On the Pricing of European Swaptions

Thomas Gustavsson May 13th, 1997

Abstract This paper shows that the market standard swaption pricing formula is correct provided we choose the forward annuity as the numeraire asset and assume that the equilibrium forward swap rate is log-normally distributed.

This paper was written while the author was visiting Cambridge. I want to thank Dr. Carlos Sin at the Statistical Laboratory for helpful discussions. Dr. Riccardo Rebonato, Director and Head of Research at BZW suggested using the forward annuity as the numeraire asset. As this obviously is the crucial idea in the paper I owe him plenty. The usual disclaimer applies.

Dept.Economics Uppsala University P.O.Box 513, Uppsala 75120 SWEDEN Thomas.Gustavsson@nek.uu.se Phone +46 1855 8001 Fax +46 1818 1478

Brace, Gatarek, and Musiela (1995) showed how to use the family of forward-neutral measures for pricing European swaptions. Their method was to evaluate and discount each future cash ow of the underlying swap separately. Eectively, this means pricing the swap and the option simultaneously. But from the denition of the (equilibrium) swap rate we already know what the value of this (o-market) swap will be upon expiry of the option. Indeed, often the swaption is settled in cash upon expiry. So why bother with all future cash ows of the underlying swap when its value is a known function of random variables that are measurable on option expiry? Here we pursue the single expiry payment approach and show how a particular choice of a numeraire and the corresponding change of measure turns the forward swap rate process into a martingale. This extends the argument in Neuberger (1990) who used the classical hedging approach for a one-factor model to identify the volatility input in the market standard swaption formula. The basic arbitrage-free framework for a Brownian ltration {Ft } with continuous semi-martingales is assumed throughout the text.

The Swap Rate Process

The value at time t of a plain-vanilla xed for oat forward swap starting at time T0 > t with rst payment at time T1 and nal payment at time Tn is
n

Pt (Tn ) Pt (T0 ) + xt
i=1

Pt (Ti )

where xt is the (forward) swap rate, Pt (Ti ) is the price at time t of a pure discount bond maturing at time Ti , and = Ti Ti1 . In order to avoid arbitrage the swap rate must be xt = Bt /At (1)

where Bt = Pt (T0 ) Pt (Tn ), and At = n Pt (Ti ) is an equally weighted i=1 portfolio of bonds. Rebonato (1996, section 1.3) describes the appropriate hedging strategy. We refer to the portfolio At as the forward annuity. The swap rate process {xt } is a sequence of random variables each measurable at time t. Applying Itos lemma to (1) we get dxt = 1 dBt + Bt d + < Bt , 1/At > dt At At 2 (2)

where the bracket term <, > is the (previsible) quadratic covariation of the two processes {Bt } and {1/At }, see Rogers and Williams (1987, Lemma IV.32.4). Applying Itos lemma to 1/At implies d 1 At = dAt < At , At > dt + A2 A3 t t

where < At , At > is the quadratic variation of the forward annuity process {At }. Inserting into (2) we get dxt = 1 (dBt xt {dAt < At , At > /At }) dt+ < Bt , 1/At > dt At (3)

This is about as far as we can go without specifying in more detail the nature of the stochastic process for each asset.

The Roll-Over Numeraire

For dierent choices of a numeraire asset the stochastic processes followed by asset prices will be dierent, see El Karoui, Geman, and Rochet (1995). For starters we choose the roll-over asset
t

t = exp

rs ds

as the numeraire asset. In this case any discounted price Pt (T )/t is a martingale with respect to the risk-neutral measure Q . Using martingale representation any arbitrage-free bond price can be written
t

Pt (T ) = t P0 (T ) exp

s (P (T ))dWs

1 2

t 0

|s (P (T ))|2 ds

see Gustavsson (1992). For convenience we set s (T ) = s (P (T )). The bond price is the product of the roll-over asset t and a (Doolans) martingale e with respect to the risk-neutral measure Q . If interest rates are positive the roll-over asset is an increasing process and dt = rt t dt so using Itos lemma leads to dPt (T ) = rt Pt (T )dt + t (T )Pt (T )dWt (4) see Rogers and Williams (1987, Theorem IV.32.1). Thus, dBt = dPt (T0 ) dPt (Tn ) = rt Bt dt + {t (T0 )Pt (T0 ) t (Tn )Pt (Tn )}dWt 3

