An Analytical Hybrid Equity and Interest Rate Model

ShekKeung Tony Wong

Abstract

In this article, we introduce a new pricing model for equity and interest rate hybrids that can capture
the eects of implied volatility skews and stochastic interest rates simultaneously. The proposed model
is a simple modification of an existing hybrid model often used by market practitioners. While both
models can be calibrated eciently and accurately along the lines of Piterbarg (2005), it is shown that
the proposed model is analytically solvable leading to an explicit equity price expression. Using this
expression, we manage to establish an exact Monte Carlo simulation scheme for generic pricing purposes.
In addition, it is shown that a pathwise approach along the lines of Glasserman (1996) can be applied
to the proposed model in a straightforward manner for the calculation of equity deltas and gammas. For
illustration purposes, we apply the results developed in this article to the pricing of conditional trigger
swaps or Enmansai structures. Numerical results indicate that the exact simulation scheme developed in
this article is both ecient and robust. Moreover, both the proposed model and the existing model lead
to similar prices, equity deltas, and equity gammas. However, owing to the exact simulation scheme, the
proposed model compares favorably to the existing model due to its superior computational eciency and
robustness in pricing. As a benchmark, with a simulation size of 100K, calculation of price, equity deltas,
and equity gammas of a 30year Enmansai trade with semiannual coupons typically takes less than 5
seconds under the proposed model, while the existing model can take nearly 100 seconds to achieve a
comparable accuracy.

Introduction

In practice, there exists financial instruments whose values cannot be fully characterized by liquidly traded market
instruments. In such cases, it is typical that a model is needed to complete the price characterization. Equity and
interest rate (EIR) hybrids are particular examples of such instruments. The value of an EIR hybrid depend crucially
on the stochasticity in both interest rate and equity price movements, yet cannot be uniquely represented by market
prices of liquidly traded interest rate and equity vanillas. In the context of financial modelling, this is equivalent
to saying that the value of the instrument under a twofactor (2F) pricing model is significantly dierent from its
value under a onefactor (1F) pricing model. Consequently, a 2F pricing model is needed to capture the multiple risks
embeded in the instrument and hence riskmanage these risks appropriately. On the other hand, for many existing EIR
hybrids, the eects of implied volatility (IV) skews also play a crucial role in pricing, which adds another dimension
of diculty in the pricing of such products. A detailed introduction of EIR hybrids and their risk characteristics can
be found in Overhaus (2006) for a detailed description.
The applications of 2F pricing models are hindered by their increasing computational intensity in pricing and
diculty in calibration. While a simple 2F hybrid model with normal short rates and lognormal equity prices may be
suciently ecient in both calibration and pricing, it fails to produce IV skews commonly observed in equity option
markets. The challenge remains to identify a pricing model that can strike a good balance between computational
eciency in pricing and calibration and the capability of capturing the essential risk factors associated with EIR
hybrids. Piterbarg (2005) presents a candidate pricing model fitting these criteria. The Piterbarg model, tailored
for the pricing of power reverse dual currency (PRDC) swaps, is formulated in a doublecurrency setting with the
forex rate following a diusion process with a CEV volatility function and the short rates in the two underlying
currencies driven by onefactor HullWhite (HW1F) models. Due to the analogy between forex rate modelling and
Global

Methodology Oce, Mizuho Securities, Tokyo, Japan. The contents of this article only reflect the views of the author and not
necessarily those of Mizuho Securities. The author is indebted to Tsukasa Yamashita, Hiroshi Nishida, Sebastien Gurrieri, and Masaki
Nakabayashi for useful comments and suggestions. All remaining mistakes are my own.

Electronic copy available at: http://ssrn.com/abstract=1950001

equity price modelling, this model can be easily adapted to the pricing of EIRs1 . The popularity of the Piterbarg
model is particularly attributed to: (i) the existence of an ecient and accurate calibration procedure, and (ii) the
ease of control of IV skews. An existing model that is widely used by market practitioners for the pricing of EIRs is
indeed closely related to the Piterbarg model. The existing model replaces the CEV volatility function in the Piterbarg
model with a displaced diusion volatility function2 . It turns out that calibration of this model can also be performed
eciently and accurately along the lines of Piterbarg (2005).
In this article, we present a new hybrid pricing model for EIRs that can incorporate the eects of implied volatility
skews and stochastic interest rates simultaneously. An ecient and accurate calibration procedure along the lines
of Piterbarg (2005) is presented. Hinging on a simple modification of the volatility function of the existing model
discussed above, the proposed model can be solved analytically leading to an exact Monte Carlo simulation scheme for
generic pricing purposes. The proposed model is also subject to some limitations that are similar to those discussed
in Piterbarg (2005). In particular, it cannot be well fitted to convex implied volatility smiles. However, the current
article does not aim to provide a perfect solution to the pricing of EIRs, but rather a parsimonious pricing model which
is capable of capturing the crucial risk factors underlying EIRs and allows for fast and accurate model calibration
and pricing. The remainder of this article is organized as follows. The next section provides the model definition and
a brief comparison between the proposed model and the existing model. In Section 3, we describe the calibration
procedure while its derivation is given in the Appendix. In Section 4, we derive an explicit expression for the spot
equity price and subsequently an exact Monte Carlo pricing framework for EIRs. An analytical formula for moments
of spot equity price is also given. In Section 5, we illustrate the results developed in this article through a few practical
pricing examples. Finally, Section 6 concludes the article.

The Model

2.1

The Short Rate Dynamics

Let r(t) denote the short rate. We assume that r(t) follows a HW1F process
r(t) =
dy(t) =

(t) + y(t),
a(t)y(t)dt + r (t)dWr (t),

y(0) = 0,

(1)
(2)

where Wr (t) is a standard Brownian motion under the risk neutral measure Q. The parameters a(t) and r (t) denote
the mean reversion speed and the short rate volatility, respectively.
In addition, (t) is a deterministic function of time which can be used to achieve an exact fit to an initial yield
curve. Let P (t, T ) denote the time t price of a zero coupon bond (ZCB) maturing at T . Under the HW1F short rate
model, P (t, T ) is given by
P (t, T )

exp (A(t, T ) B(t, T )y(t)) ,

(3)

where

A(t, T )

B(t, T )
E(t)

T
1
E(t)
du,
E(u)
t
( t
)
= exp
a(u)du ,
=

VI (t, T )

1
(u)du + VI (t, T ),
2

(5)
(6)

0
T

B 2 (u, T )r2 (u)du.

(4)

(7)

Assume an initial discount curve P = {P (0, t)}t0 , where P (0, t) is dierentiable in t. Then, the HW1F model can be
fitted exactly to P by setting
(t) =

ln P (0, t) 1 VI (0, t)
+
.
t
2
t

(8)

1 When pricing EIRs using the Piterbarg model, one may regard the forex rate as the underlying equity price while treating the foreign
short rate as the dividend yield.
2 Several studies reveal that CEV models can be well approximated by displaced diusion models, see Marris (1999) and SvobodaGreenwood (2007) etc., for example.

Electronic copy available at: http://ssrn.com/abstract=1950001

Following some simple arguments, one can solve (2) to obtain

T
1
y(T ) =
E(u)r (u)dWr (u),
E(T ) 0
T
T
T
VI (0, T )
r(u)du = ln P (0, T ) +
+ B(0, T )
E(u)r (u)dWr (u)
B(0, u)E(u)r (u)dWr (u).
2
0
0
0

(9)

(10)
For a detailed review of the HW1F model, see Brigo (2001), for example.

2.2

The Equity Price Dynamics

Let S(t) be the price of an underlying equity asset. In conjunction with the HW1F short rate dynamics, we propose
the following dynamics for S(t)
dS(t)

= (r(t) d(t)) S(t)dt + ((t)S(t) + (1 (t))x(t)) S (t)dWS (t),

S(0) = S0 ,

(11)

where d(t) denotes the dividend yield and WS (t) a standard Brownian motion under Q with
< dWr (t), dWS (t) > = dt.
The variable x(t) is defined as

(
x(t) =

S0 exp

)
(r(u) d(u)) du .

