Hull and White [28]. Consider a derivative security
contingent on an underlying asset S. Let V =
2
be the instantaneous variance of this asset.
Additionally, S and V are driven by the dynamics:
dS = rSdt +(t)SdW,
dV = (, t)V dt +(, t)V dZ,
where r is the risk free rate, the drift and diusion coecients of the variance process are independent
of S and the Brownian motions
1
are uncorrelated, i.e. dWdZ = 0.
Within this framework, the time t derivative price must be the present value of the expectation of
the time T derivative value
2
. Hence:
(3.1) (S
t
,
2
t
, t) = exp(r(T t))
_
(S
T
,
2
T
, T)p(S
T
|S
t
,
2
t
)dS
T
,
where (S
T
,
2
T
, T) = max [0, S
T
K] is the payout of a European call option and p(S
T
|S
t
,
2
t
)
is the conditional distribution of S
T
given time t asset price and instantaneous variance. This
highlights that the distribution of S
T
is dependent on the processes driving the asset price, S, and
the variance,
2
. Hull and White use the following relationship between three dependent random
variables:
p(x|y) =
_
g(x|z)h(z|y)dz
to simplify (3.1). Dening

V , the average or term variance as:
V =
1
T t
_
T
t
2
u
du,
the conditional density function of the asset price may be simplied as:
p(S
T
|
2
t
) =
_
g(S
T
|
V )h(
V |
2
t
)d
V .
The conditional distributions of S on either side remain dependent on the starting asset value S
t
,
but this notation is suppressed for simplicity. Hence, (3.1) becomes:
(S
t
,
2
t
, t) = exp(r(T t))
_ _
(S
T
,
2
T
, T)g(S
T
|
V )h(
V |
2
t
)dS
T
d
V
=
_ _
exp(r(T t))
_
(S
T
,
2
T
, T)g(S
T
|
V )dS
T
_
h(
V |
2
t
)d
V
=
_

(
V )h(
V |
2
t
)d
V , (3.2)
where

is the Black Scholes call price with input variance

V . Hence, the derivative price is the
Black Scholes price integrated over the distribution of the term variance. This last step is only
valid in the case that the asset price and variance processes are instantaneously uncorrelated and of
course, only applicable to European style derivatives where the valuation depends on term variance
only; that is the path taken by the variance is immaterial.
1
These are risk-neutral dynamics, hence W and Z are Brownian motions in the risk-neutral world.
2
Where time T is usually taken to be expiry time and hence the derivative value is the terminal payout.
4. ANDERSEN, BROTHERTON-RATCLIFFE APPROACH 36
To fully determine the price of the European derivative (S
t
,
2
t
, t) we need an analytic form for the
distribution of the term variance, i.e. an analytic form for its conditional pdf h(
V |
2
t
). This is not
possible for a general process for V . Determining the rst few moments of this distribution, Hull
and White use a Taylor series expansion of

(
V ) around

V , the mean value of the term variance,

to approximate (S
t
,
2
t
, t) as follows:
V ) =

(
V ) +

V )
V
(
V ) +
1
2
V )
V
2
V
(
V )
2
+
1
6
V )
V
3
V
(
V )
3
+ ,
(S
t
,
2
t
, t) =
_

(
V )h(
V |
2
t
)d
V
=

(
V ) +
_

V )
V
(
V ) h(
V |
2
t
)d
V +
_
1
2
V )
V
2
V
(
V )
2
h(
V |
2
t
)d
V
+
_
1
6
V )
V
3
V
(
V )
3
h(
V |
2
t
)d
V +
=

(
V ) +
1
2
V )
V
2
V
_
(
V )
2
h(
V |
2
t
)d
V
+
1
6
V )
V
3
V
_
(
V )
3
h(
V |
2
t
)d
V +
=

(
V ) +
1
2
V )
V
2
V
Var(
V ) +
1
6
V )
V
3
V
Skew(
V ) + . (3.3)
The last two steps follow since the derivative terms are constants and the integrals represent the
second and third central moments of the distribution of

V .
4. Andersen, Brotherton-Ratclie Approach
4.1. Forward rate and volatility dynamics. Andersen and Andreasen [2] extended the
classical (lognormal) LMM to allow volatility functions with a freely speciable level dependence,
with arbitrage free dynamics of the forward rates expressed as
3
:
(4.1) df
k
(t) = (f
k
(t))
k
(t)dW
k
(t), k = 0, , n 1,
where
k
is an m-dimensional
4
volatility function and W
k
is an n-dimensional Brownian motion
under the Q
k
forward measure. Alternatively, under the spot pricing measure Q, we have:
df
k
(t) = (f
k
(t))
k
(t) [
k
(t)dt +dW(t)] , k = 0, , n 1, (4.2)
k
(t) =
k
j=n(t)
j
(f
j
(t))
j
(t)
1 +
j
f
j
(t)
, T
n(t)1
< t T
n(t)
, (4.3)
3
See Chapter 3 4.2 for the detailed analysis.
4
In previous sections f
k
is driven by a single Brownian motion, hence
k
was a scalar function. This extension
to m Brownian sources represents a simple change of co-ordinates.
where the correlation between the k
th
and j
th
forward rates is implied in the volatility loadings
constituting
j
and
k
. Andersen and Brotherton-Ratclie [3] extend this set-up by specifying a
scalar mean-reverting variance process of the form:
(4.4) dV (t) = ( V (t))dt +(V (t))dZ(t),
where Z(t) is a Brownian motion under Q; , and are positive constants and is a well behaved
function such that : R
+
R
+
. This positivity is required to preclude negative variance, hence
set
5
(0) = 0. V (t) becomes a multiplicative scaling factor on the diusion coecient of the forward
rate process, that is:
(4.5) df
k
(t) = (f
k
(t))
_
V (t)
k
(t)
_
_
V (t)
k
(t)dt +dW(t)
_
, k = 0, , n 1,
where
k
is unchanged from (4.3) and dZ(t) is uncorrelated with the Brownian motions driving the
forward rates, i.e. dZ(t)dW
i
(t) = 0, i = 1, , m.
This assumption of independence of the sources of randomness is contrary to that assumed in
stochastic volatility models for equity and FX. In equity/FX models the stochastic volatility process
is overlaid on a lognormal process for the underlying; the correlation between sources of uncertainty
is required to t the asymmetry observed in volatility smiles. In this implementation, the stochastic
volatility factor is overlaid on a forward rate process with level dependent volatility specied by
function (f
k
(t)). This function is perfectly (positively or negatively) dependent on the forward
rate and introduces asymmetry (skewness) into the volatility prole. The remaining uncertainty in
the volatility specication can then be introduced by means of an uncorrelated Brownian motion.
This is the two-component set-up supported by Rebonato [51] and discussed in Chapter 3 3.
The independence of the Brownian motions means we can express the forward rate dynamics in
(4.5) under the forward risk neutral measure Q
k
, leaving the process for V (t) unchanged. Hence
(4.5) becomes:
(4.6) df
k
(t) = (f
k
(t))
_
V (t)
k
(t)dW
k
(t), k = 0, , n 1,
with V (t) unchanged as in (4.4). This can easily be shown by revisiting to the change of measure
analysis in Chapter 1. Specically from equation (3.14) of Chapter 1, the drift under the new
probability measure may be specied as
6
:
k
t
(V (t)) =
t
(V (t)) +
dV (t)d ln(P(t, T
k+1
)/B(t))
dt
=
t
(V (t)).
As detailed in Chapter 1 4, ln(P(t, T
k+1
)/B(t)) is a function of forward rates and hence
dV (t)d ln(P(t, T
k+1
)/B(t)) is a sum of covariances between dV (t) and df
j
(t), j = n(t), , k for
T
n(t)1
< t T
n(t)
, which are all zero (since we dened the Brownian motion driving the variance
to be independent to those driving the forward rates).
As mentioned above, approximations allowing fast and accurate pricing of caps and swaptions are
key to ecient calibration to market prices. Andersen and Brotherton-Ratclie develop asymptotic
expansions for the pricing of these instruments.
5
When variance becomes zero, (4.4) becomes a deterministic process with positive drift, ensuring a return to
positivity.
6
Since V (t) is not lognormal, unlike the asset in the original analysis, I substitute the correct co-ordinates.
4.2. Caplet Pricing Approximations. A cap comprises a series of caplets, each paying at
time T
k+1
an amount
k
(f
k
(T
k
) X)
+
where X is the strike. The time t price is:
C(t) = P(t, T
k+1
)
k
E
Q
k
t
_
(f
k
(T
k
) X)
+
.
Let G(t, f
k
(t), V (t)) = E
Q
k
t
[(f
k
(T
k
) X)
+
]. For European caplets we require only the total term
volatility hence we may replace
k
(t)dW
k
(t) in (4.6) with
k
(t)dY (t), where dY (t) is a scalar
Brownian motion such that dZ(t)dY (t) = 0. Dynamics of V (t) in (4.4) remain unchanged and we
apply the Keynmann-Kac Theorem to derive the PDE for G(t, f, V ) as:
G
t
+( V )
G
V
+
1
2
2
(V )
2
G
V
2
+
1
2
2
(f
k
)V
k
2

