Understanding the Pricing of Fixed Income

Derivatives
Project Proposal

Course Project – Term IV

Instructor: Prof. Vineet Virmani

Submitted on March 15, 2018 by

Akhil Garg
Lakshay Gupta
Introduction
Fixed income refers to any type of investment under which the borrower or issuer is obliged
to make payments of a fixed amount on a fixed schedule. Fixed income derivatives include
(i) Interest Rate Derivatives: A derivative whose payments are determined through
calculation techniques where the underlying benchmark product is an interest rate, or set
of different interest rates.
(ii) Credit Derivatives: It contains various instruments and techniques designed to separate
and then transfer the credit risk or the risk of an event of default of a corporate or
sovereign borrower, transferring it to an entity other than the lender or debtholder.

Interest rate derivatives account for the majority of OTC derivative positions, accounting for
$584.4 trillion, i.e., or 85.3% of the $710.2 trillion industry. FX and credit derivatives were
valued at $70.6 trillion and $21.0 trillion or 10.3% and 3.1% of OTC notional value
outstanding respectively. Interest rate derivatives holds the largest share in the derivatives
market. Within the interest rate derivatives, relative sizes of OTC and exchange-traded
derivatives have undergone a change. Average daily turnover in OTC interest rate derivatives
markets increased by 16% over the last three years, to $2.7 trillion in April 2016. While for
the exchange-traded derivatives turnover increased by 7.8% to $5.1 trillion in the same
duration. Such high market share and growth rates forms the motivation of this project, i.e. to
understand and analyse the pricing of such securities.

Interest Rate Derivatives (IRD)

Interest rate derivatives primarily are of two types: linear IRD, whose present values are
closely dictated by one-to-one movement of underlying interest rate index, and non-linear
IRD, for which it is not. Non-linear IRD’s present a bigger challenge in pricing than linear
IRD’s and are the subject of this project.

Pricing Models
The limitation with the classic Black-Scholes model in pricing of interest rate derivatives is
that it assumes constant values for risk free rate of return and volatility over the option
duration. Hence, we intend to study the following advanced models of pricing:
(i) Black Model: The Black model is a variant of the Black-Scholes option pricing model in
which spot price of the underlying is replaced by a discounted futures price F.
(ii) Interest Rate models: These models provide description of how interest rates evolve
through time. There are three alternatives for the same:
• Vasicek model: This model is based on the fact that zero bond curve is completely
characterized by probabilistic properties of the short rate r. This model incorporates
mean reversion, as the expected value of short rate tends to a constant value with
velocity as time grows, while its variance does not explode.
• Heath Jarrow Morton(HJM): This model recognizes that the drifts of the no-
arbitrage evolution of certain variables can be expressed as functions of their
volatilities and the correlations among themselves. HJM type models capture the full
dynamics of entire forward rate curve unlike the short-rate Vasicek model.
• LIBOR Market Model: This model uses lognormal processes to model a set of
forward rates. This resolves the drawback of HJM Model, which is based in terms of
instantaneous forward rates that are not directly observable in the market.

Apart from these basic models, we will look into other promising models present in the
literature. We plan to implement these and other methods, and compare the prices of interest
rate derivatives like swaptions and caps predicted by these models with their actual real life
prices to judge their predictive power. Hence a comparative analysis will be performed
revealing the strengths and weakness of these models.

References
1. Hull, J., & White, A. (1990). Pricing interest-rate-derivative securities. The Review of
Financial Studies, 3(4), 573-592.
2. Rebonato, R. (2002). Modern pricing of interest-rate derivatives: The LIBOR market
model and beyond. Princeton University Press.
3. Ait-Sahalia, Y. (1995). Nonparametric pricing of interest rate derivative
securities (No. w5345). National Bureau of Economic Research.
4. Marchioro, M. (2008). Pricing simple interest-rate derivatives. The Pricing Library,
Quantitative Research Series. StatPro website.