(12)

(13)

Within the current model, the volatility parameter (t) influences mainly the level of atthemoney (ATM) implied
volatilities, while (t) controls the slope of implied volatility curves along the strike axis and is often referred to as
the skew parameter. Note that x(t) is lognormally distributed under the HW1F assumption for r(t).
As in many practical applications, we assume that the parameters (t) and (t) are piecewise constants:

(0 , 0 ),
t [0, T1 ),

(1 , 1 ),
t [T1 , T2 ),
((t), S (t)) =
(14)
..
..

.
.

(N 1 , N 1 ), t [TN 1 , TN ).
With this specification, one has the flexibility of fitting the model to a term structure of implied volatility skews
observed in the markets.

2.3

Comparison to an Existing Hybrid Model

The proposed model is a simple modification of an existing hybrid model which is popular among market practitioners.
Under the existing model, S(t) follows
dS(t) =

(r(t) d(t)) S(t)dt + ((t)S(t) + (1 (t))F (0, t)) S (t)dWS (t),

(15)

where F (0, t) denotes the initial equity forward price given by

F (0, t) =

d(u)du
S(0)e 0
.
P (0, t)

(16)

Hence, our proposed model can be obtained from the existing model simply by replacing the forward price F (0, t)
appearing in (15) by x(t). Note also that the proposed model and the existing model coincide under the degenerating
case r (t) = 0, where both models reduce to a onefactor displaced diusion (DD1F) model (e.g. see Rebonato
(2004)).
Using (10), we may rewrite x(t) as follows
)
(
t
t
VI (0, t)
+ B(0, t)
E(u)r (u)dWr (u)
B(0, u)E(u)r (u)dWr (u) .
(17)
x(t) = F (0, t) exp
2
0
0
Since the volatility of x(t) is generally much smaller than the volatility of S(t), we expect that the pricing behaviors
of the two models are similar in general. Note that the existing model is not solvable in general in that there exists
no explicit expression for the equity price S(t). This is indeed the main motivation for us to introduce the alternative
equity price dynamics (11). In a later section, we shall present an explicit expression of S(t) under the proposed model
which consequently leads to an ecient Monte Carlo simulation scheme for generic pricing purposes.
3

Model Calibration

Calibration of the model involves the determination of the HW1F parameters, the correlation , and the equity skew
and volatility parameters. With the HW1F model, an initial yield curve can be fitted exactly using the time dependent
parameter (t) while the mean reversion speed a(t) and the volatility r (t) are usually chosen to match market prices
of European swaptions and/or caps/floors. There exists a large body of literature on the calibration of the HW1F
model, e.g. see Brigo and Mercurio (2001) or Hagan (2000). The model correlation , on the other hand, is typically
estimated from time series of historical interest rates and equity prices. The main challenge lies in the calibration of the
1
equity skew and volatility parameters {(i , i )}N
i=1 . A widely used approach for calibrating these parameters under
the existing model (15) follows the method of Piterbarg (2005), which is both ecient and accurate. It turns out that
a similar calibration procedure can also be derived for the proposed model. The calibration procedure involves two
main approximation steps: (i) Markovian projection, and (ii) skew averaging. In what follows, we present a detailed
derivation of these approximations under the context of the proposed model and subsequently summarize the resulted
calibration procedure.

3.1

Markovian Projection

Consider call options with a maturity Ti for which the relevant forward equity price is F (t, Ti ). Under the proposed
model, the dynamics of F (t, Ti ) is given by
dF (t, Ti )
F (t, Ti )

= B(t, Ti )r (t)dWrTi (t) + (t, S(t)) dWSTi (t),

(18)

where WrTi (t) and WSTi (t) are two correlated Brownian motions under the forward measure QTi and
[
]
x(t)
(t, S) =
(t) + (1 (t))
S (t),
S(t)

dt =
dWrTi (t), dWSTi (t) .

(19)
(20)

This step aims to replace (t, S(t)) in (18) by

(t, Ti , F ) =
t
Since S(t) = P (t, Ti )e

d(u)du


[
]
E QTi (t, S(t))  F (t, Ti ) = F .

(21)

F (t, Ti ), this boils down to calculating the following conditional expectation


[
]
x(t) 
QTi
E
F (t, Ti ) = F .
P (t, Ti ) 

(22)

For this purpose, we apply the approximation

(t, S(t)) (t, x(t)) = S (t),

(23)

to (18), which gives

(

1
F (t, Ti ) F (0, Ti ) exp
2

B(u, Ti )r (u)dWrTi (u)

(u, Ti )du +
0

+
0

S (u)dWSTi (u)

(24)

where
(u, Ti )

[ 2
]1
B (u, Ti )r2 (u) + S2 (u) + 2S (u)B(u, Ti )r (u) 2 .

Note that with this approximation ln F (t, Ti ) is normally distributed. On the other hand, we have
(
)
t
x(t)
VI (0, Ti ) VI (t, Ti )
= F (0, Ti ) exp
+
B(u, Ti )r (u)dWrTi (u) ,
P (t, Ti )
2
0

(25)

(26)

which implies ln P x(t)

(t,Ti ) is also normally distributed. Using (24) and (26), we obtain
[
E

QT


)(t)
]
(
x(t) 
F
F (t, Ti ) = F
F (0, Ti )
exp (R(t))
P (t, Ti ) 
F (0, Ti )
4

(27)

where R(t) is a quantity of quadratic order in volatilities and

t 2
t
B (u, Ti )r2 (u)du + 0 S (u)B(u, Ti )r (u)du
0
(t) =
.
t
2 (u, Ti )du
0

(28)

Dropping the quadratic term R(t), we have

[
(t, Ti , F )

(t) + (1 (t))

F (0, Ti )
F

)1(t) ]
S (t).

(29)

= B(t, Ti )r (t)dWrTi (t) + (t, F (t, Ti )) dWSTi (t),

(30)

Consequently, we have the following approximated dynamics for F (t, Ti ):

dF (t, Ti )
F (t, Ti )

which can be further rewritten in a onedimensional form

dF (t, Ti )
F (t, Ti )

= (t, Ti , F (t, Ti ))dWFTi (t),

(31)

where WFTi (t) is a standard Brownian motion under QTi and

(t, Ti , F )

3.2

[ 2
]1
B (t, Ti )r2 (t) + 2 (t, Ti , F ) + 2
(t, Ti , F )B(t, Ti )r (t) 2 .

(32)

Skew Averaging

Define
g(t, Ti , F ) =
g(Ti , F ) =

F (t, Ti , F ),
F
F (Ti )
+ (1 F (Ti )).
F (0, Ti )

(33)
(34)

Following Piterbarg (2003), the forward price dynamics given in (31) can be well approximated by
dF (t, Ti )

g(t, Ti , F (0, Ti ))
g (Ti , F (t, Ti ))dWFTi (t),

(35)

provided that


Ti

F g(t, Ti , F ) F =F (0,T )
g(Ti , F )
=
(t)
dt,
F
g(t, Ti , F (0, Ti ))
0
F =F (0,T )

(36)

where
(t) =
u(t) =

u(t)
,
Ti
u(t)dt
0

(37)

g 2 (s, Ti , F (0, Ti ))ds.

g (t, Ti , F (0, Ti ))

(38)

We may write (35) explicitly as

dF (t, Ti )

(t, Ti , F (0, Ti )) [F (Ti )F (t, Ti ) + (1 F (Ti ))F (0, Ti )] dWFTi (t).

(39)

The condition (36) implies

F (Ti ) 1

2
=

Ti
0

((t) 1)

t
0

)(
)
2 (u, Ti , F (0, Ti ))du S2 (t) + S (t)B(t, Ti )r (t) (t)dt
.
(
)2
Ti 2

(u,
T
,
F
(0,
T
))du
i
i
0

(40)

This implies that the approximated forward price follows a DD1F model with skew F and a timedependent volatility
parameter (t, Ti , F (0, Ti )). Notice that the dynamics (39) follows a DD1F model with a constant skew parameter F
5

and timedependent volatility (t, Ti , F (0, Ti )). As far as the distribution of F (Ti , Ti ) is concerned, we may replace
(39) with the following DD1F dynamics
dF (t, Ti )

F (Ti ) [F (Ti )F (t, Ti ) + (1 F (Ti ))F (0, Ti )] dWFTi (t),

(41)

where

F (Ti )

Ti
0

2 (u, Ti , F (0, Ti ))du

.
Ti

(42)

Notice that the right hand side of (42) is independent of the model skew parameter (t).