2
G
f
k
2
= 0,
s.t. G(T
k
, f
k
(T
k
), V ) = (f
k
(T
k
) X)
+
.
Given the above PDE with associated dynamics of f
k
(t) and V (t), there are two points of deviation
from the standard Black formulation:
The forward rate dynamics (4.6) are not lognormal under the forward risk neutral mea-
sure associated with their payo time. Instead the level dependence of the volatility is
determined by a general function of the forward rate (f
k
(t)).
The variance is not deterministic, but driven by a mean reverting stochastic process.
To determine a solution to the above PDE, and hence an analytic caplet pricing formula, Andersen
and Brotherton-Ratclie rst consider the deviation from lognormality of the forward rate dynamics.
They develop an asymptotic solution for this PDE which takes the form of a small-time expansion
around (f
k
) = f
k
, the lognormal dynamics of the underlying for which a known solution, the Black
caplet formula, exists.
Then, allowing volatility to be stochastic, they use the Taylor series expansion developed by Hull
and White [28] (see 3) which requires the central moments of the integrated volatility distribution
to be calculated.
To ease notation we let
k
(t)
k
(t) in what follows.
4.3. Asymptotic Expansion of the Pricing PDE. Andersen and Brotherton-Ratclie rst
consider the case where V and (t) are constant i.e. V (t)(t)
2
= c, a constant. This is used as a
base which is extended for stochastic V and time dependent .
For this special case of V (t)
2
= c, the above PDE becomes:
(4.7)
G
t
+
1
2
2
(f
k
)c
2
G
f
k
2
= 0 s.t. G(T
k
, f
k
(T
k
)) = (f
k
(T
k
) X)
+
.
Let = T
k
t, the asymptotic solution to PDE (4.7) is G(t, f
k
) = g(t, f
k
; c) with
g(t, f
k
; c) = f
k
N(d
+
) XN(d
), (4.8)
d
=
ln(f
k
/X)
1
2
(t, f
k
, c)
2
(t, f
k
, c)
,
where N() is the cumulative normal distribution function and takes the form:
(t, f
k
, c) =
0
(f
k
)c
1/2
1/2
+
1
(f
k
)c
3/2
3/2
+O(
5/2
), (4.9)
with:
0
(f
k
) =
ln(f
k
/X)
_
f
k
X
(u)
1
du
, (4.10)
1
(f
k
) =

0
(f
k
)
_
_
f
k
X
(u)
1
du
_
2
ln
_
0
(f
k
)
_
(X)f
k
(f
k
)X
_
1/2
_
. (4.11)
The details of this solution are presented in the Appendix.
Slightly relaxing our volatility assumptions to allow V (t) and (t) to be a functions of time, the
asymptotic solution (4.8) remains largely unchanged if we set c to be the integrated variance, that
is:
c =
1
_
T
k
t
(u)
2
V (u)du.
For the fully general case of stochastic V (t) and time-dependent (t), the asymptotic solution
becomes:
G(t, f
k
, V ) = E
t
_
g(t, f
k
;
1
U(T
k
))
=
_

0
g(t, f
k
;
1
U(T
k
))P(U(T
k
)|V (t))dU(T
k
),
U(T
k
) =
_
T
k
t
(u)
2
V (u)du,
where the expectation is over the distribution of U(T
k
) under the Q
k
measure, hence P(U(T
k
)|V (t))
is the pdf of the integrated volatility, conditional on V (t).
To evaluate the above expectation using a Taylor series expansion requires the central moments of
the distribution of U(T
k
). From the denition of U(T
k
), the rst central moment is:
E
t
[U(T
k
)] =
_
T
k
t
(u)
2
E
t
[V (u)] du =
7
_
T
k
t
(u)
2
_
+ (V (t) )e
(ut)
_
du
U
(t, V (t)).
4.4. Finding the Higher Moments. Andersen and Brotherton-Ratclie follow the ideas in
Lewis [37], who shows that for the case of uncorrelated Brownian motions driving the processes for
the underlying and the volatility, the density function of the term volatility and the fundamental
transform are Laplace transform-inversion pairs. That is:
(4.12)
L
T
k
P(U(T
k
)|V (t))(s) = E
t
_
e
sU(T
k
)
_
=
_

0
e
sU(T
k
)
P(U(T
k
)|V (t))dU(T
k
) =

H(t, V (t); s),
7
From the deterministic part of the dynamics of V (t) are:
dV (t) = ( V (t))dt,
which may be solved as a simple ODE:
_
u
t
dV (s)
V (s)
=
_
u
t
ds,
V (u) = + (V (t) ) e
(ut)
.
where L
T
k
denotes the Laplace transform of the time T
k
variable, s is the transform variable and
H(t, V (t); s) is the fundamental transform

8
of derivative H(t, f
k
, V ).
If we are able to determine this fundamental transform of a derivative, given our specic forward
rate and volatility processes, we can use a Laplace transform-inversion to determine the pdf of the
term volatility U(T
k
). Alternatively, the Laplace transform above may be interpreted as the moment
generating function of U(T
k
) with parameter s. This allows us to determine the raw moments of
the pdf by taking progressively higher order derivatives of the moment generating function.
Following Lewis [37] we derive the PDE for

H and attempt to solve it
9
.
The derivative price G(t, f
k
, V ), is an expansion around the know solution for the case (f
k
) = f
k
,
hence in determining the PDE for

H we consider this special case of the f
k
dynamics (4.6), namely:
df
k
(t) = f
k
(t)
_
V (t)
k
(t)dW
k
k
(t), k = 0, , n 1,
d lnf
k
(t) =
1
2
V (t)
k
(t)
2
dt +
_
V (t)
k
(t)dW
k
k
(t).
Applying Itos lemma, the PDE for H(t, f
k
, V ) in terms of ln f
k
(t) is:
(4.13)
H
t

1
2
V (t)(t)
2
H
lnf
k
+( V (t))
H
V
+
1
2
V (t)(t)
2

2
H
(lnf
k
)
2
+
1
2
2
(V (t))
2
2
H
V
2
= 0.
Introducing the Fourier transform of H(t, f
k
, V ):
H(t, V, q) =
_

e
iq ln x
H(t, x, V ) d lnx,

H
t
=
_

e
iq ln x
H
t
d lnx.
Substituting for
H
t
from (4.13) yields:

H
t
=
_

e
iq ln x
_
1
2
V (t)(t)
2
H
lnx
( V (t))
H
V

1
2
V (t)(t)
2

2
H
(ln x)
2
1
2
2
(V (t))
2
2
H
V
2
_
d lnx
= ( V (t))

H
V

1
2
2
(V (t))
2
2

H
V
2
+
1
2
V (t)(t)
2
_

e
iq ln x
H
lnx
d lnx (4.14)
1
2
V (t)(t)
2
_

e
iq ln x

2
H
(lnx)
2
d lnx.
8
The fundamental transform is the Fourier transform of a derivative price, such that it satises the terminal
boundary condition

