Example: caplet formula from LIBOR market model . 33

To be able to arrive at pricing formulae of the Black and Scholes type, we needL(·) to be log-normal. We know that increments of{B_t^T+α}are normally distributed (with expectation zero) underQ^T+α, so forL(·) to be log-normal it suffices that the volatility function λ(·) is deterministic. We also note that if this is satisfied, L(·) will be log-normal under any measure equivalent toQ and Q^T+α. This follows from the Girsanov theorem, telling us that a change of measure will only change the drift of the process, and that the drift will change as a function of the (deterministic) volatility only. The model for L(t, T, α) is then set to be

dL(t, T, α)_t=L(t, T, α)λ(t, T, α)dB_t^T+α, t∈[0, T]

where the volatility function λ(t, T, α) is state independent and L(t, T, α) satisfies the initial condition (6) above The differential is with respect to the current time variable t. The solution to this SDE is the geometric Brownian motion

L(t, T, α) =L(0, T, α) exp

−1 2

Z t 0

λ(s, T, α)²ds+

Z t 0

λ(s, T, α)dB_s^T+α

(2.3)

2.2.1 Example: caplet formula from LIBOR market model

To exemplify, we apply the LIBOR market model to price an interest rate derivative. This will demonstrate how closely linked the LIBOR market model for interest rates is to the Black-Scholes model. Acaplet is the interest rate equivalent to the call option: If the interest rate at maturity is above an agreed level, the cap rate, the caplet pays the difference between the actual interest rate and the cap rate for an agreed notional amount and accrual period. In the case of LIBOR rates, the period is of length α. The caplet gives one single payment, but caplet contracts for subsequent maturities in the tenor structure can be put together to a cap contract.

The caplet or cap is then suitable for floating rate debtors wanting to hedge the risk of high interest rates. With a cap contract the cost of the debt can be capped as interest above the cap rate can be offset by gains from

the cap contract. The caplet and cap contracts are therefore often referred to as debtor insurance or protection against high interest rate.

For a loan accruing floating LIBOR over the interval [T, T+α], the interest will be random until the LIBORL(T, T, α) is fully determined (i.e. no longer stochastic) at timeT. At any timetprior toT a debtor with such a loan can cap his interest due at time T +α by buying a caplet contract. The caplet on this forward LIBOR with cap rate Lis a contract that pays the difference

L(T, T, α)−L⁺ times the length of the time interval times the face value.

This cash flow is paid at time T+α, the date whenL(T, T, α)-loans are due.

We say that payment is madein arrear. AsL(T, T, α) is determined at time T the amount to be paid from the caplet is also completely determined at timeT — i.e. givenFT the amountL(T, T, α)−L⁺ is no longer a random variable.

caplet at time T +α=αV(L(T, T, α)−L)⁺

As the forward LIBOR L(T, T, α) is a martingale under the T +α forward measure, the time t value of the caplet can be given as

caplet at time t=αV P(t, T +α)E_t^QT+αh(L(T, T, α)−L)⁺ⁱ

This expectation can be evaluated using the same indicator function trick as we have already used to derive the Black-Scholes formula. Let D denote the exercise set of the caplet, so that the indicator function 1D takes the value 1 if the state of the world is in the exercise set D and zero otherwise. The caplet at time t is

=αV P(t, T +α)E_t^QT+α[L(T, T, α)1_D]−E_t^QT+α[L1_D] (2.4) We evaluate the last expectation first. Use the solution (2.3) of the LIBOR to compute thisQ^T+α-probability. Note also that the forward LIBOR is com-pletely determined at time T, so the volatility function λ is only integrated up to this date.

The random variable ^R_t^Tλ(s, T, α)dB_s^T+α is normally distributed with zero mean and variance ^R_t^T λ(s, T, α)²ds. Use this to normalize:

= LQ^T+α

Where the value a₂ written in full notation is

a₂ = ln^{L(t,T ,α)}_L − ¹₂^R_t^T λ(s, T, α)²ds

q RT

t λ(s, T, α)²ds

(2.5) To evaluate the first expectation in (2.4), we proceed as we did when calculating the Black-Scholes formula from Feynman-Kaˇc. Let Z denote a standard normally distributed random variable which will be used to replace (B_T^T+α−B_t^T+α). We can then rewrite the LIBOR to Where the value a₁ is given as

a₁ = ln^{L(t,T ,α)}

L + ¹₂^R_t^T λ(s, T, α)²ds

qRT

t λ(s, T, α)²ds

The LIBOR market model caplet formula can then be summed up to

caplet at time t = αV P(t, T +α)E_t^QT+αh(L(T, T, α)−L)⁺ⁱ

= αV P(t, T +α)L(t, T, α)N(a₁)−LN(a₂)

2.3 The swap rate market model

We may also use the idea from Jamshidian [7] of modelling a term structure of swap rates. When we model the LIBOR, dynamics are given under the forward measure with the discount bond as numeraire. Here we model the swap rate dynamics under the forward swap measure, where the numeraire is what we will call the annuity. But first we will have a closer look at the contract of rate-swapping.