3.3

The Calibration Procedure

1
Utilizing the approximations above, the parameters {(i , i )}N
i=0 can be calibrated as follows

1. At each maturity Ti , where i = 1, ..., N , fit a DD1F model with constant skew and volatility parameters i,F

and i,F to the observed market implied volatilities, i.e. a model with the following dynamics

dF (t, Ti ) =

i,F
F (t, Ti ) + (1 i,F
)F (0, Ti ) i,F
dW (t).

(43)

{
}N 1

This gives a collection of eective DD1F skew and volatility parameters (i,F
, i,F
) i=0 .
1
N 1

2. Solve {i }N
i=0 recursively using (42) and replacing F (Ti ) by i,F . (Note that the determination of {i }i=0
1
does not require the knowledge of {i }N
i=0 .)
{ }N 1
1
N 1

3. Given {i }N
i=0 and i,F i=0 , solve {i }i=0 recursively using (40) and replacing F (Ti ) by i,F .

In the first step above, at each maturity, we first set the DD1F volatility parameter equal to the ATM market implied
volatility and optimize the DD1F skew parameter against the selected market implied volatilities. Next, we adjust the
DD1F volatility parameter so that the ATM market implied volatility is matched exactly. This process is fast since it
involves only onedimensional optimization in which the initial guess is suitably set. The second and third steps of the
calibration procedure are instantaneous since they involve solving a series of quadratic equations and linear equations
only.
It is worth noting that a similar calibration procedure can also be derived for the existing model based on the
dynamics (15). The resulted calibration procedure follows exactly the same steps as above where the only modification
is in the function (t). This implies that the calibrated model volatility parameters coincide under the two models
while the calibrated skew parameters may dier.

Valuation

Derivative pricing under the proposed model can be carried out either by a Monte Carlo simulation method or a finite
dierence method. For a general payo, the pricing partial dierential equation (PDE) arising from the proposed
model is threedimensional, where the additional factor is attributed to the variable x(t) appearing in the equity
volatility function. The establishment of an ecient and robust implementation of a meshbased finite dierence
scheme for a threedimensional pricing PDE is a highly nontrivial task. Moreover, it is generally dicult to apply
a finite dierence method to strongly pathdependent products such as those with a TARN or snowball feature. For
these reasons, we choose to devote our eorts to identifying an ecient Monte Carlo simulation method for general
pricing purposes. As we shall see, the strength of the proposed model is indeed best realized within the Monte Carlo
pricing framework to be developed in this section.

4.1

An Explicit Equity Price Expression

Consider the shifted equity price S(t),

defined by

S(t)
=

S(t) +

1 (t)
x(t),
(t)

(44)

where we assume (t) = 0 for 0 t TN . Applying Itos Lemma and using the assumption that (t) and S (t) are
constant on [Ti1 , Ti ), we have

dS(t)
=

(r(t) d(t)) S(t)dt

+
S (t)S(t)dW
S (t),

S (t) = (t)S (t),

(45)

follows a lognormal dynamics on each subinterval [Ti1 , Ti ). Note that the

for t [Ti1 , Ti ). This implies that S(t)

process S(t) is discontinuous at Ti if i1 = i , while the process S(t) is continuous at each Ti .

Now define
)
(

t
1 t 2

S (u)du +

S (u)dWS (u) , s t,
(46)
M (s, t) = exp
2 s
s

1
k = 0,

0 ,

1k1
1k
ci,k =
(47)
k k1 , 1 k i,

i
1
k = i + 1,
i ,
for i = 0, , N 1. The theorem below follows readily.
Theorem 4.1. For T [Ti1 , Ti ), we have
)
]
[(
S(Ti1 )
ci1,i M (Ti1 , T ) + ci1,i x(T ).
S(T ) =
x(Ti1 )
Applying this expression recursively, we also obtain
(
S(T )

ci1,i +

i1

(48)

)
ci1,k M (Tk , T ) x(T ).

(49)

k=0

Note that (48) and (49) do not hold if some i is equal to zero. This, however, shall not give rise to any practical
diculties in pricing since the pricing impacts of replacing i = 0 by some small number are likely to be negligible
in general. The expressions (48) and (49) have two crucial implications. First, since both M (s, t) and x(t) are
lognormal variables, one can calculate moments of the spot equity price analytically using (49), which can be useful
in various financial applications such, e.g. approxmation of Asian option prices, and variance reduction via moment
matching etc.. Second, it is clear that that one may simulate the equity price process exactly without the need of path
discretization using the two price expressions.
4.1.1

ClosedForm Formula for Moments of Spot Equity Price

Define
Ei,n

= E QTi [S n (Ti )] = E QTi [F n (Ti , Ti )] ,

n = 1, 2,

(50)

where E QTi denotes the forward measure associated with P (t, Ti ). In what follows, we illustrate how Ei,n can be
calculated analytically. The risk neutral moments can be obtained in a similar fashsion and hence are omitted. Using
(49), we may write
( i
)

S(Ti ) =
ci1,k M (Tk , Ti ) x(Ti ),
(51)
k=0

and hence
(
n

S (Ti ) =

i
i

k1 =0 k2 =0

)
ci1,k1 ci1,k2 ci1,kn M (Tk1 , Ti )M (Tk2 , Ti ) M (Tkn , Ti )

xn (Ti ),

(52)

kn =0

To calculate Ei,n , it suces to consider the following expected value

mi,n (k1 , k2 , , kn )

E QTi [M (Tk1 , Ti )M (Tk2 , Ti ) M (Tkn , Ti )xn (Ti )] .

7

(53)

Assume k1 k2 kn . Let Qi,n be a probability measure characterized by the following RadonNikodym

Derivative (RND) process:
( 2
)
t
n (VI (0, Ti ) VI (t, Ti ))
dQi,n
(t) = exp
+n
(54)
B(u, Ti )r (u)dWrTi (u) ,
dQTi
2
0
where B() and VI () are defined in (5) and (7), respectively. It is easy to verify that the following holds
(
)
dQi,n
xn (Ti )
n(n 1)
(Ti ) =
exp
VI (0, Ti ) .
dQTi
F n (0, Ti )
2

(55)

Applying Girsanovs Theorem, we conclude that

Wri,n (t)

WrTi (t)

B(u, Ti )r (u)du,

(56)

WSi,n (t) =

WSTi (t) n

B(u, Ti )r (u)du,

(57)

are two correlated Brownian motions under Qi,n with

< dWri,n (t), dWSi,n (t) >

= dt.

(58)

Consequently, we have
(
mi,n (k1 , k2 , , kn )

F (0, Ti ) exp

)
n(n 1)
VI (0, Ti ) E Qi,n [M (Tk1 , Ti )M (Tk2 , Ti ) M (Tkn , Ti )] ,
2

where each M (Tkj , Ti ) can be rewritten as

(
)

Ti
Ti
1 Ti 2
i,n
M (Tkj , Ti ) = exp

(u)du + (n 1)

S (u)B(u, Ti )r (u)du +

S (u)dWS (u) .
2 Tkj S
Tkj
Tkj
Since each M (Tkj , Ti ) is lognormally distributed, direct calcualtion gives

n Ti

n(n 1)
VI (0, Ti ) + (n 1)

S (u)B(u, Ti )r (u)du
mi,n (k1 , k2 , , kn ) = F n (0, Ti ) exp
2
j=1 Tkj

Ti
n1
j(j 1) Tkj+1
n(n 1)
exp

S2 (u)du +

S2 (u)du .
2
2
Tkj
Tkn
j=1

4.2

(59)

(60)

(61)

An Exact Monte Carlo Pricing Framework

M

We consider a hybrid instrument consisting of a stream of net payments {i }i=1 which take place at the times {Tip }i=1 ,
respectively. Each payment i takes the form:
))
)
(
) (
)
(
( (
f
f
f
f
,
(62)
,

,
S
T
,
S
T
, , r Ti,n
i = i r Ti,1
i,ni
i,1
i
f
f
f
where Ti,1
< Ti,2
< < Ti,n
Tip . This hypothetical instrument covers a reasonably wide range of existing
i
products. In particular, it can account for typical pathdependent features such as knockin (KI), knockout (KO),
TARN, or range accrual. Such pathdependent features can be handled in a straightforward manner within a Monte
Carlo pricing framework. In practice, the instrument may also consist of an early exercise provision. We shall not
consider such cases here as there exists a rich literature on the treatment of an early exercise provision within a
Monte Carlo pricing framework. To evaluate an instrument in the presence of an early exercise provision, one may, for
example, apply the algorithm of Longsta and Schwartz (2001) in conjunction with the Monte Carlo pricing scheme
to be developed here.

