Aichinger

Longstaff Schwarz Revisited:
A Least Squares Approach for Valuating Bermudan

Multi-Factor Interest Rate Derivatives
M. Aichinger & C. Kletzmayr
IMCC/MathConsult
Friday, April 17, 2009
Motivation
The instrument
The models
(Quasi) Monte Carlo methods
A modied least squares algorithm
How to solve the corresponding PDE
Results and Comparison

Outline
Motivation
Pricing of Bermudan callable interest rate derivatives

using (Quasi) Monte Carlo
Method should be independent of underlying

interest rate / FX rate processes - least squares MC
Valuing American Options by Simulation: A Simple Least

Squares Approach, Longstaff and Schwartz (2001)
Pricing and hedging callable Libor exotics in forward Libor

models, Piterbarg (2005)
Solve the corresponding PDE using Finite

Differences or Finite Elements
Results and Comparison

Bermudan callable interest rate instruments
a contract between two parties exchanging

periodic payments C
PL
and C
RL
dene a set of points in time

T = {T
0
, T
1
, . . . , T
N+1
}

periodic payments C
PL
and C
RL

Maturity Date - usually
also a coupon date
Evaluation Date
T = {T
0
, T
1
, . . . , T
N+1
}

periodic payments C
PL
and C
RL

T = {T
0
, T
1
, . . . , T
N+1
}

periodic payments C
PL
and C
RL

T = {T
0
, T
1
, . . . , T
N+1
}
the value of the swap at a certain coupon date

T
i
can be calculated by
CV
i
=
RL
i
C
RL
i

PL
i
C
PL
i
the respective set of coupon weights for coupon date T
i


periodic payments C
PL
and C
RL

T = {T
0
, T
1
, . . . , T
N+1
}

T
i
CV
i
=
RL
i
C
RL
i

PL
i
C
PL
i

periodic payments C
PL
and C
RL

T = {T
0
, T
1
, . . . , T
N+1
}

T
i
CV
i
=
RL
i
C
RL
i

PL
i
C
PL
i

periodic payments C
PL
and C
RL

T = {T
0
, T
1
, . . . , T
N+1
}

T
i
CV
i
=
RL
i
C
RL
i

PL
i
C
PL
i
the value of the swap at a certain date t is

SV
t
=
N+1
l=
t
exp
T
l
t
r
d
(s)ds
CV
l

periodic payments C
PL
and C
RL

T = {T
0
, T
1
, . . . , T
N+1
}

T
i
CV
i
=
RL
i
C
RL
i

PL
i
C
PL
i

periodic payments C
PL
and C
RL

T = {T
0
, T
1
, . . . , T
N+1
}

T
i
CV
i
=
RL
i
C
RL
i

PL
i
C
PL
i
the value of the swap at the evaluation date is

SV
0
=
N+1
l=1
exp
T
l
T
0
r
d
(s)ds
CV
l
Interest rate and exchange rate models
Hull & White Model (H&W)

dr(t) = ((t) (t)r(t))dt +
r
(t)dW(t)
Hull & White 2 Factor Model (H&W 2 Factor)

dr(t) = ((t) + u(t) a(t)r(t))dt +
r
(t)dW
1
(t),
du(t) = b(t)u(t)dt +
u
(t)dW
2
(t)
Black & Karasinski Model (B&K)

d lnr(t) = ((t) (t) lnr(t))dt +
r
(t)dW(t)
FX Rates: Garman & Kohlhagen Model

df
l
(t)
f
l
(t)
= (r
i
(t) r
j
(t))dt +
f
l
(t)dW
l
(t)
(Quasi) Monte Carlo Simulation
For the Monte Carlo Simulation the different interest

rate models are discretized using an Euler scheme
(Incremental construction of the Wiener
processes ) W
t
i+1
= W
t
i
+
t
i

t
i
,
t
i
N(0, 1)
Applying QMC instead of randomly distributed points

in [0;1] so called low discrepancy sequences are used
for calculation (Sobol, Halton, Faure, ...) - the Wiener
process is discretized using the Brownian Bridge
technique
W
t
i
= (1 )W
t
j
+ W
t
k
+
(1 )(t
k
t
j
)
t
i
=
(t
i
t
j
)
(t
k
t
j
)
, t
j
< t
i
< t
k
,
t
i
N(0, 1)
Comparison of MC with QMC
Callable Floater - Instrument:

Start date: December 1, 2008
Evaluation date: December 1, 2008
Duration: 10 years
Coupons: quarter-annual
Coupon rate: max(7.5%-1.5*(3M LIBOR),0.0)
Coupon basis: 30/360
Redemption rate: 100%
Callable Floater - Hull&White model

short rate r(0)=2%
drift ! = 0.0375
reversion speed " = 1
volatility # = 0.015
Initialization (M runs and N call dates):
call rate matrix C for every call date (1xN matrix)
swap value matrix (MxN matrix) - during the algorithm the

entries of this matrix will be replaced by the option values

SV
1,1
SV
1,2
. . . SV
1,N
.
.
.
.
.
.
.
.
.
.
.
.
SV
M,1
SV
M,2
. . . SV
M,N
S
k,i
denotes the value of the swap at time T
i
in the k
th
path


discount factor matrix D (MxN matrix)

D
k,i
= exp
T
i
T
0
r
d
(s)ds




set of short rate matrices (MxN matrix) for each short rate
used in the regression SR
l

set of FX rate matrices (MxN matrix) for each FX rate used in

the regression FX
l



set of short rate matrices (MxN matrix) for each short rate
used in the regression SR
l

set of FX rate matrices (MxN matrix) for each FX rate used in

the regression FX
l


SR
l
k,i
= r
l
k,i
FX
l
k,i
= f
l
k,i
A modied least squares algorithm cont.
Compute the least square regression of swap values

as a function of short rates and exchange rates at
last call date T
n
min
k=1
(S
k,N
g({A
N
}, {r
k,N
}, {f
k,N
}))
2


last call date T
n
regression function
min
k=1
(S
k,N
g({A
N
}, {r
k,N
}, {f
k,N
}))
2


last call date T
n
min
k=1
(S
k,N
g({A
N
}, {r
k,N
}, {f
k,N
}))
2


last call date T
n
min
k=1
(S
k,N
g({A
N
}, {r
k,N
}, {f
k,N
}))
2
Compute the current regression value RV

g
k,N
for
each path using the optimal parameter set A
*
N
RV
g
k,N
= g({A
N
}, {r
k,N
}, {f
k,N
})

last call date T
n
min
k=1
(S
k,N
g({A
N
}, {r
k,N
}, {f
k,N
}))
2


last call date T
n
min
k=1
(S
k,N
g({A
N
}, {r
k,N
}, {f
k,N
}))
2
Compare the regression value to the call rate for

each path: If the latter is smaller than RV
g
k,N
it is
better to exercise the option and take the
difference SV
k,N
-C
N
, otherwise set S
k,N
to 0
SV
k,N
=
SV
k,N
C
N
if C
N
< RV
g
k,N
0 else
The swap value matrix may look like
SV
1,1
SV
1,2
. . . SV
1,N1
SV
1,N
C
N
SV
2,1
SV
2,2
. . . SV
2,N1
0
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
SV
k1,1
SV
k1,2
. . . SV
k1,N1
0
SV
k,1
SV
k,2
. . . SV
k,N1
SV
k,N
C
N
SV
k+1,1
SV
k+1,2
. . . SV
k+1,N1
0
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
SV
M,1
SV
M,2
. . . SV
M,N1
0

Switch to call date T

N-1
and compute two least
square regressions:

N-1
square regressions:
min
k=1
(SV
k,N1
C
N1
g({A
N1
}{r
k,N1
}, {f
k,N1
}))
2
tting current gains