A swap contract has one party paying floating rate and receiving fixed, and vice versa for the other party. Payoff from the floating leg of the swap contract where rates are swapped over the time interval [T0, Tn] is a series of interest payments according to the forward LIBORs maturing in the interval.

Each payment has the valueαL(Ti−1, Ti−1, α) at its payoff dateT_i. The time tvalue of the floating leg is then, using that the LIBOR is a martingale under the forward measure of its payoff date:

floating leg =

n

X

i=1

P(t, T_i)αE_t^QTi[L(T_i−1, T_i−1, α)]

=

n

X

i=1

P(t, T_i)αL(t, Ti−1, α)

Substitute in for L(·) from equation (1) to get a telescoping series folding up into

= P(t, T₀)−P(t, T_n)

Each interest payment to the fixed leg with the fixed rate sis of the amount αs, so the timet value of the fixed leg is

fixed leg =

n

X

i=1

P(t, T_i)αs

= sα

n

X

i=1

P(t, T_i)

= sB(t;T_o, . . . , T_n)

where the expression B(t;T_o,· · ·, T_n) will be called the annuity. In the liter-ature, B(·) is also called the present value of a basis point (PVBP).²

Each party of the swap contract is short one leg and long the other, and the (par) swap rate is defined as the value of the fixed rate s that gives the contract zero value at the time of initiation, say time t:

s(t;T_o, . . . , T_n)B(t;T_o, . . . , T_n) = P(t, T₀)−P(t, T_n) s(t;T_o, . . . , T_n) = P(t, T₀)−P(t, T_n) B(t;T_o, . . . , T_n)

Note that P(t, T₀)−P(t, T_n) is the price process of a self-financing trading strategy up to timeT₀, so by absence of arbitrage there must be a martingale measure equivalent to Q such that this price process is a martingale when properly discounted. As the annuity is a portfolio of α units of each of the zero-coupon bonds, it must be a strictly positive process. We can then use the annuity as a numeraire, and define the forward swap measure Q^T0,Tn as the equivalent martingale measure with numeraire B(t;T_o, . . . , T_n). The swap rate

s(t;T_o, . . . , T_n) = P(t, T₀)−P(t, T_n) B(t;T_o, . . . , T_n) is then a Q^T0,Tn-martingale.

Note also that the swap rates(·) can be expressed in terms of the LIBORs:

s(t;T_o, . . . , T_n) =

Pn

i=1P(t, T_i)L(t, T_i−1, α)

Pn

i=1P(t, T_i)

so we cannot have deterministic volatility for both LIBOR and swap rates, meaning that we cannot consistently model both LIBOR and swap rates as log-normal. The LIBOR and the swap market model are then inconsistent with each other.³

Analogously to the LIBOR market model, we then specify the dynamics of the par swap rate over the time interval [T_i, T_j] under the Q^Ti,Tj-measure as

ds(t;T_i, . . . , T_j)_t=s(t;T_i, . . . , T_j)ψ(t;T_i, . . . , T_j)dB_t^Ti,Tj

so that the swap rate is a martingale under the appropriate forward swap measure, and is log-normal if the volatility function ψ(·) is deterministic.

2See [14] and [18].

3This was pointed out in the original paper of Jamshidian [7].

We have from [14] that we can model two possible sets of log-normal swap rates. For each set the rest of the swap rates will be given, but they will in general not be log-normally distributed. The reason follows from the no-arbitrage argument that a swap contract over some interval must have the same value if it is broken up into several contracts together covering the same interval as the original contract. This means that a model of the swap rates over e.g. [T0, Tn] and [T0, Ti] implicitly gives the swap rate for [Ti, Tn].

In our modelling of the swap rate we use a tenor of ntime intervals (of length α), giving us n degrees of freedom.

Note first that the swap rate over a time interval of length α (so that interest payments are swapped for only one maturity) is simply the LIBOR rate for that interval. A model of these swap rates would be the LIBOR model once again. Note also that as the LIBOR rates will be given when swap rates are modelled, it follows again that the log-normal swap model is not consistent with log-normal LIBORs.

The first set of (proper) swap rates we can model is then the set ofnrates s(t;T_i, . . . , T_n), i= 0, . . . , n−1, the other possible set is the model of varying final dates s(t;T₀, . . . , T_i), i= 1, . . . , n. For the first of these sets, [14] shows how to bring all swap rates under the single forward measure of their shared final date, Q^Tn. For the other set, a model is derived under the forward measure of the shared start date, namely Q^T0. However, as drift terms are complicated in the swap market model, [14] uses Monte Carlo methods here.

In document Asset pricing theory and the LIBOR market model (sider 37-42)