H(T, V ; s) = 1. It can be used as a fundamental derivative from which other derivative prices
are determined.
9
Of course our ultimate goal is a solution to the caplet pricing problem, G(t, f
k
, V ). However, we use the
Fourier transform technique as a tool to determine the moments of the integrated variance distribution, rather than
a nal solution to G(t, f
k
, V ). These required moments are a function of the forward rate and variance specications
rather than a specic derivative payo, hence we use the simplest possible derivative which will allow us to apply the
relationship (4.12).
For the last two terms, integrate by parts:
_

e
iq ln x
H
lnx
d lnx = e
iq ln x
H iq
_

e
iq ln x
H d lnx,
_

e
iq ln x

2
H
(lnx)
2
d lnx = e
iq ln x
H
lnx
iq
_

e
iq ln x
H
lnx
d lnx
= e
iq ln x
H
lnx
iq e
iq ln x
H + (iq)
2
_

e
iq ln x
H d lnx.
Here, it is assumed that the boundary terms associated with this integration by parts can be ignored
(see Lewis [37] on this point), hence (4.14) becomes:

H
t
= ( V (t))

H
V

1
2
2
(V (t))
2
2

H
V
2

1
2
iqV (t)(t)
2

H
1
2
(iq)
2
V (t)(t)
2

H
= ( V (t))

H
V

1
2
2
(V (t))
2
2

H
V
2
+
1
2
V (t)(t)
2
(q
2
iq)

H.
Setting s =
1
2
(q
2
iq) the PDE for

H becomes:
(4.15)

H
t
+( V (t))

H
V
+
1
2
2
(V (t))
2
2

H
V
2
V (t)(t)
2
s

H = 0.
By Lewis

H(t, V ; s) is the fundamental transform if it is a solution to the above PDE and satises
the boundary condition

H(T
k
, V ; s) = 1. Specically the boundary condition

H(T
k
, V ; s) is given
by the Fourier transform of the derivative payo function.
Now dene a centred transform h(t, V (t); s) as:
h(t, V ; s) = e
s
U
(t,V )

H(t, V ; s) (4.16)
= e
s
U
(t,V )
E
t
_
e
sU(T
k
)
_
= E
t
_
e
s(U(T
k
)
U
(t,V ))
_
.
Formulating the PDE is terms of the centred transform focuses the solution on deviations from the
mean. These will be small close to expiry i.e. for small = T
k
t and for small volatility of variance
parameter .
Substituting into PDE (4.15) and using the denition of
U
(t, V ) yields:
(4.17)
h
t
+( V (t))
h
V
+
1
2
2
(V (t))
2
_
2
h
V
2
+ (s(t))
2
l 2s(t)
h
V
_
= 0,
where (t)
_
T
t
(u)
2
e
(ut)
du and since

H(T
k
, V ; s) = e
s
U
(T
k
,V )
h(T
k
, V ; s) = 1, we have
boundary condition
10
h(T
k
, V ; s) = 1. Hence h(t, V ; s) may be interpreted as the centred funda-
mental transform.
All that remains is to solve PDE (4.17) for h(t, V ; s). This could be done by asymptotic series
expansion for small , as for (4.7), although here, the time dependent term (t) complicates matters.
Instead Andersen and Brotherton-Ratclie apply an expansion in the square of the volatility of
variance parameter
2
, hence their solution takes the form:
h(t, V ; s) = 1 +
2
h
1
(t, V ; s) +
4
h
2
(t, V ; s) +O(
6
),
10
Since
U
(T
k
, V ) = 0.
where h
1
(t, V ; s) and h
2
(t, V ; s) are found by substituting the above expansion into (4.17), grouping
terms with coecients
i
, i = 2, 4 and solving the resulting ODEs. h
1
(t, V ; s) and h
2
(t, V ; s) are
specied in terms of double integrals which need to be computed numerically in most cases. I do
not show these results.
Having found the solution h(t, V ; s) we combine the denitions of the transforms in (4.12) and (4.16)
as:
h(t, V ; s) = E
t
_
e
s(U(T
k
)
U
(t,V ))
_
=
_

0
e
s(U(T
k
)
U
(t,V ))
P(U(T
k
)|V (t))dU(T
k
).
Interpreting this representation as a moment generating function, we can determine the central
moments by taking derivatives of h(t, V ; s) with respect to s, hence:
E
t
[(U(T
k
)
U
(t, V ))
n
] = (1)
n

n
h
s
n
s=0
, n = 2, 3, .
Here the second and third moments E
t
_
(U(T
k
)
U
(t, V ))
2
_
and E
t
_
(U(T
k
)
U
(t, V ))
3
_
are the
variance and skew used in the Taylor expansion (see equation (3.3)) to approximate the derivative
price. The rst term of the expansion is derivative price evaluated at the mean integrated variance,
i.e. g(t, f
k
;
1
U
(t, V )).
4.5. Swaption Pricing Approximation. Treating the swap rate as the weighted sum of its
constituent forward rates, and using approximations similar to those discussed in 7 of Chapter
1, its dynamics may be expressed in terms of the forward rate volatilities, while maintaining the
martingale structure of the forward rate dynamics in (4.6). This means the caplet and swaption
pricing problems are identical (although they are formulated under dierent numeraires), and the
results developed above may be applied to swaptions as well.
An application of Itos Lemma and a change of measure yields:
(4.18) dS
,
(t) =
_
V (t)
1
j=
S
,
(t)
f
j
(t)
(f
j
(t))
j
(t)dW
,
(t).
We would like the swap rate dynamics to assume the same form as that of forward rates in (4.6),
hence:
dS
,
(t) = (S
,
(t))
_
V (t)
,
(t)dW
,
(t).
Equating these two we have:
dS
,
(t) = (S
,
(t))
_
V (t)
1
j=
w
j
(t)
j
(t)dW
,
(t), (4.19)
with:
w
j
(t) =
S
,
(t)
f
j
(t)
(f
j
(t))
(S
,
(t))
. (4.20)
Now, assuming that
S
,
(t)
f
j
(t)
and
(f
j
(t))
(S
,
(t))
vary little with time, freeze the weights at their time
t = 0 values and the swap rate dynamics are approximated as:
dS
,
(t) = (S
,
(t))
_
V (t)
1
j=
w
j
(0)
j
(t)dW
,
(t),
5. PITERBARG APPROACH 43
or in terms of the swap rate volatility:
dS
,
(t) = (S
,
(t))
_
V (t)
,
(t)
dW
,
(t).
The validity of the assumptions underlying this approximation is dependent on reasonable shifts
in the yield curve and the specic form of . See Andersen and Andreasen [2] and Andersen and
Brotherton-Ratclie [3] on these points.
4.6. Asymptotic Expansions. The pricing solution discussed above relies on two sets of
asymptotic expansions. The rst is a small time (specically term to expiry) expansion for the
solution of PDE (4.7), second is the volatility-of-variance expansion to solve the PDE for the centred
transform (4.17). This brings into question the performance of these solutions when time is not small
or when volatility-of-variance becomes large. Andersen and Brotherton-Ratclie comment that the
small time expansion works well, even for long term options. They show close correspondence
between the expansion solution and analytic solutions of a 10-year option, for a variety of forms of
().
Market conditions can make the volatility-of-variance expansion unsuitable. A more recent update of
the paper by Andersen and Brotherton-Ratclie [3] (this is the paper referenced here, although much
of the work studied already appeared in a 2001 version) as well as a published version (Andersen and
Andreasen [1]) explores solutions for the specic case (x) =

