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Black-Karasinski framework
Peter J ackel
Quant Congress Europe
London, October 2006
Semi-analytic valuation of credit linked swaps in a Black-Karasinski framework 1
Contents
I. Credit linked swaps 2
II. Generic valuation considerations 3
III. Positive hazard rates and swaption skew control 4
IV. Forward and swap measure calibration 6
V. Valuation by conditioning on one of the driving processes 11
VI. Ornstein-Uhlenbeck process path space quadrature 15
Contents Peter J ackel
Semi-analytic valuation of credit linked swaps in a Black-Karasinski framework 2
I. Credit linked swaps
We consider option payoffs at default of the type
1
{T}
( (S
T
() K))
+
A
T
() , (1)
where:-
t the valuation time
the time of a credit event in the reference credit
T the maturity of an underlying swap
S
T
(u) the -into-(T ) (forward) swap rate observed at time u
K the swap strike
A
T
(u) the into (T ) annuity observed at time u
1 for payer/receiver swaps
We make no explicit assumptions as to the nature of the underlying swap. It can
be a conventional interest rate swap, but also a cross-currency FX swap, etc.
I. Credit linked swaps Peter J ackel
Semi-analytic valuation of credit linked swaps in a Black-Karasinski framework 3
II. Generic valuation considerations
The net present value of the credit linked swap at time t is
V (t) =
_
T
t
P
u
(t)E
M(P
u
())
t
_
(u ) ( (S
uT
(u) K))
+
A
uT
(u)
du , (2)
=
_
T
t
P
u
(t)E
M(P
u
())
t
_
(u)e
R
u
t
(s) ds
( (S
uT
(u) K))
+
A
uT
(u)
_
du (3)
=
_
T
t
A
uT
(t)E
M(A
uT
())
t
_
(u)e
R
u
t
(s) ds
( (S
uT
(u) K))
+
_
du (4)
where:-
P
u
(t) the value of the risk-free zero coupon bond maturing at time u as seen at time t
(u) the stochastic hazard rate, i.e. the stochastic instantaneous default rate
E
M(N())
t
[f] expectation of f under the measure induced by the num eraire N() in ltration F
t
II. Generic valuation considerations Peter J ackel
Semi-analytic valuation of credit linked swaps in a Black-Karasinski framework 4
III. Positive hazard rates and swaption skew control
In order to avoid the fundamental problems arising from reverse defaults implied
by negative hazard rates, we choose to model the stochastic hazard rate as an
exponential Ornstein-Uhlenbeck process
(u, x(u)) =
(u) e
1
2
V
tu
[x]+x(u)
(5)
dx(u) =
x
x(u) du +
x
(u) dW
x
(u) (6)
similar to the well-known Black-Karasinski model for interest rates.
Note that the usual issues associated with instantaneously-lognormal short in-
terest rate processes are of no concern for the hazard rate since expectations
such as
E
M()
t
_
e
R
T
t
(s,x(s)) ds
_
required for the valuation of interest rate futures contracts play no role in the
valuation of credit linked swaps
1
.
1
The expectation of rollover returns is divergent when short rates evolve lognormally [HW93, SS97].
III. Positive hazard rates and swaption skew control Peter J ackel
Semi-analytic valuation of credit linked swaps in a Black-Karasinski framework 5
To control the models implied swaption skew, we use a displaced exponential
Ornstein-Uhlenbeck process for the swap rate in its own natural measure:-
S
uT
(u, y(u)) =
S
uT
_
e
1
2
(u)
2
V
tu
[y]+(u)y(u)
+(u) 1
__
(u) (7)
dy(u) =
y
y(u) du +
y
(u) dW
y
(u) (8)
For (T) = 1, the swaption skew for expiry T is virtually at, whereas for
(T) = 0 it resembles that generated by a Hull-White model.
The driving processes dW
x
and dW
y
are correlated:
E[dW
x
(u) dW
y
(u)] = du (9)
The deterministic expressions V
tu
[x] and V
tu
[y] represent the variance of the
respective process variables for observation time u out of ltration F
t
with
u > t, i.e.:
V
tu
[] :=
_
u
t
e
2
(us)
(s)
2
ds for = x, y (10)
III. Positive hazard rates and swaption skew control Peter J ackel
Semi-analytic valuation of credit linked swaps in a Black-Karasinski framework 6
IV. Forward and swap measure calibration
A convenient way of calibrating the credit part of this model is to match a given
term structure of T
i
-forward measured survival probabilities
G
T
i
(t) :=
P
T
i
(t)
P
T
i
(t)
(11)
with
P
T
i
(t) denoting the risky zero coupon bond maturing at time T
i
conditional
on survival until t.
The function G
T
i
(t) can be specied parametrically through
G
T
i
(t) := e
R
T
i
t
(s) ds
(12)
where
(T
i
) is the term structure of implied default rates supplied to represent
T
i
-forward measured survival probabilities.
