Pricing Interest Rate Derivatives: Autumn 2 0 0 9

A U T U M N 2 0 0 9
PRICING INTEREST RATE DERIVATIVES
Numerical Methods in Finance (Implementing Market Models)

COMPUTATIONAL FINANCE
MSc
©Finbarr Murphy 2007
Lecture Objectives
 Pricing Interest Rate Derivatives
 How one can use our implied BDT binomial trees to calculate
options on pure discount bound
 Swaption values
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Agenda
Page
Pricing Interest Rate Derivatives 21
3
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Pricing Interest Rate Derivatives

 Constructing a tree to fit the existing yield and
volatility curves allows us to price a wide variety
of interest rate derivatives
 And, this is the point of the work so far!
 Using the same software, every time there is a

change in the yield curve or volatility curve, a
new bi/trinomial is created
 And the associated derivative values are re-

calculated
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 As an example we will consider an option on a
discount bond
 Such options are not actively traded but the

pricing principal is easily translated to swaptions
 The total amount of equity derivatives

outstanding at the end of 2006 was
$7,178,480,000,000
 The total amount of IR and Currency derivatives

outstanding at the end of 2006 was
$285,728,140,000,000
 Source ISDA – Figures based on Notional Amounts
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 Using the following notation:
 T = Option maturity
 S = Underlying bond maturity
 K = Strike Price
 NS = No of steps to Bond Maturity
 NT = No of steps to Option Maturity
 PSi,j = Value of S-Maturity Bond at node i,j
 We start by setting some boundary conditions

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 Clearly, the discount bond matures at S with a
value 1
PSN S,N S=1
j=N
PSN S,N S-1 =1

j=2
j=1
j=0
j=-1
j=-2
j=-N
PSN S,-N S=1
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i=0 i=1 i=2 i=NT i=NS-1 i=NS 7


 In other words,
PSN S , j = 1 ∀ nodes j at N S
 Now, using backward induction, we can calculate
the price of a Psi,j bond (one that matures at S) for
each node
 We only need to work back as far as node T for
European style options
[
PSi , j = 12 d i , j PSi+1, j+1 + PSi+1, j−1 ]
 We have calculated all the di,j’s previously
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 Here are the discount values created by
BDT90CurveFit.m, changing T from 4 to 10
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 Now, when we reach the T step, we can stop
(european style) and calculate the maturity
values of the call options
{
PNT , j = max 0, PSNT , j − K } ∀ j at N T
 When the terminal conditions are calculated, we
can work back to find the current value of the
option
[
Ci , j = 12 d i , j Ci +1, j +1 + Ci +1, j −1 ]
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 Next, we consider how we might use the fitted
BDT tree to price swaptions
 A swaption gives the holder the right to pay fixed
and receive floating (“payer” option)
 The option has a maturity date and the underlying
Swap will have a maturity
 This can be considered a put on a fixed coupon
bond with a strike price equal to the swap

notional
 The coupons are equal to half the quoted swap
rate (assuming semi-annual reset dates)
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 A “receiver” swaption gives the holder the right
to pay floating and receive fixed
 This is equivalent to a call option on a coupon

bearing bond
 The following timeline shows a 1-year option on a

3-year swap (see C&S P251)
Period of Option Period of Swap
0 1 2 3 4
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 Using the same notation as that describing an
option on a pure discount bond, we start at the
end of the bond life
 The terminal bond price for all nodes at i=NS is

given by
coupon
BN S , j = 1+
2
 Recall that the final coupon is paid at maturity

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 As before we can work these terminal values
backwards to NT using discounted expectations di,j
 But we must include coupon payments when

these are traversed
 At NS, we can calculate the terminal option values

as before and work these back in time to t=0
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 At NS, the terminal option values are given as
payer swaption {
= ∑ QNT , j max 0,1 − BNT , j }
max{0, B − 1}
j
= ∑ QN T , j
receiver swaption
NT , j
j
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Recommended Texts
 Required/Recommended
 Clewlow, L. and Strickland, C. (1996) Implementing derivative
models, 1st ed., John Wiley and Sons Ltd.
— Chapter 8
 Additional/Useful
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A U T U M N 2 0 0 9

PRICING INTEREST RATE DERIVATIVES

Numerical Methods in Finance (Implementing Market Models)

Pricing Interest Rate Derivatives 21

Pricing Interest Rate Derivatives

 And, this is the point of the work so far!

 Using the same software, every time there is a

 And the associated derivative values are re-

Pricing Interest Rate Derivatives

 Such options are not actively traded but the

 The total amount of equity derivatives

 The total amount of IR and Currency derivatives

Pricing Interest Rate Derivatives

 We start by setting some boundary conditions

Pricing Interest Rate Derivatives

PSN S,N S-1 =1

i=0 i=1 i=2 i=NT i=NS-1 i=NS 7

Pricing Interest Rate Derivatives

Pricing Interest Rate Derivatives

Pricing Interest Rate Derivatives

Pricing Interest Rate Derivatives

bond with a strike price equal to the swap

Pricing Interest Rate Derivatives

 This is equivalent to a call option on a coupon

 The following timeline shows a 1-year option on a

Period of Option Period of Swap

Pricing Interest Rate Derivatives

 The terminal bond price for all nodes at i=NS is

 Recall that the final coupon is paid at maturity

Pricing Interest Rate Derivatives

 But we must include coupon payments when

 At NS, we can calculate the terminal option values

Pricing Interest Rate Derivatives

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