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Overview Interest Rate Modelling

This document provides an overview of interest rate modelling and pricing of interest rate derivatives. It discusses modelling interest rates, calibrating models like Hull-White, and calculating sensitivities. The guiding example is pricing and hedging Bermudan swaptions, one of the most actively traded exotic interest rate derivatives. Various techniques are covered, including tree-based methods, Monte Carlo simulation, and algorithmic differentiation for sensitivity analysis.

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Arghadeep Ghosh
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173 views3 pages

Overview Interest Rate Modelling

This document provides an overview of interest rate modelling and pricing of interest rate derivatives. It discusses modelling interest rates, calibrating models like Hull-White, and calculating sensitivities. The guiding example is pricing and hedging Bermudan swaptions, one of the most actively traded exotic interest rate derivatives. Various techniques are covered, including tree-based methods, Monte Carlo simulation, and algorithmic differentiation for sensitivity analysis.

Uploaded by

Arghadeep Ghosh
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Interest Rate Modelling and Derivative Pricing

Sebastian Schlenkrich∗

d-fine GmbH, Frankfurt, Germany


September, 2019

1 Sumary
In this lecture we discuss the modelling of interest rates and the pricing of interest rate derivatives.
The guiding example will be the pricing and risk management of Bermudan swaptions, one of the
most actively traded exotic interest rate derivatives in the market. Along the way we will present the
various building blocks which are relevant for derivative pricing in general.
The lecture is structured in three blocks. In the first block we focus on the modelling of interest
rates. We start by introducing quantities for static yield curve modelling and pricing of linear prod-
ucts. Then we derive the basic pricing models for Vanilla interest rate options (caps and European
swaptions). This is supplemented by an analysis of the classical SABR model. In a next step we
analyse the basic principles of term structure models in the Heath-Jarrow-Morton framework. This
allows us to specialise to the classical Hull White interest rate model which will be discussed in detail.
We also present relevant pricing methods applicable for Bermudan swaptions.
The second block is dedicated to the calibration of the interest rate models. We discuss the
resulting optimization problems for static yield curve construction and Hull White model calibration.
Moreover, we eleborate on the numerical sulution methods for the optimization problems in question.
This discussion includes various aspects for improving computational efficiency and robustness of the
algorithms relevant in practice.
In the third block we analyse sensitivity calculation. This is particularly important in practice since
Delta and Vega sensitivities are the building blocks for hedging and risk management. We discuss the
pro’s and con’s of the still widely-used finite difference approximation methods. Then we present the
basic methodologies from Algorithmic Differentiation which become more and more applied in the
financial industry.
The lecture follows in most parts the presentations in the three volumes of [1]. A further important
reference is [2]. This will be complemented by references for special topics, e.g. [3, 4, 5, 6, 7].

References
[1] L. Andersen and V. Piterbarg. Interest rate modelling, volume I to III. Atlantic Financial Press,
2010.
[2] D. Brigo and F. Mercurio. Interest Rate Models - Theory and Practice. Springer-Verlag, 2007.
[3] P. Glasserman. Monte Carlo Methods in Financial Engineering. Springer, 2003.
[4] J. Nocedal and S. J. Wright. Numerical Optimization. Springer-Verlag, 2006.
∗ Correspondence to: Sebastian Schlenkrich, d-fine GmbH, An der Hauptwache 7, D-60313 Frankfurt, Germany.

E-mail: [email protected]

1
[5] A. Griewank. The "global" convergence of Broyden-like methods with a suitable line search. J.
Austral. Math. Soc. Ser. B, 28:75–92, 1986.
[6] A. Griewank and A Walther. Evaluating derivatives: principles and techniques of algorithmic
differentiation - 2nd ed. SIAM, 2008.
[7] M.B. Giles and P. Glasserman. Smoking adjoints: fast monte carlo greeks. Risk, January 2006.
[8] F. Ametrano and M. Bianchetti. Everything you always wanted to know about Multiple In-
terest Rate Curve Bootstrapping but were afraid to ask (April 2, 2013). Available at SSRN:
http://ssrn.com/abstract=2219548 or http://dx.doi.org/10.2139/ssrn.2219548, 2013.
[9] P.S. Hagan, D. Kumar, A.S. Lesniewski, and D.E. Woodward. Managing smile risk. Wilmott
magazine, September 2002.
[10] D. Duffy. Finite Difference Methods in Financial Engineering. Wiley Finance, 2006.

2 Draft Contents
2.1 Interest Rate Modelling
1. Recap and preliminaries ([1, Sec. 1.1 - 1.8], [2, Sec. 2])
• Basic notation, relevant math finance results
• Risk-neutral pricing, numeraire, change of meassure
2. Static yield curve modelling ([2, Sec. 1],[8])
• Single-curve setting (discount factors, zero rates forward rates, year fractions, conventions)
• Classical yield curve construction from deposits and swap rates
• Tenor basis, interst rate indeces, FRAs and Vanilla swaps
• Market forward Libor and swap rates
• Modern multi-curve yield curve construction
3. Vanilla modells ([9])
• Bachelier, Black, Shifted-Black model
• Implied volatility smiles, volatility dynamics (volatility backbone)
• SABR model
– Specification and properties
– Pricing methods (PDE, MC)
– Asymptotic expansion for Vanilla options, arbitrage for negative strikes
• (brief) SABR extensions for negative interest rates (Shifted SABR, ...)
4. HJM term structure modelling framework ([1, Sec. 4.4], [2, Sec. 5])
• Bond price and forward rate dynamics
• Gaussian HJM modells
• Gaussian HJM models with Markovian short rate
5. Hull White modell ([2, Sec. 3.3])
• dynamics, model properties (yield curve fit, future yield curves, mean reversion)

2
• analytic formulas for bonds and bond options
• incorporating tenor basis (simple versus continuous compounded spreads)
• equivalence swaption and bond options

6. Pricing methods for Bermudan swaptions ([2, Sec. 3.3.3], [10, Sec. 25], [3, Sec. 3.3, 8.6.1], [1,
18.3])
• Bermudan swaption as max-European swaption plus switch option
• Trinomial tree method, PDE (finite difference method, boundary conditions), Density inte-
gration
• Monte Carlo simulation for short rate models
– state diffusion, SDE integration
– numeraire simulation, simulation in forward meassure
– American Monte Carlo via regression

2.2 Model Calibration


1. Optimisation problem for yield curve calibration ([1, Sec. 6])
• Curve parametrization and regularisation
• Bootstrapping versus full optimisation
• Multi-curve calibration and dependencies
2. Optimisation problem for Hull White Model ([1, Sec. 10.1.4])
• Short rate volatility calibration
• Mean reversion calibration (auto-correlation, swaption volatility ratio, switch value)

2.3 Sensitivity Calculation


1. Yield curve deltas ([1, Sec. 6.4])
• Benchmark-rate versus zero/forward rate sensitivities
• Jacobian method for risk transformation
2. Vega and smile sensitivities
• Swaption Vega versus short rate Vega
• Risk aggregation
• Vega contribution to Delta (smile and volatility backbone)
3. Numerical methods for sensitivitiy calculation ([6], [7], [1, Sec. 24]
• Finite difference approximation via bump-and-reval (convergence versus stability)
• Sensitivities via Algorithmic Differentiation
– basic principles of AD (chain rule applied to elementary operations)
– forward (tangent) mode versus reverse (adjoint) mode; use cases and complexity
• Path-wise sensitivities for Monte-Carlo methods

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