IV. Forward and swap measure calibration Peter J ackel
Semi-analytic valuation of credit linked swaps in a Black-Karasinski framework 7
The calibration procedure entails a numerical search for a suitable functional t
of the amplitude term structure
() such that
P
T
i
(t) G
T
i
(t) = N(t) E
M(N())
t
_
e
R
T
i
t
(s,x(s)) ds
1
N(T
i
)
_
. (13)
for the chosen num eraire N(). Note that this means that the calibrated function
R
T
i
t
(s,x(s)) ds
_
(14)
= E
M(A
T
i
T
())
t
_
e
R
T
i
t
(s,x(s)) ds
_
. (15)
IV. Forward and swap measure calibration Peter J ackel
Semi-analytic valuation of credit linked swaps in a Black-Karasinski framework 8
Interest rate annuity measure calibration
In general, we also allow for the hazard rate and the underlying swap rate to be
correlated. When the underlying swap rate is an interest swap rate, the annuity
function A
uT
() is inevitably sensitive to changes in the swap rate S
uT
(). In that
case, we can calibrate
() by matching
G
t
i
(t) =
A
t
i
T
(t)
P
t
i
(t)
E
M(A
t
i
T
())
t
_
e
R
t
i
t
(s,x(s)) ds
_
A
t
i
T
(t
i
)
_
. (16)
In other words, since we ultimately aim to compute the expectation inside the
integral in equation (4) in the annuity measure induced by A
uT
, we calibrate
(u) accordingly.
Since the value of the annuity A
uT
() is, strictly speaking, not a deterministic
function of the swap rate, we cannot do this unambiguously without further ap-
proximations or assumptions.
IV. Forward and swap measure calibration Peter J ackel
Semi-analytic valuation of credit linked swaps in a Black-Karasinski framework 9
An approximation that is both convenient and commonly accepted as sufciently
accurate for practical purposes to relate the inverse of an annuity to its dening
swap rate is a rst order expansion of the constant-yield-to-maturity rule used for
cash settled swaptions [Hag03], also known as linear swap rate model [HK00]:
1
A
uT
(u)
=
P
u
(u)
A
uT
(u)
c
1
+c
2
S
uT
(u) (17)
with
c
1
=
1
T u
c
2
=
P
u
(t)/ A
uT
(t) c
1
S
uT
(t)
. (18)
Applying this approximation to (16) gives us the calibration equation
G
T
i
(t) E
M(A
T
i
T
())
t
_
e
R
T
i
t
(s,x(s)) ds
__
1
S
T
i
T
(T
i
)
S
T
i
T
(t)
_
A
T
i
T
(t)
P
T
i
(t)(TT
i
)
+
S
T
i
T
(T
i
)
S
T
i
T
(t)
__
.
(19)
IV. Forward and swap measure calibration Peter J ackel
Semi-analytic valuation of credit linked swaps in a Black-Karasinski framework 10
Note that for T
i
= T, this reduces to
G
T
(t) = E
M(A
TT
())
t
_
e
R
T
t
(s,x(s)) ds
_
(20)
which is not surprising since M(P
T
()) M(A
TT
()).
The calibration equation (19) and the main pricing equation (3) are evaluated in
the same fashion by conditioning on the evolution of the hazard rate (s, x(s)).
IV. Forward and swap measure calibration Peter J ackel
Semi-analytic valuation of credit linked swaps in a Black-Karasinski framework 11
V. Valuation by conditioning on one of the driving processes
To compute (3), we change the order of integration in time and expectation over
all possible evolutions of the standard Wiener process that drives the hazard
rate:-
V (t) =
_
W
x
[x] d(x) (21)
[x] :=
_
T
t
A
uT
(t)(u, x(u))e
R
u
t
(s,x(s)) ds
(t, u, x(u)) du (22)
(t, u, x(u)) := E
M(A
uT
())
t
_
( (S
uT
(u, y(u)) K))
+
x(u)
(23)
For the calculation of (t, u, x(u)), we use the fact that y(u) conditional on x(u)
is a Gaussian variate with known mean and variance.
