Marketing StrategyEssay Preview: Marketing StrategyReport this essayMarketing strategyCallable Libor exotics are among the most challenging interest rate derivatives to price and risk-manage. These derivative contracts are loosely defined by the provision that the holder has a Bermuda-style (i.e. multiple-exercise) option to exercise into various underlying interest rate instruments. The instruments into which one can exercise can be, for instance, interest rate swaps (for Bermuda swaptions), interest rate caps (for captions, callable capped floaters, callable inverse floaters), collections of digital call and put options on Libor rates (callable range accruals), collections of options on spreads between various CMS rates (callable CMS coupon diffs), and so on.
Marketing StrategyEssay Preview: Marketing strategyReport this essayMarketing strategyCallable Libor exotics are among the most challenging interest rate derivatives to price and risk-manage. These derivative contracts are loosely defined by the provision that the holder has a Bermuda-style (i.e. multiple-exercise) option to exercise into various underlying interest rate instruments. The instruments into which one can exercise can be, for instance, interest rate swaps (for Bermuda swaptions), interest rate caps (for captions, callable capped floaters, callable inverse floaters), collections of digital call and put options on Libor rates (callable CMS coupon diffs), and so on.
Marketing StrategyEssay Preview: Marketing strategyReport this essayMarketing strategyCallable Libor exotics are among the most challenging interest rate derivatives to price and risk-manage. These derivative contracts are loosely defined by the provision that the holder has a Bermuda-style (i.e. multiple-exercise) option to exercise into various underlying interest rate instruments. The instruments into which one can exercise can be, for instance, interest rate swaps (for Bermuda swaptions), interest rate caps (for captions, callable capped floaters, callable inverse floaters), collections of digital call and put options on Libor rates (callable CMS coupon diffs), and so on.
The first three concepts of this essay present some of the most important and important questions that market-makers and experts must think about when discussing LIBOR. With each of these issues approached, a general analysis of the fundamentals and the fundamental elements of market volatility that they consider is introduced. A discussion of how the basic concepts are to be understood within this approach can be included in an introduction to Libor. Such a discussion aims to educate clients to the fundamental principles that must be followed from their point of view to become effectively informed by, and effectively engage in market-friendly, market-oriented policies that protect their business. At times a good example of a specific section of this writing is the report of John B. Zabar of KPMG Advisory in its 2008 annual report on Libor related issues. In that report, the chief executive of KPMG is quoted as saying that “most people who know market-wise are probably not aware of LIBOR.” This is a very important statement. It must be known if one is really in control of the market, will take a risk, or will be motivated by a desire to minimize costs. As such, even when it is known that the issuer of the Libor-related instrument is doing anything wrong, you will still want caution, and a greater awareness that LIBOR is NOT an effective risk management measure. When an issuer is failing to take action, those who understand the dynamics of Libor are likely not to use LIBOR very highly. What they are talking about is liquidity, or perhaps an underlying asset allocation. With that said, if one believes that LIBOR is the best indicator of Libor, then one may choose only to use these particular risks-to-fundamentals as a basis for determining whether or not to exchange the asset. To be clear, this is NOT a statement in “most people who know market-wise are probably not aware of LIBOR.” The problem arises when markets and institutions are at war. If one’s economic objectives and objectives are to sell out of Libor, then it needs to do something to make sure that Libor has no chance of trading. For example, the markets or institutions of a single issuer, like the NYSE, have a long-term liquidity advantage. If banks are at a risk, then they should make sure their customers have the ability (and ability) to hold for up to seven years. The US government may hold Libor for 12 years in the event that this is the case. However, an issuer needs to be aware of the liquidity disadvantage of keeping this asset in circulation and of course, the fact that they will not be able to do so at a later date, which would severely limit their ability to do so with the asset. A more common point about the various derivatives that investors must be aware of is the risk of “liquidity” within certain instruments. This term has a positive and negative connotation. Liquidity is when money is held in short cash in a series of short positions and can be liquidated as currency
The first three concepts of this essay present some of the most important and important questions that market-makers and experts must think about when discussing LIBOR. With each of these issues approached, a general analysis of the fundamentals and the fundamental elements of market volatility that they consider is introduced. A discussion of how the basic concepts are to be understood within this approach can be included in an introduction to Libor. Such a discussion aims to educate clients to the fundamental principles that must be followed from their point of view to become effectively informed by, and effectively engage in market-friendly, market-oriented policies that protect their business. At times a good example of a specific section of this writing is the report of John B. Zabar of KPMG Advisory in its 2008 annual report on Libor related issues. In that report, the chief executive of KPMG is quoted as saying that “most people who know market-wise are probably not aware of LIBOR.” This is a very important statement. It must be known if one is really in control of the market, will take a risk, or will be motivated by a desire to minimize costs. As such, even when it is known that the issuer of the Libor-related instrument is doing anything wrong, you will still want caution, and a greater awareness that LIBOR is NOT an effective risk management measure. When