x and (x) = x or (x) = ax + b,
hence the variance follows a square-root process while the forward rate is either lognormal or a
displaced-diusion. This is motivated by recent market conditions, characterised by high volatility-
of-volatility which makes the volatility-of-variance expansion unreliable. A square root process for
the volatility is more tractable and the solution makes use of Fourier transforms as in Carr and
Madan [11] and Lewis [37], avoiding the volatility-of-variance asymptotic expansion. However, for
general () the expansion solution is still applied.
5. Piterbarg Approach
Piterbarg [45], [46], [47] bases his model on the work of Andersen and Brotherton-Ratclie above,
but makes use of displaced-diusion dynamics rather than the CEV approach. The complexity of
approximating cap and swaption prices in the CEV framework makes the appeal of the simplicity
of displaced-diusion dynamics obvious.
Consider the CEV dynamics of Andersen and Brotherton-Ratclie [4] as in (4.6)
df
k
(t) = (f
k
(t))
_
V (t)
k
(t)dW
k
(t),
with:
(f
k
(t)) = f
k
(t)
.
Then using the parameterisation in (4.2) of Chapter 3, 4.1 and the link between CEV and displaced
diusion described in Chapter 3, 4.3 the above dynamics may be reparameterised as a displaced-
diusion process
11
:
(5.1) df
k
(t) =
_
f
k
(t) + (1 )f
k
(0)
_
_
V (t)
k
(t)dW
k
(t),
11
The volatility parameter
k
will also change in the transition to displaced-diusion dynamics, I have left the
notation unchanged since it has no bearing on what follows.
where V (t) has dynamics given by (4.4) with (V (t)) =
_
V (t), that is:
(5.2) dV (t) = ( V (t))dt +
_
V (t)dZ(t).
In this set-up, each forward rate has deterministic local volatility component which determines
the slope of the skew ATM, this is driven by parameter . Additionally each forward rate has a
stochastic volatility component
_
V (t) which determines the curvature of the smile through the
volatility-of-variance parameter, . Since the same local volatility function and stochastic volatility
perturbation are applied across forward rates, the same general volatility smile shape is produced
for all swaption expiries and maturities.
Based on the observation that swaptions of dierent expiries and maturities display varying smile
shapes, Piterbarg uses an entire swaption skew matrix as input to calibrate to all European swaptions
across expiries, maturities and strikes. To achieve this he introduces a time and LIBOR rate specic
volatility skew parameter; but leaves the stochastic volatility perturbation uniform across LIBOR
rates.
5.1. Model Inputs and Synopsis of Modelling Process. Piterbarg takes as his starting
point a trading desk using a stochastic volatility model to price swaptions, specically a displaced-
diusion swap market model with dynamics of the form in (5.1) and (5.2), that is:
dS(t) =
_
S(t) + (1 )S(0)
_
_
V (t)dW(t),
dV (t) = ( V (t))dt +
_
V (t)dZ(t),
V (0) = ,
dWdZ = 0.
This model is calibrated separately for each swap rate S
,
, giving rise to a matrix of triples
{(
,
,
,
,
,
)}
n1
,=0
( + <= n 1).
The Monte Carlo pricing of exotic derivative products is in a forward LIBOR framework, so the
aim of Piterbargs work is to obtain model parameters {
j,k
(t), t 0}
j,k
and {
j
(t), t 0}
j
from
the market implied ones, {(
,
,
,
,
,
)}
n1
,=0
. See section 5.2 below for an exact denition of
j,k
(t),
j
(t).
The model parameters are volatility and skew of the forward rate process, while input parameters
are related to swap rates. The modelling procedure attempts to link up these quantities in two
steps:
Determine time dependent swap rate volatility
,
(t) and skew
,
(t) as a function
of time dependent forward rate volatility
j,k
(t) and skew
j
(t), these being the model
parameters.
Formulate eective skew,
,
and eective volatility,
,
parameters as the time in-
dependent skew and volatility functions approximating the time dependent ones,
,
(t)
,
(t).
The model calibration then becomes a least squares t of
,
and
,
to market implied parameters
{(
,
,
,
,
,
)}
n1
,=0
, that is:
min

,
,
(
,
,
)
2
,
min

,
,
(
,
,
)
2
.
5.2. Model Set-Up. Introduce a set of time dependent functions, the instantaneous forward
LIBOR skews:
{
j
(t), t 0}
n1
k=0
,
then the dynamics, under measure Q
k
, of the set of spanning forward LIBOR rates are:
(5.3) df
k
(t) =
_
k
(t)f
k
(t) + (1
k
(t))f
k
(0)
_
_
V (t)
k
(t)dW
k
(t), k = 0, , n 1.
We would like to approximate swap rates by an SDE of the same form as that of forward rates in
(5.3), that is:
dS
,
(t) =
_
,
(t)S
,
(t) + (1
,
(t))S
,
(0)
_
_
V (t)
,
(t)
dW
,
(t). (5.4)
Hence we need to nd
,
(t) and
,
(t) in terms of appropriate forward rate parameters. To
determine the swap rate instantaneous volatility,
,
(t), in terms of forward rate volatilities follow
the steps in 4.5 with:
(f
j
(t)) =
j
(t)f
j
(t) + (1
j
(t))f
j
(0),
(S
,
(t)) =
,
(t)S
,
(t) + (1
,
(t))S
,
(0),
hence the weights take the form:
w
j
(t) =
S
,
(t)
f
j
(t)
(f
j
(t))
(S
,
(t))
=
S
,
(t)
f
j
(t)
j
(t)f
j
(t) + (1
j
(t))f
j
(0)
,
(t)S
,
(t) + (1
,
(t))S
,
(0)
,
w
j
(0) =
S
,
(0)
f
j
(0)
f
j
(0)
S
,
(0)
,
and the swap rate volatility may be expressed as:
(5.5)
,
(t)
=
1
j=
w
j
(0)
j
(t).
Having matched the volatility level, we need to match the slope of the skew function,
,
(t). We do
this by equating (4.18) (with appropriate form of (f
j
(t))) and (5.4), having rst taken derivatives
with respect to f
i
(t). Hence, derivative of (4.18) is:
f
i
(t)
_
V (t)
1
j=
S
,
(t)
f
j
(t)
_
j
(t)f
j
(t) + (1
j
(t))f
j
(0)
_
j
(t)
dW
,
(t) (5.6)
=
_
V (t)
1
j=
2
S
,
(t)
f
j
(t)f
i
(t)
_
j
(t)f
j
(t) + (1
j
(t))f
j
(0)
_
j
(t)
dW
,
(t)
+
_
V (t)
S
,
(t)
f
j
(t)

j
(t)
j
(t)dW
,
(t).
Similarly, derivative of (5.4) is:
(5.7)
,
(t)
S
,
(t)
f
j
(t)
_
V (t)
,
(t)
dW
,
(t).
In the approximation of the swap price in 4.5 we assumed the
S
,
(t)
f
j
(t)
w
j
(t), that is, the weights
w
j
are independent of the forward rates themselves. (The same approximation was applied above
in approximating volatility levels.) It follows that
2
S
,
(t)
f
j
(t)f
i
(t)
= 0
and equating (5.6) and (5.7) yields:
j
(t)
j
(t)
=
,
(t)
,
(t)
,
for all constituent forward rates j, j = , , + 1. Since this system of simultaneous equations
does not have a unique solution, we nd
,
(t) by least squares minimization. Hence:
min
,
(t)
j
_
,
(t)
,
(t)
j
(t)
j
(t)
_
2
,
and so
12
:
(5.8)
,
(t) =
j
(t)

j
(t)
,
(t)
,
(t)
,
(t)
,
making the matrix multiplication explicit, this may also be expressed as:
,
(t) =
j
(t)
m1
k=0

j,k
(t)
(,),k
(t)
m1
i=0

(,),i
(t)
2
.
As with previous models, the main challenge is to obtain fast and accurate approximations for
cap and swaption prices to facilitate calibration to market observed values. The eective skew
relates the time dependent slope of the instantaneous volatility function to the total amount of
skew generated by the model over a period and hence to the market-implied term skew. The
eective volatility is akin to the root-mean square volatility in simple lognormal models with time
dependent instantaneous volatility (thought signicantly more complex given the richer volatility
construction). These two eective parameters allow caps and swaptions to be priced via the Black
formula, making approximations such as those in 4 unnecessary.
12
Set derivative with respect to
,
(t) equal to zero.
5.3. Eective Skew. Piterbarg [46] formulates the time averaging result for the skew as a
generic theorem and applies in to the specic dynamics in an associated corollary. I merely present
the statement of the corollary without the associated proof.
Given the SDE for a generic swap or forward rate as:
(5.9) dS(t) = (t) ((t)S(t) + (1 (t))S(0))
_
V (t)dW(t).
The eective skew over time horizon [0, T] is given by:
=
_
T
0
(t)w(t)dt,
where weights w() are given by:
w(t) =
v(t)
2
(t)
2
_
T
0
v(t)
2
(t)
2
dt
,
v(t)
2
=
2
_
t
0
(s)
2
ds +
2
e
t
_
t
0
(s)
2
e
s
e
s
2
ds.
This value of the weights w() gives the most accurate call/put pricing, with accuaracy to o(
2
), all
other values of w() give O(
2
) accuracy.
Using this time averaged eective skew parameter the SDE for generic swap/forward rate in (5.9)
now becomes:
(5.10) dS(t) = (t) (S(t) + (1 )S(0))
_
V (t)dW(t).
5.4. Eective Volatility. In order to reduce the time dependent volatility in (5.10) to its
time averaged eective volatility equivalent, Piterbarg draws on the result by Hull and White [28]
(3), where option price may be expressed as the Black price, integrated over the distribution of the
term variance:
(S(0), X, 0) =
_