V. Valuation by conditioning on one of the driving processes Peter J ackel
Semi-analytic valuation of credit linked swaps in a Black-Karasinski framework 12
Assuming, without loss of generality, that x(t) = y(t) = 0, we can use the
Cholesky decomposition
y(u)|x(u)
Cov
tu
[x, y]
V
tu
[x]
x(u) +
z
(u)
u t z (24)
with
z
(u)
2
(u t) =
V
tu
[x] V
tu
[y] Cov
tu
[x, y]
2
V
tu
[x]
(25)
Cov
tu
[x, y] =
_
u
t
e
(
x
+
y
)(us)
x
(s)
y
(s) ds (26)
z N(0, 1) . (27)
V. Valuation by conditioning on one of the driving processes Peter J ackel
Semi-analytic valuation of credit linked swaps in a Black-Karasinski framework 13
to calculate (t, u, x(u)) analytically:
(t, u, x(u)) =
+
_
_
_
S
uT
(u)
e
1
2
(u)
2
V
tu
[y]+(u)y(u)
1(u)
(u)
S
uT
K
__
+
(z) dz
=
+
_
_
_
S
uT
(u)
e
1
2
(u)
2
z
(u)
2
(ut)+(u)
z
(u)
utz
K
(u)
__
+
(z) dz
(28)
with
(z) := e
1
2
z
2
_
2 (29)
K
(u) := K +
1 (u)
(u)
S
uT
(30)
uT
:=
S
uT
e
1
2
(u)
2
Cov
tu
[x,y]
2
V
tu
[x]
+(u)
Cov
tu
[x,y]
V
tu
[x]
x(u)
(31)
V. Valuation by conditioning on one of the driving processes Peter J ackel
Semi-analytic valuation of credit linked swaps in a Black-Karasinski framework 14
This means that (t, u, x(u)) is equivalent to the Black-Scholes closed form ex-
pression with the following inputs:
strike = K
(u),
forward =
S
uT
_
(u),
volatility = (u)
z
,
time to expiry = u t.
The computation of the x-path conditional integral [x] given by (22) can be done
with any appropriate temporal quadrature scheme once we have generated a
discretized standard Wiener process path and selected an interpolation rule in
between the discretization points for x.
V. Valuation by conditioning on one of the driving processes Peter J ackel
Semi-analytic valuation of credit linked swaps in a Black-Karasinski framework 15
VI. Ornstein-Uhlenbeck process path space quadrature
The integration over all possible path evolutions x is the most challenging part.
It can be done in various ways.
The most straightforward approach is probably a Monte Carlo simulation.
However, since, for the purpose of valuing credit linked swaps, the path condi-
tional functional [x] turns out to be rather benign, it is also possible to devise
a rapidly convergent spectral quadrature scheme over the entire process path
space.
Since the functional [x] depends on the x-process path as an integral over time
along a function of x, most of the value of the integral [x] is contained in the
lowest frequency modes of x.
This holds true particularly for low mean reversion values
x
, or more generally,
for low values of
x
T ( 1).
VI. Ornstein-Uhlenbeck process path space quadrature Peter J ackel
Semi-analytic valuation of credit linked swaps in a Black-Karasinski framework 16
An analytical approximation to the spectral decomposition of the Ornstein-
Uhlenbeck process x generated by (6) for constant
x
and constant
x
from
t = 0 to T is given by
x(u) =
x
l
a
l
(u) z
l
z
l
N(0, 1) (32)
a
l
(u) =
x
cos
l
u +
l
sin
l
u
x
e
x
u
2
l
+
2
x
_
2
T
l
=
2l 1
2T
(33)
where we have assumed, wlog, that x(t) = 0.
In general, when
x
(u) is not constant, a spectral decomposition of the auto-
covariance matrix of the Ornstein-Uhlenbeck process x over a set of discretisa-
tion points {t
i
} in time can be computed efciently from
Cov[x(t
i
), x(t
j
)] =
_
min(t
i
,t
j
)
0
e
x
(t
i
+t
j
2s)
x
(s)
2
ds (34)
using the well-known routines tred2, tqli, and eigsrt described
in [PTVF92], or any of dsyev, dsyevd, dspev, or dspevd in Lapack [ABB
+
95].
VI. Ornstein-Uhlenbeck process path space quadrature Peter J ackel
Semi-analytic valuation of credit linked swaps in a Black-Karasinski framework 17
-0.75
-0.25
0.25
0.75
1.25
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
Figure VI.1. The rst ve Ornstein-Uhlenbeck modes for = 50%, = 10%, T = 5.
VI. Ornstein-Uhlenbeck process path space quadrature Peter J ackel
Semi-analytic valuation of credit linked swaps in a Black-Karasinski framework 18
Truncating the number of modes to m, we view any x-process path as a func-
tional of m standard normal variates {z
1
, ..., z
m
} :
x(u) x(u; z
1
, ..., z
m
) (35)
Denoting w
jn
as the j-th Gauss-Hermite weight of a one-dimensional quadra-
ture over n nodes, and z
jn
as the associated Gauss-Hermite root, the spectral
appoximation to the value of the contract is given by
V =
n
1
j
1
=1
w
j
1
n
1
n
2
j
2
=1
w
j
2
n
2
n
m
j
m
=1
w
j
m
n
m
[x(; z
j
1
n
1
, ..., z
j
m
n
m
)] (36)
where we have allowed for a different number of Gauss-Hermite nodes for each
of the contributing modes.
VI. Ornstein-Uhlenbeck process path space quadrature Peter J ackel
Semi-analytic valuation of credit linked swaps in a Black-Karasinski framework 19
References
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+
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[BK91] F. Black and P. Karasinski. Bond and option pricing when short rates are lognormal. Financial Analysts Journal, pages 5259,
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[Hag03] P. Hagan. Convexity Conundrums: Pricing CMS Swaps, Caps, and Floors. Wilmott, pages 3844, March 2003.
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References Peter J ackel