an issuer is failing to take action, those who understand the dynamics of Libor are likely not to use LIBOR very highly. What they are talking about is liquidity, or perhaps an underlying asset allocation. With that said, if one believes that LIBOR is the best indicator of Libor, then one may choose only to use these particular risks-to-fundamentals as a basis for determining whether or not to exchange the asset. To be clear, this is NOT a statement in “most people who know market-wise are probably not aware of LIBOR.” The problem arises when markets and institutions are at war. If one’s economic objectives and objectives are to sell out of Libor, then it needs to do something to make sure that Libor has no chance of trading. For example, the markets or institutions of a single issuer, like the NYSE, have a long-term liquidity advantage. If banks are at a risk, then they should make sure their customers have the ability (and ability) to hold for up to seven years. The US government may hold Libor for 12 years in the event that this is the case. However, an issuer needs to be aware of the liquidity disadvantage of keeping this asset in circulation and of course, the fact that they will not be able to do so at a later date, which would severely limit their ability to do so with the asset. A more common point about the various derivatives that investors must be aware of is the risk of “liquidity” within certain instruments. This term has a positive and negative connotation. Liquidity is when money is held in short cash in a series of short positions and can be liquidated as currency
The first three concepts of this essay present some of the most important and important questions that market-makers and experts must think about when discussing LIBOR. With each of these issues approached, a general analysis of the fundamentals and the fundamental elements of market volatility that they consider is introduced. A discussion of how the basic concepts are to be understood within this approach can be included in an introduction to Libor. Such a discussion aims to educate clients to the fundamental principles that must be followed from their point of view to become effectively informed by, and effectively engage in market-friendly, market-oriented policies that protect their business. At times a good example of a specific section of this writing is the report of John B. Zabar of KPMG Advisory in its 2008 annual report on Libor related issues. In that report, the chief executive of KPMG is quoted as saying that “most people who know market-wise are probably not aware of LIBOR.” This is a very important statement. It must be known if one is really in control of the market, will take a risk, or will be motivated by a desire to minimize costs. As such, even when it is known that the issuer of the Libor-related instrument is doing anything wrong, you will still want caution, and a greater awareness that LIBOR is NOT an effective risk management measure. When an issuer is failing to take action, those who understand the dynamics of Libor are likely not to use LIBOR very highly. What they are talking about is liquidity, or perhaps an underlying asset allocation. With that said, if one believes that LIBOR is the best indicator of Libor, then one may choose only to use these particular risks-to-fundamentals as a basis for determining whether or not to exchange the asset. To be clear, this is NOT a statement in “most people who know market-wise are probably not aware of LIBOR.” The problem arises when markets and institutions are at war. If one’s economic objectives and objectives are to sell out of Libor, then it needs to do something to make sure that Libor has no chance of trading. For example, the markets or institutions of a single issuer, like the NYSE, have a long-term liquidity advantage. If banks are at a risk, then they should make sure their customers have the ability (and ability) to hold for up to seven years. The US government may hold Libor for 12 years in the event that this is the case. However, an issuer needs to be aware of the liquidity disadvantage of keeping this asset in circulation and of course, the fact that they will not be able to do so at a later date, which would severely limit their ability to do so with the asset. A more common point about the various derivatives that investors must be aware of is the risk of “liquidity” within certain instruments. This term has a positive and negative connotation. Liquidity is when money is held in short cash in a series of short positions and can be liquidated as currency
From a modeling prospective, callable Libor exotics are difficult to handle. Simple, “firstgeneration” interest rate models like Ho-Lee, Hull-White, Black-Karasinsky cannot be used because of their inability to calibrate to a rich enough set of market instruments. One has to use “second generation” models with richer, more flexible volatility structures. Among the latter, forward Libor models (also known as Libor Market and BGM models) are arguably the best suited for the job.
Building a pricing and risk management framework for callable Libor exotics based onforward Libor models is a formidable task. Conceptual and technical issues abound. Calibration, valuation and risk sensitivities calculations all present unique challenges.
This paper takes a look at these problems and possible ways that may be used to address these challenges. We aim to present a comprehensive review of problems one has to deal with when developing the callable Libor exotics capability for forward Libor models.
To get an idea of the scope of the paper, one just needs to ask why using forward Libormodels for callable Libor exotics (CLE for short) is so hard? Problems start with volatility calibration. Multiple types of optionality embedded in CLEs mean that they depend on volatilities of many different rates. What market instruments do we calibrate the model to?
Matching todays prices of market instruments is just one part of the solution. Choices affecting the dynamics of the volatility structure have a significant impact on CLE prices. Questions arising out of this situation though in the domain of general interest rate modeling, have profound importance for callable Libor exotics.
After calibration comes pricing. Pricing must be done using Monte-Carlo, as it is theonly viable numerical method available for forward Libor models. Successful pricing ofBermuda-style options in Monte-Carlo hinges on the ability