To valuate the instrument above with Monte Carlo simulation under the risk neutral measure Q, the relevant
variables to be simulated are
(
)
(
)
(
)
(
)
f
f
f
f
y T1,1
, , y T1,n
, S T1,1
, , S T1,n
,
1
1
..
. (
)
(
)
(
)
(
)
f
f
f
f
y TM,1
, , y TM,n
, S TM,1
, , S TM,n
,
M
M
(

T1p

exp

r(u)du , , exp

p
TM

r(u)du .

(63)

From (9), (10), (17), (46), and (48), this reduces to simulating
{
}

t
M
f 
the process X(t) = 0 E(u)r (u)dWr (u) at Ti,j
i = 1, , M, j = 1, , ni and {Tip }i=1 ,
t

B(0, u)E(u)r (u)dWr (u) at {Tip }i=1 , and

{
}

t
f 
S (u)dWS (u) at Ti,j
i = 1, , M, j = 1, , ni .
the process Z(t) = 0
the process Y (t) =

To achieve exact simulation via (48), our simulation time grids should include both the parameter time grids {Ti }i=1 .
N
For ease of exposition, we simply assume that the time grids {Ti }i=1 consist of all relevant product related time grids
described above.
It is clear that X(t), Y (t), and Z(t) are Gaussian processes and hence can be simulated exactly without the need
of path discretization. It suces to consider the simulation of the following three variables

Ti

X =

E(u)r (u)dWr (u),

Ti1

Ti

Y =

B(0, u)E(u)r (u)dWr (u),

Ti1

Ti

Z =

S (u)dWS (u).

(64)

Ti1

The three variables above are normally distributed with a mean of zero while their variances and covariances can also
be calculated readily. In practice, the variances and covariances can be calculated and cached before carrying out the
pricing simulation. Our experience suggests that this can reduce the computational time of pricing considerably. For
each simulation of the three processes, a sample of the variables in (63) can then be constructed according to (9), (10),
(17), (46), and (48) respectively.
It is worth mentioning that the existing model (15) does not lead to any explicit expression for S(t). A path
discretization scheme is therefore required for the simulation of the existing model. Hence, Monte Carlo pricing under
the existing model gives rise to both discretization errors and Monte Carlo noises in prices. To reduce the discretization
errors, one often needs to insert additional simulation time grids which, needless to say, increases the time of the pricing
simulation. In contrast, the exact Monte Carlo simulation scheme presented above requires simulation of the underlying
processes only at relevant model and payo time grids. Consequently, path samples generated from the scheme are
subject to the inherent Monte Carlo noises only and are free of discretization errors. We believe that an exact Monte
Carlo simulation scheme not only enhances the eciency and robustness of pricing but also provides a reliable way
for price (e.g. PDE or tree prices) and error (e.g. calibration errors) verification.

4.3

Computation of Risk Sensitivities

For hedging purposes, one often needs to compute the sensitivities of an instrument with respect to the underlying
risk factors. Here, we particularly focus on the calculation of equity deltas and gammas. Suppose that the value of a
certain instrument is given by
V (w) =

E [g (w)] ,

(65)

where w is the variable of interest. The first and second order sensitivities of V with respect to w are defined by
(w) =

V
,
w

(w) =

These sensitivities often need to be estimated numerically.

2V
.
w2

(66)

The conventional bumpandrevalue approach attempts to approximate them using finite dierences of the price
function:
(w)

V (w + h) V (w)
,
h

V (w + h) 2V (w) + V (w h)
,
h2

(67)

where h is the perturbation size. Within a finite dierence pricing approach, these approximated sensitivities are
naturally obtained in the pricing stage, while within a Monte Carlo pricing approach revaluations of the instrument
are generally required. The bumpandrevalue method has a few potential issues. In particular, it is generally dicult
to come up with a robust choice of the perturbation size h under all pricing settings. A good choice of h often depends
on, for example, the underlying instrument and the range of model parameters. For a small h or a higher order
sensitivity, the estimate tends to be more vulnerable to numerical noises. This is a particularly the case for Monte
Carlo pricing methods due to discretization errors and Monte Carlo noises. To obtain accurate and smooth higher
order sensitivities, one often needs to increase the number of simulations substantially or utilize certain variance
reduction techniques to reduce the noises. On the other hand, for a large h, the approximated sensitivities may consist
of a significant bias. For a detailed discussion of this approach and the related issues, see Jeckel (2001), for example.
On the other hand, the approach of Glasserman (1996), known as the pathwise method, oers an alternative way
of calculating sensitivities which is not based on taking finite dierences of the price function and hence avoids revaluations. In contrast to the bumpandrevalue approach, the pathwise method calculates sensitivities by dierentiating
the underlying payo function with respect to the variables of interest and is naturally suited for a Monte Carlo pricing
framework. With the pathwise method, the sensitivities above are given by
]
]
[
[ 2
g (w)
g (w)
(w) = E
, (w) = E
.
(68)
w
w2
Consequently, one may obtain the sensitivities by evaluating the expected values above through Monte Carlo simulation. Since the calculation of sensitivities can be carried out within the same simulation loop for pricing, this
method is generally more ecient than the bumpandrevalue method. In essence, the pathwise method involves
an interchange of the order of dierentiation and expectation, which, technically speaking, imposes some smoothness
conditions on the payo function. A detailed discussion of such conditions can be found in Glasserman (1996). In
Glasserman (2003), it is reported that the pathwise method, when applicable, tends to produce more accurate greek
estimates with lower variances.
We now show that under the current model it is extremely simple to calculate equity deltas and gammas using the
pathwise method along with our exact Monte Carlo simulation scheme. To fix ideas, consider the payment i of the
instrument defined in Section 4.2. The value of the payment and the pathwise delta and gamma are given by
[ ( (
)
(
) (
)
(
))]
f
f
f
f
Vi (S0 ) = E i r Ti,1
, , r Ti,n
,
S
T
,

,
S
T
,
(69)
i,1
i,ni
i

f
ni

i S(Ti,j )
i (S0 ) = E
,
(70)
f
S0
j=1 S(Ti,j )

(
)2
f
f
ni
2

S(Ti,j
)
2 S(Ti,j
)

i
i
.

i (S0 ) = E
+
(71)
2
f
2 (T f )
S
S
0
S
S(T
)
0
i,j
i,j
j=1
Note that the partial derivatives of the payo with respect to the underlying equity prices depend only on the form of
the payo, while the modeldependent part lies in the evaluation of the partial derivatives
f
S(Ti,j
)
,
S0

f
2 S(Ti,j
)
.
S02

(72)

By applying (49), we obtain

S(T )
S0n

S(T )
S0 ,

n = 1,

0,

n > 1.

(73)

For payos involving a running maximum and/or minimum of the equity prices sampled at a series of time points,
one may also need to calculate the following partial derivatives
n M (T1 , , Ti ; )
,
S0n
10

(74)

where
M (T1 , , Ti ; )

max {S(T1 ), , S(Ti )} ,

= 1.