N-1
square regressions:
min
k=1
l>N1
S
k,l
D
l,k
D
N1,k
h({B
N1
}{r
k,N1
}, {f
k,N1
})
tting the sum of discounted future cash ows

Compute both regression values using the optimal

parameter sets A* and B* in each path
RV
g
k,N1
= g({A
N1
}, {r
k,N1
}, {f
k,N1
})
RV
h
k,N1
= h({B
N1
}, {r
k,N1
}, {f
k,N1
})
Compute both regression values using the optimal

parameter sets A* and B* in each path
RV
g
k,N1
= g({A
N1
}, {r
k,N1
}, {f
k,N1
})
RV
h
k,N1
= h({B
N1
}, {r
k,N1
}, {f
k,N1
})
compare RV
g
to RV
h
: If the rst regression value is
smaller than the second regression value, it is better
to exercise the option and take the difference
SV
k,N-1
-C
N-1
, otherwise set S
k,N-1
to 0
SV
k,N1
=
SV
k,N1
C
N1
if RV
g
k,N1
< RV
h
k,N1
0 else
The swap value matrix may look like
SV
1,1
SV
1,2
. . . 0 SV
1,N
C
N
SV
2,1
SV
1,2
. . . SV
1,N1
C
N1
0
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
SV
j1,1
SV
j1,2
. . . SV
j1,N1
C
N1
0
SV
j,1
SV
j,2
. . . 0 SV
j,N
C
N
SV
j+1,1
SV
j+1,2
. . . 0 0
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
SV
M,1
SV
M,2
. . . SV
M,N1
C
N1
0
Repeat this step for all remaining call dates

The nal swap value matrix has at most one entry

different from 0 per row and may look like
0 0 . . . 0 SV
1,N
C
N
0 0 . . . SV
1,N1
C
N1
0
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
SV
j1,1
C
1
0 . . . 0 0
0 SV
j,2
C
2
. . . 0 0
0 0 . . . 0 0
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
0 0 . . . SV
M,N1
C
N1
0

The nal swap value matrix has at most one entry

different from 0 per row and may look like
0 0 . . . 0 SV
1,N
C
N
0 0 . . . SV
1,N1
C
N1
0
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
SV
j1,1
C
1
0 . . . 0 0
0 SV
j,2
C
2
. . . 0 0
0 0 . . . 0 0
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
0 0 . . . SV
M,N1
C
N1
0
Each of these values is discounted to the valuation

date and the nal value of the option is
E[CV ] =
1
M
M
k=1
n
i=0
D
k,i
S
k,i
Regression functions
The functions g and h have a polynomial form

(X, {r}, {f}) =
||<S
x
Y

, x
R
Regression functions
The functions g and h have a polynomial form

basis functions (multi-dimensional
power functions)
vector that contains all interest and exchange rates
|| =
N
r
+N
f
i=1
i
, N
N
r
+N
f
0
,
Y

=
N
r
+N
f
i=1
Y

i
i
(X, {r}, {f}) =
||<S
x
Y

, x
R
The corresponding PDE
PDE for a cross currency swap

u
t

1
2
3
i,j=1
ij
2
u
x
i
x
j
i=1
i
u
x
i
+
31
1
u
x
3
+x
2
u = 0

u
t

1
2
3
i,j=1
ij
2
u
x
i
x
j
i=1
i
u
x
i
+
31
1
u
x
3
+x
2
u = 0
x
1
= fx
x
2
= r
d
x
3
= r
f

diffusion
u
t

1
2
3
i,j=1
ij
2
u
x
i
x
j
i=1
i
u
x
i
+
31
1
u
x
3
+x
2
u = 0

convection
u
t

1
2
3
i,j=1
ij
2
u
x
i
x
j
i=1
i
u
x
i
+
31
1
u
x
3
+x
2
u = 0

reaction
u
t

1
2
3
i,j=1
ij
2
u
x
i
x
j
i=1
i
u
x
i
+
31
1
u
x
3
+x
2
u = 0

u
t

1
2
3
i,j=1
ij
2
u
x
i
x
j
i=1
i
u
x
i
+
31
1
u
x
3
+x
2
u = 0
Discretization using Finite Differences (FD) or (FEM)


u
t

1
2
3
i,j=1
ij
2
u
x
i
x
j
i=1
i
u
x
i
+
31
1
u
x
3
+x
2
u = 0
Numerical instabilities in areas with dominating

convection - use methods known from CFD for
stabilization (FD: upwinding FEM: SD, SUPG,...)