Furthermore, as dAt =

dPt (Ti ) we have At t (Ti )Pt (Ti )

dAt = rt At dt + t At dWt where t = and

< Bt , 1/At > dt = t (B)Bt t /At dt = t (B)t xt dt Inserting this into (3) the swap rate process can be written dxt = (t {t t (B)}xt ) dt + {t (B) t }xt dWt where t (B) = (t (T0 )Pt (T0 ) t (Tn )Pt (Tn )) /Bt Thus, if we could only make an equivalent change of measure so as to remove the drift we would indeed have a measure for which the swap rate was an exponential (Doolans) martingale with volatility e t (x) = t (B) t (6) (5)

which we could plug into the market standard Black (1976) formula to evaluate the swaption.

The Forward Annuity as the Numeraire Asset

Choose the (normalized) forward annuity At = At /A0 as the numeraire asset. This corresponds to a change of measure from the risk-neutral measure Q to a new measure QA , which is dened by the Radon-Nikodym derivative dQA /dQ (on the nest -algebra of the underlying Brownian ltration). The likelihood ratio is Lt = E [ At dQA |Ft ] = dQ A0 t

Clearly Lt is a martingale with respect to Q and E [Lt ] = 1.We have dLt = dAt r t At dAt dt = Lt rt Lt dt = t Lt dWt A0 t A0 t At 4

Assuming nite variance we get

t

Lt = exp

s dWs

1 2

t 0

|s |2 ds

According to Cameron-Martin-Girsanov theorem (see Baxter and Rennie (1996, p.74)) there exists a new Brownian motion WtA with respect to the new measure QA that is related to the previous one by a simple drift transformation dWtA = dWt t dt In order to nd the swap rate process with respect to the new measure QA we use (6) to rewrite (5) as dxt = t (x){dWt t dt} = t (x) dWtA xt Thus, when the forward-annuity is choosen as the numeraire asset the (forward) swap rate is a martingale with respect to the corresponding swapneutral measure QA . In view of this the evaluation of swaptions is straightforward: If the volatility is deterministic the swap rate is log-normal. Assuming constant volatility we get the market standard Black (1976) formula. On expiry the value of a receivers swaption with strike rate k is AT0 (k xT0 )+ and the conditional expected value at time t discounted with the forward annuity is At E A (k xT0 )+ |Ft = At (xt N (h1 ) kN (h2 )) where At is the current value of the forward annuity, xt 1 1 h1,2 = ln c2 c k 2 = T0 t, and c is the constant (forward) swap rate volatility. Neuberger (1990) provides a classical hedging argument to support this result. Extensions to options on coupon bonds is straightforward.

Conclusion

Collapsing the future swap payments to the single expiry date of the swaption avoids the correlation problems between forward rates of dierent maturities discussed by Brace, Gatarek, and Musiela. These are obviously important when hedging with caps (or oors) but for the basic hedge in the underlying swap they will not aect the hedging ratio directly. As only the (forward) swap rate and its volatility are relevant for the basic hedge it is their correlated (average) sum that matters in this case, which, of course, is what the expert trader knew in the rst place...

References
[1] Baxter, M. and A. Rennie, Financial Calculus. Cambridge University Press 1996. [2] Black, F., 1976, The pricing of commodity contracts, Jour. Fin. Econ., 3, 167-79. [3] Brace, A., Gatarek, D. and M. Musiela, 1995, The Market Model of Interest Rate Dynamics, published in Mathematical Finance. [4] El Karoui, N., Geman, H. and J.-C. Rochet, 1995, Changes of numeraire, changes of probability measure, and options pricing, J.Appl.Probability 32: 443-458. [5] Gustavsson, T., 1992, No Arbitrage Pricing and the Term Structure of Interest Rates, Dept. Economics, Uppsala University, Economic Studies 2/92. [6] Neuberger, A.J., Pricing Swap Options using the forward swap market, London Business School, IFA Working Paper 139-91. [7] Rebonato, R. Interest-Rate Option Models. Wiley 1996. [8] Rogers, L.C.G., and D. Williams. Diusions, Markov processes, and Martingales: Vol.2 Ito Calculus. Wiley 1987.