(75)

Applying (49) and using the following property

{

M (T1 , , Ti ; )

S(T1 )
S(T1 )
S0 max
,,
S0
S0

we also obtain
n M (T1 , , Ti ; )
S0n

M (T1 ,,Ti ;)
,
S0

n = 1,

0,

n > 1.

}
.

(76)

(77)

Numerical Illustration

As an illustration, we apply the proposed model and the results developed earlier to evaluate a conditional trigger swap
(CTS), also known as an equity Enmansai in Japanese markets. An Enmansai is essentially a swap contract involving
the exchange of cash flows between two counterparties over time, with the funding leg paying Liborplusspread
coupons and the structured leg paying equitylinked structured coupons. In addition, the contract is autocallable
with an upandout (UO) condition. Consequently, the contract terminates either on the maturity of the trade or
the first monitoring time at which the equity price exceeds the UO barrier, whichever comes first. In essence, CTSs
are designed to pay high coupons as long as the underlying equity index (typically the Nikkei 225) is above a certain
level, and redeem out if it further climbs above a predefined barrier. This explains the great success of these products
during the Japanese equity market rally (20032007). Although the demand for CTSs diminishes substantially due
to the recent market deterioration, many banks still have large blocks of active positions in CTSs. For these banks, it
remains an important task to evaluate and riskmanage their CTS positions appropriately.
In practice, there exists variations of CTS structures. Here, we consider only a basic form of the product, as
described in Overhaus et al (2007). With this structure, the structured leg pays an initial guaranteed coupon CH
(adjusted by an accrual factor 1 ) at T1 and subsequently a structured coupon in the form
[
]
i CH I{S(Ti )K} + CL I{S(Ti )<K} I{Mi <U } ,
(78)
at each Ti , for i = 2, , N , where CL and CH are constant coupon rates with CL < CH , i the payment accrual, and
Mi

max {S(T1 ), , S(Ti1 )} .

(79)

Here, K denotes the digital coupon strike and U the UO barrier. On the other hand, the funding leg pays the following
coupon at each Ti
i [Li (Ti ) + s] I{Mi <U } ,

(80)

where Li (t) denotes the time t forward Libor rate applied to the period3 [Ti , Ti+1 ] and s a spread. Note that we
assume that all product related times (fixing, payment, and barrier monitoring times) fall exactly on the model time
grids {Ti }N
i=1 for the ease of exposition only.

5.1

Data and Parameter Settings

Throughout our numerical tests, we assume the following test settings

underlying currency: Japanese yen (JPY).
underlying equity: Nikkei 225.
initial spot equity price: 10000.
initial JPY yield curve: a NelsenSiegel curve with the time T zero rate given by
[
(
)]
1
1 e T
1 e T
T
N S(T ) =
b1 + b2
+ b3
e
,
100
T
T
where b1 = 2.57, b2 = 2.30, b3 = 2.61, and b3 = 0.37. See also Fig. 1.
3 Note

that we adopt the inarrears notion for Libor coupons here.

11

(81)

 market implied volatilities: see Table 4.

60

time grids: {Ti = 0.5 i}i=1

HW1F model parameters: a(t) = 0.75% and r (t) = 0.7%.
model correlation: = 0.6.
The data and parameter settings above are chosen so that they roughly reflect the recent market conditions.

5.2
5.2.1

Test Results
Calibration

We apply the calibration procedure described in Section 3 along with the market data and parameter settings described
1
above to determine the model parameters {(i , i )}N
i=0 . With this calibration method, the calibration time is typically
within a few seconds. Fig. 2 and Fig. 3 show both the fitted DD1F parameters and model parameters.
Table 5 shows the dierences between the model implied volatilities and the actual market implied volatilities.
The fit of the model at most calibration points is excellent with fitting errors typically less than one volatility point.
There remains a few individual points with large fitting errors, which are mostly associated with a short maturity
(6M/1Y) and a deep OTM/ITM moneyness. Since short maturity ITM/OTM options usually have a small vega risk,
we believe that these poorly fitted points should not give rise to significant pricing impacts on long dated CTS trades.
It also appears that the quality of the fit of the model at longer maturities deteriorates slightly. However, the fitted
errors in such cases are still well within bid ask spreads. We believe that the overall calibration results achieved in
this example are suciently accurate for practical pricing purposes. More importantly, the calibrated model gives an
adequate accounting of the term structure of implied volatility skews exhibited in the market data.
It should be pointed out that the poorly fitted cases are largely due to a limitation of the underlying model rather
than the calibration algorithm. To see this, we show in Table 6 the dierences between the model implied volatilities
and the fitted DD1F implied volatilities. The fit of the model to the fitted DD1F implied volatilities is excellent. In
particular, all fitted errors for maturities up to 15Y are below 0.50% while for maturities beyond 15Y there exists only
one case with a fitted error above one volatility point. Consequently, the fitting capability of the underlying model
is to some extent reflected in the fitting capability of the DD1F models to market option prices. This implies that
the underlying model may not be well fitted to convex implied volatility smiles or skews beyond the limits of a DD1F
model.
5.2.2

Pricing

We evaluate two test CTS trades described in Table 1 using the exact simulation scheme presented in Section 4 along
with the calibration results obtained in the previous section. For comparison, the trades are also evaluated using three
common pathdiscretization based simulation schemes (Euler, Milstein, and predictorcorrector (PC)), respectively.
Tables 7 and 8 report the relative price errors under dierent choices of simulation sizes and step sizes, where the
benchmark prices are obtained using the exact scheme with a simulation size of 10 millions. It should be emphasized
that a fair comparison of the four simulation schemes should be based on both price accuracy and computational
eciency. For this reason, we show in Table 9 the computational times taken for the pricing of Trade 2. The pricing
times for Trade 1 are similar and hence are omitted.
Table 1: Contract parameters of two test trades.
Trade 1
Trade 2

notional
1
1

maturity
30Y
30Y

coupon frequency
semiannual
semiannual

payment accrual
0.5
0.5

CL
0.1%
0.1%

CH
2%
2%

K
12000
10000

U
15000
12000

s
0.0
0.0

For Trade 1, the relative price errors under the exact simulation scheme are within 0.50% for all selected simulation
sizes. Under the other three schemes, it appears that a step size of 0.05 or smaller is required to obtain reliable prices.
With a step size of 0.05 and a simulation size of 50K or more, the relative price errors under the three schemes are
within 0.50%. For this trade, the Milstein scheme does not show a clear advantage over the Euler scheme in price
convergence, while the overall performance of the PC scheme appears to be better than the other two schemes. As a
benchmark comparison for the current trade, using a simulation size of 50K and a step size of 0.05 (under the three