u
t

1
2
3
i,j=1
ij
2
u
x
i
x
j
i=1
i
u
x
i
+
31
1
u
x
3
+x
2
u = 0

Time discretization with one-step procedure (!-

scheme) either semi-implicit (Crank Nicolson !=0.5)
or fully implicit (!=1)

u
t

1
2
3
i,j=1
ij
2
u
x
i
x
j
i=1
i
u
x
i
+
31
1
u
x
3
+x
2
u = 0

Time discretization with one-step procedure (!-

scheme) either semi-implicit (Crank Nicolson !=0.5)
or fully implicit (!=1)
Sparse linear system is solved with BICGSTAB

Start date: December 1, 2008
Evaluation date: December 1, 2008
Duration: 10 years
Coupons: quarter-annual
Coupon rate: max(7.5%-1.5*(3M LIBOR),0.0)
Callability: annual on December 1, 2008
Call rate: 100%
Callable Floater - Instrument

Results - Floater
Callable Floater - Hull&White model

short rate r(0)=2%
drift ! = 0.0375
reversion speed " = 1
volatility # = 0.015
regression functions:
Results - Floater
g(. . .) = a
0,.
+ a
1,.
r
k,.
+ a
2,.
(r
k,.
)
2
+ a
3,.
(r
k,.
)
3
h(. . .) = b
0,.
+ b
1,.
r
k,.
+ b
2,.
(r
k,.
)
2
+ b
3,.
(r
k,.
)
3
Results - Floater
Results - Floater
Results - Floater
PDE Value: 1.01708
Start date: January 1, 2008
Evaluation date: January 1, 2008
Duration: 10 years
Callability: annual on January 1, starting 2013
Call rate: 0%
Steepener Swap - Instrument

Results - Steepener Swap
Coupons PL: quarter-annual
Coupon rate: max(0.5*3M LIBOR-0.5%,0.0)
Duration: 10 years
Call rate: 0%
Steepener Swap - Instrument

Coupons RL: annual
Coupon rate: max(10*(10YCMS-2YCMS)+1.0%,0.0)
Steepener Swap - Hull&White 2 factor model

short rate r(0)=2%
drift ! = 0.0375
reversion speed of short rate " = 1
reversion speed of second process b = 0.05
volatility of short rate #
r
= 0.015
volatility of second process #
u
= 0.015
correlation $ = 0.2
PDE Value: 0.003299
Duration: 5 years
Call rate: 0%
Product Currency: EUR
FX Linked Swap - Instrument

Results - FX Linked Swap
Coupons RL: annual
Coupon rate: (3M CHFLIBOR)+0.02*FX
FX Linked Swap - Coupons

Coupons PL: annual
Coupon rate: 1.25*(3M EURLIBOR)
FX Linked Swap - Hull&White model EUR

short rate r(0)=4%
drift ! = 0.0125
reversion speed " = 0.25
volatility of short rate # = 0.01
correlation rd-rf: 0.8
correlation rd-fx: -0.2
FX Linked Swap - Hull&White model CHF

short rate r(0)=2%
drift ! = 0.00625
reversion speed " = 0.25
volatility of short rate # = 0.015
correlation rf-fx: -0.15
FX Linked Swap - Exchange rate model

