Interest Rate Derivatives: HJM and LMM Chapter 31 Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull 2008 1 HJM Model: Notation P(t,T ): price at time t of a discount bond with principal of $1 maturing at T Wt : vector of past and present values of interest rates and bond prices at time t that are relevant for determining bond price volatilities at that time v(t,T,Wt ): volatility of P(t,T) Options, Futures, and Other

Derivatives, 7th Edition, Copyright John C. Hull 2008 2 Notation continued (t,T1,T2): forward rate as seen at t for the period between T1 and T2 F(t,T): instantaneous forward rate as seen at t for a contract maturing at T r(t): short-term risk-free interest rate at t dz(t): Wiener process driving term structure movements Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull 2008 3

Modeling Bond Prices (Equation 31.1, page 712) dP(t , T ) r (t ) P(t , T )dt v(t , T , t ) P(t , T )dz (t ) We can choose any v function providing v(t , t , t ) 0 for all t Because ln[ P(t , T1 )] ln[ P(t , T2 )] f(t,T1,T2 ) T2 T1 we can use Ito' s lemma to determine the process for f(t,T1,T2 ). Letting T2 approach T1 we get a process for F (t,T ) Options, Futures, and Other Derivatives, 7th Edition, Copyright

John C. Hull 2008 4 The process for F(t,T) Equation 31.4 and 31.5, page 713) dF (t , T ) v(t , T , t )vT (t , T , t )dt vT (t , T , t )dz (t ) This result means that if we write dF (t,T ) m(t,T, t )dt s(t,T, t )dz we must have T m(t,T, t ) s(t,T, t ) s(t, , t ) d t Similar results hold when there is more than one factor

Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull 2008 5 Tree Evolution of Term Structure is Non-Recombining Tree for the short rate r is nonMarkov (see Figure 31.1, page 714) Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull 2008 6 The LIBOR Market Model The LIBOR market model is a model

constructed in terms of the forward rates underlying caplet prices Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull 2008 7 Notation t k : kth reset date Fk (t ): forward rate between times t k and t k 1 m(t ): index for next reset date at time t k (t ): volatility of Fk (t ) at time t vk (t ): volatility of P(t, t k ) at time t k : t k 1 t k Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull 2008

8 Volatility Structure We assume a stationary volatility structure where the volatility of Fk (t ) depends only on the number of accrual periods between the next reset date and t k [i.e., it is a function only of k m(t )] Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull 2008 9 In Theory the s can be s can be determined from Cap Prices Define i as the volatility of Fk (t ) when k m(t ) i

If k is the volatility for the (t k ,t k 1 ) caplet. If the model provides a perfect fit to cap prices we must have 2 k k k t 2k i i 1 i 1 This allows the ' s to be determined inductivel y Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull 2008 10

Example 31.1 (Page 716) If Black volatilities for the first three caplets are 24%, 22%, and 20%, then 0=24.00% 1=19.80% 2=15.23% Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull 2008 11 Example 31.2 (Page 716) n n(%) n-1(%)

n n(%) n-1(%) 1 2 3 4 5 15.50 18.25 17.91

17.74 17.27 15.50 20.64 17.21 17.22 15.25 6 7 8 9

10 16.79 16.30 16.01 15.76 15.54 14.15 12.98 13.81 13.60

13.40 Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull 2008 12 The Process for Fk in a OneFactor LIBOR Market Model dFk k m( t ) Fk dz The drift depends on the world chosen In a world that is forward risk - neutral with respect to P (t , ti 1 ), the drift is zero Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull 2008

13 Rolling Forward Risk-Neutrality (Equation 31.12, page 717) It is often convenient to choose a world that is always FRN wrt a bond maturing at the next reset date. In this case, we can discount from ti+1 to ti at the i rate observed at time ti. The process for Fk is i i Fi i m( t ) k m( t ) dFk dt k m( t ) dz Fk j m( t ) 1 i Fi Options, Futures, and Other

Derivatives, 7th Edition, Copyright John C. Hull 2008 14 The LIBOR Market Model and HJM In the limit as the time between resets tends to zero, the LIBOR market model with rolling forward risk neutrality becomes the HJM model in the traditional risk-neutral world Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull 2008 15 Monte Carlo Implementation of

LMM Model (Equation 31.14, page 717) We assume no change to the drift between reset dates so that i i Fi (t j ) i j k j 2k j k k j j Fk (t j 1 ) Fk (t j ) exp 1 j Lj 2 j k Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull 2008

16 Multifactor Versions of LMM LMM can be extended so that there are several components to the volatility A factor analysis can be used to determine how the volatility of Fk is split into components Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull 2008 17 Ratchet Caps, Sticky Caps, and Flexi Caps

A plain vanilla cap depends only on one forward rate. Its price is not dependent on the number of factors. Ratchet caps, sticky caps, and flexi caps depend on the joint distribution of two or more forward rates. Their prices tend to increase with the number of factors Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull 2008 18 Valuing European Options in the LIBOR Market Model There is an analytic approximation that can

be used to value European swap options in the LIBOR market model. See equations 31.18 and 31.19 on page 721 Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull 2008 19 Calibrating the LIBOR Market Model In theory the LMM can be exactly calibrated to cap prices as described earlier In practice we proceed as for short rate models to minimize a function of the form n

2 ( U V ) i i P i 1 where Ui is the market price of the ith calibrating instrument, Vi is the model price of the ith calibrating instrument and P is a function that penalizes big changes or curvature in a and Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull 2008

20 Types of Mortgage-Backed Securities (MBSs) Pass-Through Collateralized Mortgage Obligation (CMO) Interest Only (IO) Principal Only (PO) Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull 2008 21 Option-Adjusted Spread

(OAS) To calculate the OAS for an interest rate derivative we value it assuming that the initial yield curve is the Treasury curve + a spread We use an iterative procedure to calculate the spread that makes the derivatives can be s model price = market price. This spread is the OAS. Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull 2008 22