12

discretization based schemes), the computational times required for the four simulation schemes are 1.67 seconds, 9.97
seconds, 10.28 seconds, and 10.92 seconds, respectively, as shown in Table 9.
On the other hand, the relative price errors for Trade 2 appear to be larger in general under all simulation schemes.
The price convergence under the exact scheme remains relatively well behaved. In particular, the results indicate that
a relative price error of 0.50% or below can be achieved with a simulation size between 100K and 200K. In contrast,
the other three schemes show slower price convergence for most step sizes. It appears that a step size of 0.01 and a
simulation size of 50K or more are required to obtain reliable prices for Trade 2 under the three schemes. For this
trade, both the Milstein scheme and the PC scheme show a clear improvement in price convergence over the Euler
scheme, particularly for larger step sizes. As a benchmark comparison, using a simulation size of 100K under the exact
scheme and a simulation size of 50K together with a step size of 0.01 under the three discretization based schemes, the
computational times required for the four schemes are 3.42 seconds, 49.22 seconds, 51.11 seconds, and 54.62 seconds,
respectively, as shown in Table 9.
It is worth noting that for Trade 2 the price convergence under the three discretization based simulation schemes
is more sensitive to the step size compared to the case of Trade 1. In particular, a smaller step size appears to be
required for a reasonable price convergence for Trade 2. This is indeed expected. Since the coupon strike of Trade
2 coincides with the spot price and the UO barrier is also closer to the spot price, any numerical errors can more
easily translate into large impacts on the coupon payos due to the payo discontinuities at the coupon strike and
UO barrier. This, on one hand, explains why the price errors under all four simulation schemes are generally larger
in the case of Trade 2. On the other hand, it also implies that the price errors under the three discretization based
simulation schemes become more sensitive to the step size since a larger step size results in larger discretization errors.
In contrast, the price errors under the four simulation schemes appear to be less sensitive to Monte Carlo noises and
discretization errors in the case of Trade 1. This is a consequence of two eects: (i) both the coupon strike and the
UO barrier of Trade 1 are relatively far from the spot price, and (ii) both CH and CL are independent of the equity
prices. In practice, there exist CTS trades where the structured coupons are a series of call options on the underlying
equity prices. For these trades, each coupon payo depend directly on the relevant equity price in that each level of
the equity price leads to a dierent coupon pay. Consequently, the choice of the step size under the discretization
based simulation schemes can become more critical in order to obtain suciently accurate price figures.
Our numerical experience also suggests that the discretization based schemes perform worse when the volatility is
high. This is expected since path discretization involves freezing the drift and the volatility of the underlying process
in a certain manner over each discretization step and hence ignores some stochasticity of the process increments. As
a result, a high volatility can lead to larger distributional bias and hence larger price bias. The overall test results
suggest that the exact simulation scheme presented in this article is superior to the discretization based simulation
schemes taking into account both price accuracy and computational eciency. It is also more robust in that it avoids
the ambiguity in choosing a step size which is otherwise needed for the discretization based simulation schemes. As is
evident from the test results, choosing an appropriate step size that can strike a good balance between computational
eciency and price accuracy is not always trivial. In particular, it can depend on the type of CTS coupons, the
discretization scheme, and the levels of the contract and model parameters.
5.2.3

Equity Delta and Gamma

Let i (S0 ) and fi unding (S0 ) denote the equity deltas of the structured leg coupon and the funding leg coupon paid
at Ti , respectively. Applying the pathwise method described in Section 4.3, we have
[
]
Mi
S(Ti )
i (S0 ) = i E
U (Mi )i +
I{Mi <U } K (Si )(CH CL ) ,
(82)
S0
S0
]
[
Mi
fi unding (S0 ) = i E
U (Mi ) [L(Ti ) + s] ,
(83)
S0
where b (w) is the Dirac delta function4 at the point w = b and
i

= CH I{S(Ti )K} + CL I{S(Ti )<K} .

(85)

4 The delta Dirac function is not an ordinary function and is defined only in a distributional sense. Roughly speaking, (w) is zero
b
everywhere except at w = b and additionally has the property

b (w)f (w) dw
0

for any suciently smooth function f ().

13

f (b),

(84)

To evaluate the equity deltas by simulation, one needs to approximate U () and K () by some ordinary function. A
simple choice is to approximate them by a normal density function, i.e.
b (w, ) =

(wb)2
1

e 2 2 ,
2

(86)

where is a tuning parameter which, roughly speaking, controls how close the approximating function is to the true
Dirac delta function. Consequently, we have
[
]
Mi
S(Ti )
i (S0 ) i E
U (Mi , M )i +
I{Mi <U } K (Si , S )(CH CL ) .
(87)
S0
S0
where S and M are the tuning parameters for the two approximating normal density functions. Similarly, the equity
gammas of the structured leg coupon and the funding leg coupon are given by
[
Mi S(Ti )
U (Mi , M )K (Si , S )(CH CL )
i (S0 ) i E 2
S02
[
]
Mi2 U (Mi , M ) CH I{S(Ti )K} + CL I{S(Ti )<K} (Mi U )
+
2
S02 M
]
S(Ti )2 K (Si , S )I{Mi <U } (CH CL )(S(Ti ) U )
+
,
(88)
S02 S2
[ 2
]
Mi (Mi U )
fi unding (S0 ) i E
U (Mi , M ) [L(Ti ) + s] .
(89)
2
S02 M
Fig. 6 and Fig. 7 show the equity deltas of the structured leg coupons and the funding leg coupons, respectively,
where the tuning parameters S and M of the pathwise method and the perturbation size h of the bumpandrevalue
method are fixed to 100. The figures show a good agreement in the equity deltas between the pathwise method and
the bumpandrevalue method. The equity deltas appear to be smoother with a higher number of simulations. To
see the impacts of changing S and M and the perturbation size, Fig. 8 and Fig. 9 compare the equity deltas under
two cases: (1) S = M = 100 (resp. h = 100), and (2) S = M = 500 (resp. h = 500). As we can see, there remains
a good agreement in the equity deltas under the two cases. The results also suggest that a simulation size of 100K is
sucient for the calculation of the equity deltas under both methods.
On the other hand, the equity gammas are shown in Fig. 10 and Fig. 11, respectively. Unlike the case of equity
deltas, the equity gammas fluctuate quite irregularly under both methods. This may indicate the followings
The chosen simulation sizes are too small for the chosen tuning parameters S and M . The situation is similar
to the case of evaluating by simulation the probability of a distribution over an event which occurs with a very
small probability. In such cases, a very large simulation size is generally required for an accurate estimate of the
true probability.
Similarly, for the bumpandrevalue method, the chosen simulation sizes are too small for the chosen perturbation
size. Consequently, the gamma estimates become more sensitive to the Mont Carlo noises in prices.
To circumvent the problems above, one may either increase the simulation size or increase S , M , and h. To this
end, we consider two alternatives: (1) increasing the simulation size to 500K, and (2) increasing S , M , 500, and h to
500. The results are shown in Fig. 12 Fig. 19. It is clear that both alternatives lead to some degree of reduction in
the irregular noises present in the equity gammas. With an increased simulation size of 500K and S = M = h = 100,
however, the equity gammas remain rather unstable, particularly when using the bumpandrevalue approach. In
contrast, the equity gammas become much smoother when S , M , and h are increased from 100 to 500 (even with a
simulation size of 100K). As one may expect, with a larger S , M , or h, the equity gammas, though smoother, may
consist of a significant bias. To see whether this is case, we display in Fig. 20 and Fig. 21 the equity gammas under
two cases: (1) S = M = 100 (resp. h = 100), and (2) S = M = 500 (resp. h = 500), where a simulation size of
100 millions is used to ensure an accurate assessment. The figures show that increasing S and M from 100 to 500
does not lead to any significant bias in the equity gammas under our test settings.
5.2.4

Impacts of Implied Volatility Skews

In Table 2, we compare the prices of Trade 1 and Trade 2 under two models: (1) the hybrid Black model, and (2)
the proposed model. The hybrid Black model is obtained from the proposed model simply by setting the equity
14

skew parameters to 1 while the volatility parameters are chosen to reproduce the market ATM implied volatilities.
The results clearly indicate that the prices of the two trades are extremely sensitive to implied volatility skews. In
particular, taking into account the implied volatility skews, the prices of the two trades are adjusted down by 21.28%
and 40.60%, respectively.
Table 2: Impacts of implied volatility skews.
Model
hybrid Black model
proposed model
relative di.

structured leg
0.04877
0.05624
15.30%

Trade 1
funding leg
0.18366
0.16241
-11.57%

net
0.13488
0.10617
-21.28%

structured leg
0.04081
0.04249
4.11%

Trade 2
funding leg
0.09872
0.07689
-22.12%

net
0.05791
0.03440
-40.60%

* The tests utilize the exact simulation scheme with a simulation size of 100K.