exchange rate fx(0)=0.62
volatility of exchange rate # = 0.05
regression functions:
g(. . .) = a
0,.
+ a
1,.
r
1
k,.
+ a
2,.
(r
1
k,.
)
2
+
a
3,.
r
2
k,.
+ a
4,.
(r
2
k,.
)
2
+
a
5,.
f
k,.
+ a
6,.
(f
k,.
)
2
+
a
7,.
r
1
k,.
r
2
k,.
+ a
8,.
r
1
k,.
f
k,.
+ a
9,.
r
2
k,.
f
k,.
h(. . .) = b
0,.
+ b
1,.
r
1
k,.
+ b
2,.
(r
1
k,.
)
2
PDE Value: 0.01845
Summary
Putability is included straightforward
Algorithm allows calculation of call/put

values for interest rate derivatives - the
algorithm works independently of the
underlying stochastic processes
Comparison of the results with PDE shows

reliability of the approach
The combination with Quasi Monte Carlo

methods allows a fast calculation
Application to callable oater, callable

steepener and callable fx linked swap
Acknowledgement
We want to thank our colleagues Andreas Binder,

Andrea Fischbacher, Johannes Frst and Michael
Schwaiger for fruitful discussions on the topic.
Part of this work was supported by the Austrian

Ministry for Economy and Labor and by the Upper
Austrian government within the framework
``Industrial Competence Centers''.
Acknowledgement
Thank You

Aichinger

Caricato da

Informazioni sul documento

Copyright

Formati disponibili

Condividi questo documento

Condividi o incorpora il documento

Opzioni di condivisione

Hai trovato utile questo documento?

Questo contenuto è inappropriato?

Copyright:

Formati disponibili

Aichinger

Caricato da

Copyright:

Formati disponibili

Longstaff Schwarz Revisited:

A Least Squares Approach for Valuating Bermudan

(Quasi) Monte Carlo methods

A modied least squares algorithm

How to solve the corresponding PDE

Results and Comparison

Pricing of Bermudan callable interest rate derivatives

Method should be independent of underlying

Valuing American Options by Simulation: A Simple Least

Pricing and hedging callable Libor exotics in forward Libor

Solve the corresponding PDE using Finite

Results and Comparison

a contract between two parties exchanging

dene a set of points in time

a contract between two parties exchanging

dene a set of points in time

a contract between two parties exchanging

dene a set of points in time

a contract between two parties exchanging

dene a set of points in time

the value of the swap at a certain coupon date

a contract between two parties exchanging

dene a set of points in time

the value of the swap at a certain coupon date

a contract between two parties exchanging

dene a set of points in time

the value of the swap at a certain coupon date

a contract between two parties exchanging

dene a set of points in time

the value of the swap at a certain coupon date

the value of the swap at a certain date t is

a contract between two parties exchanging

dene a set of points in time

the value of the swap at a certain coupon date

a contract between two parties exchanging

dene a set of points in time

the value of the swap at a certain coupon date

the value of the swap at the evaluation date is

Hull & White Model (H&W)

Hull & White 2 Factor Model (H&W 2 Factor)

Black & Karasinski Model (B&K)

FX Rates: Garman & Kohlhagen Model

For the Monte Carlo Simulation the different interest

Applying QMC instead of randomly distributed points

Callable Floater - Instrument:

Callable Floater - Hull&White model

Initialization (M runs and N call dates):

call rate matrix C for every call date (1xN matrix)

swap value matrix (MxN matrix) - during the algorithm the

Initialization (M runs and N call dates):

call rate matrix C for every call date (1xN matrix)

swap value matrix (MxN matrix) - during the algorithm the

Initialization (M runs and N call dates):

call rate matrix C for every call date (1xN matrix)

swap value matrix (MxN matrix) - during the algorithm the

Initialization (M runs and N call dates):

call rate matrix C for every call date (1xN matrix)

swap value matrix (MxN matrix) - during the algorithm the

discount factor matrix D (MxN matrix)

Friday, April 17, 2009

Initialization (M runs and N call dates):

call rate matrix C for every call date (1xN matrix)

swap value matrix (MxN matrix) - during the algorithm the

discount factor matrix D (MxN matrix)