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PATRICK S. HAGAN
Abstract. Here we use the one factor LGM model to price the standard IR exotic deals: callable swaps (including amortizing swaps), callable inverse oaters, callable super- oaters, callable range notes, autocaps and revolvers, and range notes. We lay out the complete pricing of these deals: how to represent the deals, how to select the calibration instruments, how to determine the appropriate calibration strategies and algorithms, the dierent deal evaluation algorithms for each deal type, and the usage of adjusters to obtain the best possible prices and hedges. We then extend this analysis to the world of bonds. By incorporating a second, credit spread factor into the LGM model, we extend our valuation/hedging analysis to bonds with embedded options
(Part head:)Introduction In this paper we specify how to price and hedge common exotic interest rate deals: callable swaps (including amortizing swaps), callable inverse oaters, callable capped- oaters and super-oaters, callable range notes, autocaps, revolvers, and captions. Here we introduce our notation and the mathematics of swaps and vanilla options. In Part II, we work out best practices for using the one factor LGM mode for pricing and hedging: We introduce the LGM model, we determine how to select eective calibration instruments, we derive ecient calibration strategies and algorithms, we then discuss evaluation methodologies and determine ecient algorithms for evaluating the prices of exotic instruments under the calibrated model. In each of the subsequent sections, we treat a dierent exotic: callable swaps (with Bermudan and American), callable amortizing swaps, callable inverse oaters, callable capped-oaters and super-oaters, callable range notes and accrual, autocaps, and revolvers. Throughout these sections we use best practices in choosing the calibration instruments, calibrating the model, evaluating the deal, and using internal adjustors to obtain risks to the proper instrumentsand clean up the prices. In Part III, we extend the model to include a second factor for credit. The extended LGM model is used to price bond, focussing on bonds with embedded options.
1. Discount factors, zeros, and FRAs. Suppose at date t, one agrees to loan out $1 at date T , and get repaid the next day:
(1.1a) (1.1b)
1 1 + f (t, T )T
paid at T, received at T + T.
(1.1c)
f(t,T)
Tst
Tend
Instantaneous rate for date T as seen at date t Now suppose at date t one agrees to loan out $1 on Tst , with the money repaid on Tend . Economically this is equivalent to loaning out $1 on Tst , getting repaid $1 plus interest the next day, re-loaning out the $1 plus interest, getting repaid $1 plus interest plus interest on the interest, .... Clearly, if one agrees at date t to loan out (1.2a) the agreement should specify getting repaid (1.2b) e