5.2.5

Impacts of Stochastic Interest Rates

In Fig. 4 and Fig. 5, we plot the values of Trade 1 and Trade 2 as a function of the equity and interest rate
correlation parameter . For comparison, we also display the values of the trades under deterministic interest rates
where we simply set the HW1F volatility to zero and calibrate the model accordingly. It is clear that the impacts of
the correlation on the funding leg are much more significant than those on the structured leg. For both trades, the
funding leg value and also the trade value are decreasing in the correlation while the structured leg values are slightly
increasing in the correlation. These observations are consistent with those shown in Overhaus (2007).
5.2.6

Comparison to the Existing Model

Fig. 22 and Fig. 23 depict the calibrated skew and volatility parameters under the proposed model and the existing
1
hybrid model based on the dynamics (15), respectively. Notice that the calibrated volatility parameters {i }N
i=0
coincide under the two models, which is evident from the calibration procedure described in Section 3 On the other
hand, the skew parameters under the proposed model appear to be lower than those under the existing model.
As a further comparison, we show in Fig. 24 Fig. 35 the coupon values, equity deltas, and equity gammas of
the two test trades obtained under the two models. Since only discretization based simulation schemes can be applied
under the existing model, the tests utilize a PC simulation scheme under the existing model and the exact simulation
scheme under the proposed model. The simulation size is fixed to 100K under both models while a step size of 0.01
is used under the existing model. Our numerical experience suggests that these settings tend to give reliable pricing
results under typical market conditions and contract parameters. On the other hand, the equity deltas and gammas
are calculated using a pathwise method. From the figures, it is clear that both models lead to similar prices, deltas,
and gammas. Hence, computational eciency in pricing is a natural criterion for choosing between the existing model
and the proposed model.
To this end, we report in Table 3 the computational times taken for the pricing of Trade 2 under the two models.
The simulation size and step size are chosen for a benchmark comparison. As shown in the table, the proposed model,
owing to the existence of an exact Monte Carlo pricing scheme, is much more ecient than the existing model in
pricing. In particular, it requires less than 4 seconds for calculating price only (about 30 times faster than the existing
model) and less than 5 seconds when including equity deltas and gammas (about 20 times faster than the existing
model). To achieve a comparable performance, for example, one would have to decrease the simulation size to near
20K and increase the step size to 0.05 under the existing model. From our previous test results, such settings are
not reliable in general under the existing model. In addition, as is evident from our previous discussion, the proposed
model is also more robust than the existing model since it avoids the ambiguity in choosing a step size. The overall
results suggest that the proposed model is superior to the existing model from the viewpoints of both computational
eciency and robustness in pricing.

Conclusion

This article proposes a parsimonious pricing model for CTSs which can capture the eects of implied volatility skews
and stochastic interest rates simultaneously. A fast and accurate calibration procedure along the lines of Piterbarg
(2005) is presented. The proposed model is shown to be an improvement of an existing hybrid model that is often
used by market practitioners for the pricing of CTSs. In particular, it leads to an explicit equity price expression and
15

Table 3: Computational time for Trade 2 (in seconds).

computational time*
price only
price, equity deltas, and equity gammas

proposed model**
3.25
4.75

existing model***
97.68
102

* The tests are run on a 3.16GHz Duo CPU with 3.50 GB RAM.
** The exact simulation scheme is used with a simulation size of 100K.
*** The PC simulation scheme is used with a simulation size of 100K and a step size of 0.01.

consequently an exact Monte Carlo pricing scheme. Numerical results indicate that the exact simulation scheme is
more ecient and robust than discretization based simulation schemes. We also confirm that the eects of implied
volatility skews and stochastic interest rates can be very significant and cannot be neglected in the pricing of CTSs.
A further comparison between the proposed model and the existing model reveals that both models lead to similar
prices, equity deltas, and equity gammas for CTSs. However, with the exact simulation scheme, the proposed model
is shown to be a more appealing alternative to the existing model due to its superior computational eciency and
robustiness in pricing.

16

References
[1] Brigo D. and Mercurio F., Interest Rate Models: Theory and Practice, 2nd ed., Springer, 2001.
[2] Broadie M. and Glasserman P., Estimating Security Price Derivatives Using Simulation, Management Science,
1996, V42:2.
[3] Glasserman P., Monte Carlo Methods in Financial Engineering, 1st ed., Springer, 2003.
[4] Gurrieri S., Nakabayashi M., and Wong T., Calibration of the HullWhite Short Rate Model, working paper, 2009.
[5] Hagan P., Evaluating and Hedging Exotic Swap Instruments via LGM, Bloomberg Technical Report..
[6] Jeckel P., Monte Carlo Methods in Finance, 1st ed., John Wiley & Sons, 2001.
[7] Longsta A. and Schwartz S., Valuing American Options by Simulation, Review of Financial Studies, 2001, V14:
113148.
[8] Marris D., Financial Option Pricing and Skewed Volatility, MPhil Thesis, University of Cambridge, 1999.
[9] Muck M., On the Similarity between Displaced Diusion and Constant Elasticity of Variance Market Models of
the Term Structure, WHU, 2005.
[10] Overhaus M., Bermudez A, Buehler H., Ferraris A., Jordinson C., and Lamnouar A., Equity Hybrid Derivatives,
John Wiley & Sons, 2007.
[11] Piterbarg V., A MultiCurrency Model with FX volatility skew, SSRN Working Paper, 2005.
[12] Rebonato R., Volatility and Correlation: The Perfect Hedger and the Fox, 2nd ed., John Wiley & Sons, 2004.
[13] Svoboda-Greenwood S., The Displaced Diusion as an Approximation of the CEV, Appl. Math. Finance, 2009,
V66: 269286.
[14] Wong T., An Analytical Hybrid Equity and Interest Rate Model, SSRN working paper, 2009.

17

APPENDIX
A

Tables and Figures

Figure 1: JPY zero rates.

18

Figure 2: Calibrated model volatilities.

Figure 3: Calibrated model skews.

19

Table 4: Market implied volatilities of equity options at some selected moneyness (quoted as % of forward prices) and
maturities.
Maturity/Moneyness
6M
1Y
2Y
3Y
4Y
5Y
6Y
7Y
8Y
9Y
10Y
15Y
20Y
30Y

0.4
39.00%
38.15%
37.14%
35.58%
34.28%
33.30%
32.54%
32.03%
31.66%
31.41%
31.27%
31.69%
32.24%
32.68%

0.6
35.90%
33.39%
31.28%
29.98%
29.20%
28.72%
28.43%
28.31%
28.27%
28.30%
28.40%
29.42%
30.31%
31.13%

0.8
26.99%
26.11%
25.51%
25.24%
25.19%
25.26%
25.41%
25.63%
25.86%
26.12%
26.40%
27.84%
28.96%
30.05%

1.0 (ATM)
20.26%
20.55%
21.13%
21.68%
22.21%
22.72%
23.21%
23.67%
24.12%
24.54%
24.95%
26.69%
27.96%
29.24%

1.2
16.98%
17.05%
18.05%
19.09%
20.02%
20.84%
21.57%
22.22%
22.82%
23.37%
23.87%
25.81%
27.20%
28.61%

1.4
15.84%
14.91%
15.84%
17.15%
18.35%
19.40%
20.31%
21.10%
21.81%
22.46%
23.03%
25.12%
26.59%
28.11%

1.6
15.88%
13.61%
14.20%
15.65%
17.05%
18.26%
19.32%
20.21%
21.01%
21.73%
22.36%
24.56%
26.10%
27.69%

Table 5: Calibration errors in implied volatilities: model vs market, number of simulations = 1 million.
Maturity/Moneyness
6M
1Y
2Y
3Y
4Y
5Y
6Y
7Y
8Y
9Y
10Y
15Y
20Y
30Y

0.4
3.39%
0.55%
0.65%
0.78%
0.84%
0.85%
0.86%
0.87%
0.87%
0.86%
0.86%
0.94%
1.09%
1.51%

0.6
-3.51%
-3.07%
-1.26%
-0.58%
-0.29%
-0.12%
-0.02%
0.05%
0.11%
0.16%
0.21%
0.36%
0.52%
0.90%

0.8
-1.45%
-1.40%
-0.62%
-0.33%
-0.21%
-0.12%
-0.06%
-0.01%
0.04%
0.09%
0.13%
0.27%
0.42%
0.75%

1.0 (ATM)
0.00%
-0.01%
-0.01%
-0.01%
0.00%
0.02%
0.05%
0.08%
0.11%
0.15%
0.18%
0.30%
0.44%
0.74%

1.2
-1.13%
0.19%
0.11%
0.09%
0.10%
0.12%
0.14%
0.17%
0.19%
0.22%
0.24%
0.37%
0.50%
0.77%