(
V (T), X)h(
V (T))d
V (T) = E
_
V (T), X)
_
,
where:
V (T) =
_
T
0
(t)
2
V (t)dt,
and

(
V (T), X) is the displaced diusion equivalent of the Black formula

13
.
Specically, consider the at-the-money option, that is X = S(0) and the displaced diusion formula
simplies to:
V (T), S(0)) =
S(0)
_
2N
_
V (T)/2
_
1
_
,
where N() is the usual cumulative normal distribution. The problem of nding an eective
variance is transformed to one of nding such that:
E
_
_
_
T
0
(t)
2
V (t)dt, S(0)
__
= E
_
2
_
T
0
V (t)dt, S(0)
__
.
13
From Chapter 3, 4.1 this is the usual Black formula with shifted inputs as: forward rate S(0) S(0) +
S(0)(
1
+ 1), strike K K +S(0)(

1
+ 1) and integrated variance x

2
x.
6. JOSHI AND REBONATO FORMULATION 48
Using a numerical solution to the Laplace transform of
_
T
0
(t)
2
V (t)dt Piterbarg presents the ef-
fective volatility as the solution to equation:
0
_
(, S(0))
(, S(0))

2
_
=
_
(, S(0))
(, S(0))
_
, (5.11)
where:
() = E
_
exp(
V (T))
0
() = E
_
exp(
_
T
0
V (t)dt)
_
,
=
_
T
0
(t)
2
dt.
The solution to (5.11) is obtained numerically, see Piterbarg [46] for comments on the associated
speed and complexity. Again, as with the eective skew calculation, this solution is an approxima-
tion since it involves an approximation of the option pricing function

(, S(0)), see Piterbarg [46]
for details.
5.5. Time Homogeneity of Forward Skew. The time dependence of the skew parameter
(t) in the generic SDE (5.9), implies that time homogeneity is lost. While Piterbarg does mention
that one could attempt to use a time-homogenous skew function, this would probably compromise
goodness of t. A time evolution producing signicantly dierent future swaption skews would make
model prices and hedging parameters dicult to justify.
6. Joshi and Rebonato Formulation
While Andersen and Brotherton-Ratclie [3]; and Piterbarg [46] predominantly concern themselves
with goodness of t to current cap skew/smile proles (in the case of Piterbarg the skew proles
of all expiry-maturity pairs of swaptions), Joshi and Rebonato [35] analyse the evolution of the
swaption volatility matrix over time.
6.1. Model Set-Up. Consider equation (4.2) of Chapter 2, 4. This is the specic time-
homogeneous instantaneous volatility function proposed by Rebonato, taking the form:
(6.1) (T
k
t) = (a +b(T
k
t)) exp(c(T
k
t)) +d.
The Joshi-Rebonato stochastic volatility extension uses this as the base volatility function, allowing
the parameters {a, b, c, d} to vary stochastically. Therefore, the model set-up takes the form:
d(f
i
+) =
i
(f, t)(f
i
+)dt +
i
(t, T
i
)(f
i
+)dW
i
,
i
(t, T
i
) = (a
t
+b
t
(T
i
t)) exp(c
t
(T
i
t)) +d
t
,
with:
da
t
= RS
a
(RL
a
a
t
)dt +
a
dZ
a
,
db
t
= RS
b
(RL
b
b
t
)dt +
b
dZ
b
,
d lnc
t
= RS
c
(RL
c
lnc
t
)dt +
c
dZ
c
,
d lnd
t
= RS
d
(RL
d
lnd
t
)dt +
d
dZ
d
,
and:
E[dW
i
dZ
a
] = E[dW
i
dZ
b
] = E[dW
i
dZ
c
] = E[dW
i
dZ
d
] = 0,
E[dZ
a
dZ
b
] = E[dZ
a
dZ
c
] = E[dZ
a
dZ
d
] = 0,
E[dZ
b
dZ
c
] = E[dZ
b
dZ
d
] = 0,
E[dZ
c
dZ
d
] = 0,
where RS
a
, RS
b
, RS
c
, RS
d
, RL
a
, RL
b
, RL
c
, RL
d
are the reversion speeds and reversion levels of
parameters a, b, lnc and lnd while
a
,
b
,
c
,
d
are their instantaneous volatilities.
Conceptually this model seems appealing since the parameters {a, b, c, d} maintain their nancial
interpretation as described in Chapter 2, 4, but are allowed to vary randomly therefore allowing
the volatility term structure to uctuate around a desired core structure. Practically, however, the
number of tting parameters is large, and while some simplications can be made for the case of
caplet valuation (see Joshi and Rebonato [35] and Rebonato [51]), this is not the case in general.
6.2. Derivative Pricing. Since the Brownian motions driving the forward rate process and
the volatility parameters respectively are uncorrelated, the well know Hull-White result may be
applied, that is European derivative prices are Black prices integrated over the distribution of the
term variance
14
:
(S(0), K, 0) =
_

(
V (T), K)h(
V (T))d
V (T),
where this integral (expectation) is evaluated numerically by Monte Carlo simulation. Using low-
discrepancy numbers Joshi and Rebonato [35] have found that as few as 64 volatility paths may be
needed.
6.3. Volatility Term Structure Evolution. The main aim of this model is not simply to
provide a very close match to the current observed smile surface, but to introduce exibility to
describe observed time evolution of the market volatility term structure (as represented by the
swaption matrix). Fitting is not done to time series data, but to a current time, cross-section of
volatility smile data. The consistency of the time evolution achieved by the model serves as a check
of its validity.
A variety of very dierent modelling approaches can all produce a good quality t to an exogenous
smile surface (on this point, see Rebonato [51] and references there-in), so the quality of day-one
t cannot be the single criterion for assessing the validity of a model. Rebonato and Joshi [55]
propose a comparison of market-observed and model-produced changes in the swaption matrix as
an additional check for model realism. Since market-observed values are with respect to the real
world measure while model-produced ones are with respect to a risk-neutral measure, the swaption
matrix changes are not directly comparable
15
. To overcome this, they compare the eigenvectors
obtained from a principal components analysis of the two sets of swaption matrix changes.
The results of this analysis are fairly mixed. The proportion of swaption matrix variability explained
by the rst eigenvector is much higher in the model case than it appears in reality. However, other
characteristics of the rst eigenvectors are comparable - such as general shape and the decaying
behaviour as a function of maturity. These support the general mean-reverting set-up of the volatility
function.
14
See 3 for a discussion.
15
Transformation of measure will involve a change in drifts of the volatility coecients.
Other characteristics of the swaption matrix dynamics, such as the oscillation between well dened
shapes, with varying, and at times fairly short, transition periods, are not consistent with a mean-
reverting stochastic volatility. More strongly stated (see Rebonato [50]), this serves to support a
strong rejection of purely diusive dynamics of the instantaneous volatility. This forms the basis of
work discussed in the next chapter.
Appendix
Substituting G(t, f
k
) = g(t, f
k
; c) into the simplied PDE (4.7) we have
16
:
G
t
= f
k
N
(d
+
)
d
+
t
XN
(d
)
d
t
= f
k
N
(d
+
)
t
G
f
k
= N(d
+
) +f
k
N
(d
+
)
d
+
f
k
XN
(d
)
d
f
k
= N(d
+
) +f
k
N
(d
+
)

f
k
2
G
f
k
2
=
N
(d
+
)
f
k
_
1
2f
k
lnf
k
/X

f
k
+ f
k
f
k
+
f
2
k
2
(ln f
k
/X)
2
_
f
k
_
2
1
4
2
f
2
k
_
f
k
_
2
+ f
2
k
f
k
2
_
Now using the expansion of in (4.9) to determine

t
,

f
k
and

2
f
k
2
, simplifying terms where
appears in the denominator and grouping terms with coecient
1/2
we arrive at
17
:
f
k
c
1/2
0
=

