Cancelable Swap
FinPricing offers:
Four user interfaces:
- Data API.
- Excel Add-ins.
- Model Analytic API.
- GUI APP.
Cancelable Swap Valuation
FinPricing provides valuation models for:
- Cancelable Swap
- Bermudan Swaption
- Swaption
- Equity-Linked Cancelable Swap
- Equity-Linked Participation Swap
- Check FinPricing valuation models
A cancelable swap provides the right but not the obligation to cancel the
interest rate swap at predefined dates.
| 1. Cancelable Swap Introduction |
Most commonly traded cancelable swaps have multiple exercise dates. Given its Bermudan style optionality, a
cancelable swap can be represented as a vanilla swap embedded with a
Bermudan swaption. In fact, most Bermudan swaptions in a bank
book actually come from cancelable swaps. Cancelable swaps provide market participants flexibility to exit a
swap. This additional feature makes the valuation relatively complex.
| 2. Valuation Model Selection Criteria |
Given the complexity of cancellable swap valuation, there is no closed form solution.
Therefore, one needs to select an interest rate term structure model and a numeric solution to price
Bermudan swaptions.
Popular IR term structure models in the market are Hull-White, Linear Gaussian Model (LGM), Quadratic Gaussian Model (QGM),
Heath Jarrow Morton (HJM), Libor Market Model (LMM). HJM and LMM are too complex while Hull-White is inaccurate for
computing sensitivities.
After selecting a term structure model, one need to choose a numeric approach to approximate the underlying
stochastic process of the model.Commonly used numeric approaches are tree, partial differential equation (PDE),
lattice, and Monte Carlo simulation. Tree and Monte Carlo are notorious for inaccuracy in sensitivity calculation.
| 3. LGM Model |
| 4. LGM Assumptions and Calibration |
The LGM model is mathematically equivalent to the Hull-White model but offers significant improvements in calibration
stability and accuracy. It is also more accurate and stable in sensitivity calculation. The state variable is normally
distributed under the appropriate measure. The LGM model has only one stochastic driver (one-factor), thus changes in rates
are perfected correlated.
At time t, X(0)=0 and H(0)=0. Thus Z(0,0;T)=D(T). In other words, the LGM automatically fits today’s
discount curve. To calibrate swaption implied volatilities, first
select a group of market swaptions and then solve parameters by minimizing the relative
error between the market swaption prices and the LGM model swaption prices.
| References |