2
0
f
k
_
1 2f
k
(ln f
k
/X)(
0
/
0
) +f
2
k
(lnf
k
/X)
2
(
0
/
0
)
2
_
f
2
k
2
0
=
2
(1 f
k
(ln f
k
/X)(
0
/
0
))
2
f
k
0
= (1 f
k
(ln f
k
/X)(
0
/
0
))
and hence
18
:

0
f
k
(lnf
k
/X)
=

2
0
(f
k
)(lnf
k
/X)
which is a Bernoulli type
19
, rst order ordinary dierential equation. Its solution becomes:
16
N
() is the derivative of the standard normal cumulative density function, that is the standard normal density
function: N
(x) =
1
2
e
x
2
/2
.
17
Where primes denote derivative with respect to f
k
.
18
Taking square-roots produces two ODEs, the second taking the form:
f
k
0
=
_
1 f
k
(ln f
k
/X)(
0
/
0
)
_

0
f
k
(lnf
k
/X)
=

2
0
(f
k
)(lnf
k
/X)
This gives a negative solution for
0
, which we ignore.
19
A Bernoulli ordinary dierential equation takes the form:
dy
dx
+p(x)y = q(x)y
n
51
APPENDIX 52
0
(f
k
) =
lnf
k
/X
_
f
k
X
(u)
1
du +c
1
where c
1
is a constant. Imposing the boundary condition that
0
remain bounded as f
k
X, we
have c
1
= 0.
Similarly, after grouping terms with coecient
1/2
and some careful algebra, we have:
2f
k
1
=
1
2
2
(f
k
0
+
0
) f
k
(ln f
k
/X)
_
2
0
_
which is again a Bernoulli ODE. Re-arranging, it may be expressed as:
1
+
1
_
2
0
lnf
k
/X

0
_
=

0
2 ln f
k
/X
+

0
2f
k
lnf
k
/X
Formulating the solution as in footnote 8, substituting for
0
and
0
and some extensive simpli-
cation, the solution is expressed as:
1
(f
k
) =

0
(f
k
)
_
_
f
k
X
(u)
1
du
_
2
ln
_
0
(f
k
)
_
(X)f
k
(f
k
)X
_
1/2
_
Its solution may be written as:
y =
_
_
_
(1n)
e
(1n)
p(x)dx
q(x) dx+c
1
e
(1n)
p(x)dx
_ 1
1n
for n = 1
c
2
e
(q(x)p(x))dx
for n = 1
CHAPTER 5
Two-Regime Extension of the LMM
As discussed in Chapter 4 6.3, Rebonato and Joshi [55], [52] studied time-series of changes in
market implied swaption matrices. They found features that cannot be explained by any of the
LMM extensions discussed in the preceding chapters.
A prominent feature is the tendency of the swaption matrix to oscillate between well dened shapes.
The transition times are random and, at times, fairly short. Introducing jumps into the forward
rate dynamics allows for discontinuities, so by linking the volatility to the level of forward rates,
one could observe sudden and pronounced changes in the level of the swaption matrix. However,
this extension does not support changes in the shape of the swaption matrix. Alternatively, a mean
reverting volatility process with almost instantaneous transition between a predened number of
reversion levels could be explored. However, this would imply unreasonable behaviour for the
associated reversion speed.
1. Swaption Matrix Dynamics
First I discuss why the dynamics of the volatility surface, as proxied by the swaption matrix, are a
relevant feature for derivative pricing.
On entering into an exotic derivative contract, a trader will execute vega hedges to minimize the
exposure to changes in volatility. This is done in addition to delta hedging. Although vega neutral
at inception, this portfolio of exotic derivative and vanilla hedging instruments does not remain
so. Periodically, the trader will have to transact further vega hedges to maintain vega neutrality
over the life of the instrument. These additional vega hedges are transacted at prevailing market
prices. If each future state of the world, i.e. the volatility surface at each future rehedging time,
is fully consistent with the pricing model, the rehedging transactions incur no economic costs. In
addition to periodic rehedging, the practice of regular model recalibration exposes the trader to
realised market prices in the form of realised implied volatility skews.
If realised volatility skews dier signicantly from those predicted by the pricing model, the re-
hedging cost will be higher (or lower!) than those predicted by the model and incorporated in the
calculated premium. The success of a model in predicting future volatility surfaces will result in the
inclusion of future rehedging costs in the traded premium. Therefore, for models providing ts of
similar quality to current market prices, an additional criterion should be their ability to t future
market prices with reasonable accuracy. To incorporate such a feature, we would like the smile
surface dynamics produced by the model to be in line with empirically observed dynamics.
2. Two-Regime Dynamics
2.1. Model Set-Up. With a view to incorporating the above features Rebonato and Kainth
[56] propose an extension of the stochastic volatility LMM of Joshi and Rebonato [35]. They posit
53
2. TWO-REGIME DYNAMICS 54
a latent variable, y, which follows a two-state Markov-chain process. The matrix of transition
probabilities between states x and n is dened as:
(2.1)
_
p
nn
p
nx
p
xn
p
xx
_
.
States n and x represent normal and excited market conditions respectively as discussed in Chap-
ter 2, 4.2. In these states, the instantaneous volatility function of forward rate f
k
takes the form:
n
k
(t) = (a
n
t
+b
n
t
(T
k
t)) exp(c
n
t
(T
k
t)) +d
n
t
,
x
k
(t) = (a
x
t
+b
x
t
(T
k
t)) exp(c
x
t
(T
k
t)) +d
x
t
,
where parameters {a
n
, b
n
, c
n
, d
n
}
t
and {a
x
, b
x
, c
x
, d
x
}
t
, which are themselves stochastic, describe
the shape of the volatility structure in the normal and excited states respectively. Since the process
y may only take on two values: y = 1 if volatility is in the normal state and y = 0 if it is in the
excited state, the instantaneous volatility at any time t may be expressed as:
k
(t) = y
n
k
(t) + (1 y)
x
k
(t).
2.2. Fitting the Model. The model, as presented above, has a large number of tting pa-
rameters, namely:
The initial value, reversion speed, reversion level and volatility of each of {a
i
, b
i
, c
i
, d
i
}, i
{x, n} for the normal and excited volatility functions.
The transition frequencies p
nx
and p
xn
. (The remaining frequencies follow from p
nn
+p
nx
=
1 and p
xx
+p
xn
= 1.)
The forward rate displacement coecient .
To reduce the number of tting parameters Rebonato and Kainth assign plausible shapes to the
normal and excited volatility functions and locally optimize the parameters around these values. The
transition probabilities, p
nx
and p
xx
, are set so that the relative weights of rst three eigenvalues
of model-implied changes in swaption matrix are consistent with market observed ones. See the
discussion in Chapter 4 6.3.
The normal and excited volatility functions, as well as the transition probabilities are all with respect
to the risk-neutral (pricing) measure, rather than the real-world measure under which empirical
observations are made. These quantities in the real-world and risk-neutral world are not directly
comparable. Market observed transition frequencies cannot be used for the pricing purposes, rather
these values need to be calibrated from derivative prices themselves.
Rather than formulating a rigorous calibration methodology, the aim of the work done by Rebonato
and Kainth was to determine if such a regime-shifting model adds value to the LMM framework.
Given the simplications above, the remaining parameters where calibrated to market caplet data
and used to price swaptions. The characteristics of the changes in the resulting swaption matrices
were studied. The introduction of measure dependent transition probabilities further complicates
the comparison with real world data (see Rebonato and Kainth [56] for a discussion), but in general
the results suggest the two-regime feature to be a useful component in modelling the volatility smile
dynamics.
To obtain more rigorous results, tting needs to be done to the swaption matrix, with the transition
probabilities, p
nx
and p
xn
, as free tting parameters. Given the number of free parameters and
the relatively low transition probabilities, a brute-force Monte Carlo would be slow to converge and
3. MODELLING APPROACHES 55
excessively time consuming. I have studied approximations of the regime switching process which
would allow rigorous calibration, by admitting semi-analytic solutions.
3. Modelling Approaches
Here, I propose two possible simplications of the regime shifting process and a control case, which
serves as an indicator of the goodness of the approximation. In each case the volatility functions
have deterministic and I do not consider the case of stochastic parameters {a
i
, b
i
, c
i
, d
i
}, i {x, n}.
3.1. Round Trip. Empirical observations indicate the Markov process y, displays a high de-
gree of persistence in the normal state; also once in the excited state, the probability of returning
to the normal state is high. Therefore, considering the transition probability matrix in (2.1), we
may write p
nn
>> p
nx
and p
xn
>> p
xx
. Over a given horizon T, starting in a normal state, the
probability of ending in the normal state dominates (the probability of ending in the excited state).
Hence we dene a round trip as the event over horizon T, starting in the normal state, entering the
excited state and reverting back to the normal state.
round trip =
_
y(0) = y(T) = 1,
y(i) = 0 t
s
i t
e
, t
s
, t
e
(0, T).
_
.
3.2. Weighted Sum Approach. Using the concept of the round trip as dened above, con-
sider a counting process Y (t) as the number of round trips to time t. Starting in the normal volatility
state, Y takes on values Y (T) = i, i = 1, , h, occurring with probability

P(i|
n
(0)). Theoreti-
cally, in continuous time, h ; however set h to the number of round trips with a signicant
1
probability of occurrence. The derivative price may be expressed as:
(3.1) (F, X, 0,
n
(0)) =
h
i=0
(F, X, T, i)
P(i|
n
(0)),
where (, i) is the derivative price given i round trips to expiry.
3.2.1. Calculating the Probabilities.
Discrete Time. Allowing y to be a discrete time Markov chain, the transition probability matrix
in (2.1) becomes:
(3.2)
_
p
nn
p
nx
p
xn
p
xx
_
=
_
1 p
nx
p
nx
p
xn
1 p
xn
_
_
1 p
nx

n
t
x
t 1 p
xn
_
, for small t,
where
n
and
x
are transition rates from normal to excited and excited to normal respectively.
Allowing a unit interval of 1 year, we expect
n
to be approximately 1, while
x
20. Hence we
expect to jump into the excited state once per unit interval, and remain there approximately 18
days
2
. Although these numbers are based on empirical ndings, the corresponding rates under the
risk-neutral measure should be of similar magnitude
3
.
1
Signicantly dierent from zero.
2
Allowing 360 time steps per unit interval of 1 year, this corresponds to a transition to normal state approximately
20 times per year.
3
For risk averse investors
n
would be higher than its real-world counterpart.
Example. The probability of 1 round trip over horizon T = 1, dividend into 360 time-steps, is:
P(1|
n
(0)) = p
nn
p
nx
p
xx
p
xn
p
nn
, + + + 2 = 360, , , 0
= p
nx
p
xn
358
=0
(358 1) p
358
nn
p
xx
.
Similarly, all

P(i|
n
(0)), i 2 may be calculated
4
.
Continuous Time. Allowing y to be a continuous time Markov chain with holding times in the
normal and excited states having exponential distributions with parameters
n
and
x
respectively:
n
Exp(
n
),
x
Exp(
x
).
The probability of m regime shifts (not round trips) may be represented as:
(
1
+
2
+ +
m+1
T;
1
+
2
+ +
m
< T),
with probability:
_
T
0
P(
m+1
T s)f
1
+
2
++
m
(s)ds,
where f
1
+
2
++
m
(s) is the pdf of the sum of holding times
i
, i = 1, , m.
Example. One round trip, or 2 regime shifts, is represented as:
(
1
+
2
+
3
T;
1
+
2
< T),
where
1
and
3
are times in the normal state, while
2
represents the time in excited state. The
associated probability is:
P(1|
n
(0)) =
_
T
0
P(
3
T s)f
1
+
2
(s)ds =
_
T
0
_

Ts
f
3
(y)dyf
1
+
2
(s)ds,
and f
3
(t) =
n
e
n
t
, the probability density function of the exponentially distributed holding time
in the normal state. By convolution we have:
f
1
+
2
(s) =
_
s
0
f
2
(x, s x)dx
=

n
n
_
e
n
s
e
x
s
_
.
So the probability of one round trip is evaluated as:
P(1|
n
(0)) =

n
x
T
n
e
n
T
x
(
x
n
)
2
_
e
n
T
e
x
T
_
.
Similarly all probabilities

P(i|
n
(0)) may be calculated. The extension to calculate probabilities of
ending in the excited state follows naturally.
4
The extension to calculate probabilities for events ending in the exited state is trivial. For example allowing
one regime shift, i.e. one jump into excited state over horizon T, we have p
nn
p
nx
p
xx
, + + 1 = 360, , 0.
3.2.2. Pricing the Derivative. Having calculated the probabilities, we could view (3.1) as a
variation of the Hull and White result where the derivative price is the Black price integrated over
the distribution of the terminal variance.

P(i|
n
(0))s represent the probability mass function of the
distribution of Y
T
.
Similar modelling approaches include that of Naik [42] and Duan et. al. [16]. Both use a Markov
chain to dene a regime switching process where regimes are characterised by dierent, constant
volatility levels. Naik specialises his model to the case of 2 volatility regimes and zero market price
of volatility regime shift risk, to nd a closed form price for European call options as:
C(S,
h
, t) =
_
(Tt)
0
C
_
S, K, r, T t,
_
s(x)
T t
_
f(x|
h
)dx,
s(x) =
2
h
x +
2
l
(T t x),
where C
() is the Black-Scholes call price, 0 x T t where x is the time spent in volatility

regime
h
and f(x|
h
) is the probability density function of this occupation time in
h
, conditional
on current volatility state
h
. The closed form solution for this conditional density is a result from
Pedler [43]:
f(x|
h
) = exp[x (T t x)] [
0
(T t x) +g
h
(x)I
1
(2h(x)) +I
0
(2h(x))] ,
h(x) [x(T t x)]
0.5
,
g
h
(x) [x/(T t x)]
0.5
,
where and are the rates of the volatility transition process in states
h
and
l
respectively
5
,
0
(x) is the Dirac delta function and I
p
(x) is the modied Bessel function of order p.
Along similar lines, but using a discrete time setting Duan et. al. [16] formulate a model for
European call options as:
C(S,
k
, 0) =
n
j=0
k
nj
C
_
_
S, K, r, n,
2
j
n
_
_
, k = 1, 2,
2
j
= j
2
1
+ (n j)
2
2
,
where C
() is the Black-Scholes call price and

k
nj
is the probability that, out of a possible n periods,
j are spent in volatility regime
1
, conditional on starting in volatility regime
k
, k = 1, 2. The
conditional probabilities
k
nj
, are calculated in similar fashion to the calculation in 3.2.1, with the
transition probabilities determined as functions of a standard normal random variable
6
.
Our model may be seen as a generalisation of these approaches since it allows volatility to be a
function of time in each of the regimes. Hence, the Black option price given Y (T) = i round-trips,
(F, X, T, i), is not well dened and does not have a unique solution. In fact (F, X, T, i) is highly
dependent on the position of the round trips and its value must be determined as an integral over all
possible positions of the round trips. Therefore, we would require N Monte Carlo sample paths
7
to
determine each (F, X, T, i), i = 1, , h, hence a total of hN paths to determine (F, X, 0,
n
(0)).
Without further information, and because y is uncorrelated to the forward rate process, the round
trips are uniformly distributed over horizon T. Attempting to approximate this distribution, I
5
Hence, over a small time period t, the transition probability from
h
to
l
in t. Similarly for t.
6
This is due to the specic form of the volatility updating function used by Duan et.al.. Refer to [16] for details.
7
I leave N unspecied, since it is used only for comparison of various pricing approaches.
considered placing the round trips in the centre of the distribution. Hence, for one round trip, the
distribution would be approximated by a (Dirac) delta function at the half-way point to expiry.
Similarly for two round trips, they would be positioned at points
1
3
T and
2
3
T, T being expiry time.
This approximation did not prove eective, since the position of round trips at which the Black
price best approximates the expected value over the entire distribution is strongly dependent on the
exact relative shapes of the normal and excited instantaneous volatility functions.
3.3. Poisson Sampling.
3.3.1. The Poisson Process. As for the case of continuous time probabilities in 3.2.1, we con-
sider y as a continuous time Markov chain, with holding times in the normal and excited states
having exponential distributions with parameters
n
and
x
respectively, that is:
n
Exp(
n
),
x
Exp(
x
).
The probability density function of
i
, i {n, x} is:
(3.3) f
i
(x) =
i
e
i
x
.
The time associated with a complete round trip is the time in normal state plus time in excited
state,
R
=
n
+
x
, which has probability density function:
(3.4) f
R
(x) =

n
n
_
e
n
x
e
x
x
_
.
Consider a Poisson process as a case of a continuous time Markov chain. It is dened in terms of the
number of occurrences of an event, with times between occurrences being independent, identically
distributed exponential variables with parameter . The probability of the process having some
value k after period is expressed as:
P(N
= k) =
e
()
k
k!
.
Approximating the distribution of
R
with an exponential distribution allows us to approximate the
round trip process, Y , with a Poisson process. Matching the rst moments of (3.3) and (3.4) we
have:
E[
i
] =
_

0
tf
i
(t)dt E[
R
] =
_

0
tf
R
(t)dt
=
_

0
t
i
e
i
t
dt =
_

0
t

n
n
_
e
n
t
e
x
t
_
dt
=
1
i
, =
1
n
+
1
x
,
hence let
i
= 1/
_
1
n
+
1
x
_
and the distribution of
R
is approximated as an exponential:
R
Exp
_
1
1
n
+
1
x
_
.
Now, the round trip process may be approximated as a Poisson process. Additionally, we have
x
>>
n
(alternatively
x
<<
n
) since the time spent in the excited state is much smaller than
that spent in the normal state and so:
Y Pois
_
1
1
n
+
1
x
_
Pois
_
1
n
_
.
3.3.2. Sampling the Poisson Process. Derivative pricing is by Monte Carlo. For each sample
path, the Poisson random variable determines the number of round trips. The Poisson random
variable is
Y (T) =
_
j;
j+1
i=1
(
i
+ E[
x
]) > T
_
,
where T is the time horizon,
i
Exp(
n
) and E[
x
] is the time spent in the excited state, which
is xed at the mean of its distribution. Sampling the Poisson random variable using this sum-of-
exponential variables approach gives us the number of round trips and the positions of these rounds
trips; these being the exponential times that comprise the Poisson variable.
This approach is computationally ecient since each Monte Carlo run comprises a random number
of round trips positioned at random times. We will require just N sample paths for convergence.
Additionally, few random variables need to be sampled over each path (one random variable for
each regime shift).
Figure 1. Caplet Smiles generated with parameters: a
n
= 0.02, b
n
= 0.1, c
n
=
1, d
n
= 0.14, a
x
= 0.3, b
x
= 0, c
x
= 0.5, d
x
= 0.2, time in excited state E[
x
] = 0.05,
n
= 1, displacement coecient = 0.02
3.4. Control Case - Exponential Holding Times. The control case is a simple extension
of the Poisson Sampling approach where we allow bath the times in normal and excited states to be
exponentially distributed random variables, thereby using the full exibility available. This has the
eect of removing the simplifying assumption of starting and ending in the normal state (i.e. the
assumption that only round trips are possible) and the case of ending in the excited state becomes
fully incorporated in the valuation.
Consider a point process {V (t), 0 t T} which counts the number of times a volatility regime
shift takes place up to time t. For each regime shift V (t) increments by one. The arrival rate (t)
determines the probability, per unit time, of a regime shift (i.e. a jump in value of V (t)). The
arrival rate is specied as (t) = ((t
)) where (
n
(t
)) =
n
and (
x
(t
)) =
x
.
The Monte Carlo simulation proceeds as before, except we now sample the point process V (T) as:
V (T) =
_
j;
j+1
i=1
(
n
i
(1 (i)) +
x
i
(i)) > T
_
,
(i) = I
N
(i/2).
Comparing the results produced by this control case and the Poisson sampling approach, we see
that the approximation is valid, resulting in some loss of curvature on the wings of the caplet smile.
See Fig. 2 below. For this choice of volatility parameters, transition probabilities and caplet expiry
there is a dierence of approximately 20 basis points in the Black implied volatilities. This, however,
should not be seen as an approximation error, but a result of using the same parameters in dierent
ways. Performing a full calibration of the 2 models to market data would produce slightly dierent
parameters for each model, such that the at-the-money volatilities are consistent.
Figure 2. Caplet Smiles generated by the Poisson sampling approximation and
by the control case. Parameters: a
n
= 0.02, b
n
= 0.1, c
n
= 1, d
n
= 0.14, a
x
=
0.3, b
x
= 0, c
x
= 0.5, d
x
= 0.2,
x
= 20,
n
= 1, displacement coecient = 0.02
CHAPTER 6
Future Work
The existing literature on stochastic volatility provides many avenues to explore with a view to
formalising the regime shifting model and obtaining an analytic approximation to caplet and swap-
tion prices. Calibration via a Monte Carlo simulation is unpopular due to its clumsiness and time
consuming nature, so I would like to attempt an analytic solution.
The instantaneous volatility function of the form (T t) = (a +b(T t)) exp(c(T t)) + d is
central to the empirical evidence of changes in shape of the swaption matrix. However, the stochastic
extension of this function by Joshi and Rebonato [35] is somewhat unwieldy. Possibly incorporating
this volatility function into the work of Andersen and Brotherton-Ratclie [3], by allowing a diusion
coecient of the form
_
V (t)(T t), where (T t) takes the form above and V (t) is dened by
a mean reverting process as in Chapter 4 4 will produce a more concise framework.
The Monte Carlo Poisson sampling framework discussed in the previous chapter, appears to be
a reasonable approximation, but a calibration to caplet and swaption market data is required to
produce meaningful results.
Once a calibration has been done, it will be possible to compare an econometric real-world transition
probability matrix, with the riks-neutral one implied by derivative prices. If these two proved
comparable, it may be possible to use the econometric one for calibration, thereby further reducing
the number of calibrating parameters. (This approach would be comparable to the market practise
of using a statistical forward rate correlation matrix rather than one deduced from swaption prices.)
The use of CEV and displaced diusion processes is standard for modelling of interest rate skews.
The two are seen as similar enough to allow the displaced diusion to be used as a proxy for the
computationally dicult CEV process. I have not found an actual proof that these two produce
similar forward rate distributions (and hence, similar implied volatility skews). The existing evidence
is experimental for specically chosen vanilla interest rate products. Producing a proof of this
phenomenon consitutes my current research.
61
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LIBOR Market Model with Stochastic Volatility.

First Year Transfer Report

] and a set of times {T

. We form pairs of expiry-maturity times (T

= is the instantaneous correlation matrix. That is

, > . The xed leg of the swap pays

, of a swap paying xed and receiving

= , where b is the (n m) matrix of elements b

, . Since the drifts of the forward

]. Also dene functions

() = 0. The hump is therefore at =

(0) > 0. This is satised by the joint

). Repeating this process

, > 0, (4.7) becomes:

V , the mean value of the term variance,

H(t, V (t); s) is the fundamental transform

V (T), X) is the displaced diusion equivalent of the Black formula

+ 1), strike K K +S(0)(

+ 1) and integrated variance x

() is the Black-Scholes call price, 0 x T t where x is the time spent in volatility

() is the Black-Scholes call price and

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