1.4
-3.93%
-0.40%
-0.10%
0.06%
0.13%
0.17%
0.21%
0.24%
0.26%
0.28%
0.30%
0.43%
0.56%
0.82%

1.6
-7.91%
-1.37%
-0.50%
-0.06%
0.12%
0.20%
0.25%
0.29%
0.31%
0.33%
0.35%
0.49%
0.62%
0.87%

Table 6: Dierences in implied volatilities: model vs fitted DD1F, number of simulations = 1 million.
Maturity/Moneyness
6M
1Y
2Y
3Y
4Y
5Y
6Y
7Y
8Y
9Y
10Y
15Y
20Y
30Y

0.4
0.06%
0.25%
0.12%
0.19%
0.25%
0.30%
0.33%
0.35%
0.38%
0.40%
0.41%
0.47%
0.61%
1.07%

0.6
0.01%
0.09%
0.04%
0.06%
0.09%
0.12%
0.15%
0.18%
0.21%
0.24%
0.28%
0.40%
0.55%
0.92%

0.8
0.00%
0.01%
0.00%
0.00%
0.02%
0.04%
0.07%
0.11%
0.14%
0.18%
0.21%
0.35%
0.49%
0.82%

20

1.0 (ATM)
0.00%
-0.01%
-0.01%
-0.01%
0.00%
0.02%
0.05%
0.08%
0.11%
0.15%
0.18%
0.30%
0.44%
0.74%

1.2
0.00%
0.02%
0.00%
0.00%
0.02%
0.03%
0.05%
0.08%
0.10%
0.13%
0.16%
0.27%
0.40%
0.67%

1.4
0.05%
0.11%
0.05%
0.05%
0.06%
0.06%
0.07%
0.09%
0.10%
0.12%
0.14%
0.24%
0.35%
0.61%

1.6
0.20%
0.33%
0.12%
0.13%
0.11%
0.10%
0.10%
0.10%
0.11%
0.12%
0.13%
0.21%
0.31%
0.56%

21

num. of simulation
10
20
30
50
100
200
500
1000

num. of simulation
10
20
30
50
100
200
500

num. of simulation
10
20
30
50
100
200
500

step = 0.5
1.77%
1.91%
2.21%
1.36%
1.58%
1.49%
1.42%

Euler scheme
step = 0.1
step = 0.05
0.56%
0.26%
1.22%
1.12%
1.15%
0.87%
0.44%
0.19%
0.76%
0.53%
0.58%
0.33%
0.34%
0.19%
step = 0.01
-0.11%
0.39%
0.29%
-0.14%
0.29%
0.16%
0.00%

step = 0.5
2.82%
2.86%
2.95%
2.22%
2.40%
2.31%
2.23%

Milstein scheme
step = 0.1
step = 0.05
0.94%
0.25%
1.55%
1.28%
1.32%
1.05%
0.83%
0.34%
1.06%
0.63%
0.83%
0.51%
0.59%
0.30%
step = 0.01
-0.03%
0.44%
0.31%
-0.13%
0.28%
0.15%
0.02%

step = 0.5
0.96%
1.00%
0.98%
0.28%
0.41%
0.31%
0.21%

PC scheme
step = 0.1
step = 0.05
0.42%
0.06%
1.09%
1.07%
0.88%
0.85%
0.36%
0.16%
0.65%
0.46%
0.41%
0.32%
0.18%
0.11%

Exact
0.34
0.67
1.02
1.67
3.42
6.64
16.64
33.53

Exact
-4.16%
-2.52%
-1.60%
-2.17%
-0.65%
-0.27%
0.14%

step = 0.5
0.27
0.52
0.77
1.28
2.53
5.08
12.70
25.36

step = 0.5
6.13%
9.69%
9.30%
6.77%
7.03%
7.20%
6.72%

step = 0.01
-2.26%
2.41%
2.07%
0.20%
0.68%
0.66%
0.29%

step = 0.5
1.07%
5.58%
4.65%
3.13%
4.22%
4.41%
3.95%

Milstein scheme
step = 0.1
step = 0.05
-0.35%
-3.46%
4.03%
2.96%
3.30%
2.24%
1.52%
0.69%
1.80%
1.75%
1.73%
1.31%
0.92%
0.36%
step = 0.01
-2.48%
2.40%
2.21%
0.27%
0.94%
0.85%
0.37%

step = 0.01
9.98
20.12
29.89
49.22
100.03
197.06
503.96
985.43

step = 0.5
0.27
0.52
0.78
1.31
2.61
5.27
13.14
26.36

Milstein scheme
step = 0.1
step = 0.05
1.06
2.06
2.13
4.13
3.19
6.20
5.36
10.28
10.67
20.61
21.33
41.16
53.75
103.37
106.64
206.18

step = 0.01
10.58
21.16
31.42
51.11
103.14
204.18
510.07
1029.14

*The tests are run on a 3.16GHz Duo CPU with 3.50 GB RAM.

Euler scheme
step = 0.1
step = 0.05
1.03
2.00
2.06
3.98
3.09
5.98
5.16
9.97
10.30
19.92
20.64
39.89
51.64
101.97
103.47
199.56

Table 9: Computational times for the pricing of Trade 2 (in seconds).

Euler scheme
step = 0.1
step = 0.05
-0.73%
-1.32%
4.30%
4.44%
3.81%
3.36%
2.17%
1.45%
2.47%
2.27%
2.19%
1.88%
1.50%
0.92%

step = 0.5
0.28
0.55
0.83
1.38
2.75
5.50
13.70
27.38

step = 0.5
-2.01%
2.05%
1.16%
-0.34%
0.44%
0.63%
0.24%

PC scheme
step = 0.1
step = 0.05
1.13
2.19
2.27
4.38
3.38
6.56
5.64
10.92
11.33
21.86
22.56
43.64
56.47
109.56
112.97
219.07

PC scheme
step = 0.1
step = 0.05
-1.68%
-3.76%
3.14%
2.72%
2.46%
1.95%
0.78%
0.23%
0.97%
1.34%
0.99%
0.92%
0.23%
-0.01%

Table 8: Relative price errors of Trade 2: true price = 0.034626 (based on the exact scheme with 10 million simulations).

Exact
0.41%
0.09%
0.30%
-0.50%
-0.18%
-0.25%
-0.17%

Table 7: Relative price errors of Trade 1: true price = 0.106358 (based on the exact scheme with 10 million simulations).

step = 0.01
10.84
22.06
33.12
54.62
108.09
211.95
547.20
1061.29

step = 0.01
-2.52%
2.30%
2.13%
0.21%
0.83%
0.75%
0.29%

step = 0.01
-0.08%
0.39%
0.28%
-0.16%
0.25%
0.12%
-0.02%

Figure 4: Values of Trade 1 as a function of the model correlation. (DIR refers to deterministic interest rate.)

Figure 5: Values of Trade 2 as a function of the model correlation. (DIR refers to deterministic interest rate.)

22

Figure 6: Equity deltas of Trade 2.

Figure 7: Equity deltas of Trade 2.

23

Figure 8: Equity deltas of Trade 2.

Figure 9: Equity deltas of Trade 2.

24

Figure 10: Equity gammas of Trade 2.

Figure 11: Equity gammas of Trade 2.

25

Figure 12: Equity gammas of Trade 2.

Figure 13: Equity gammas of Trade 2.

26

Figure 14: Equity gammas of Trade 2.

Figure 15: Equity gammas of Trade 2.

27

Figure 16: Equity gammas of Trade 2.

Figure 17: Equity gammas of Trade 2.

28

Figure 18: Equity gammas of Trade 2.

Figure 19: Equity gammas of Trade 2.

29

Figure 20: Equity gammas of Trade 2.

Figure 21: Equity gammas of Trade 2.

30

Figure 22: Calibrated skew parameters under the proposed model and the existing model.

Figure 23: Calibrated volatility parameters under the proposed model and the existing model.

31

Figure 24: Structured leg coupon values of Trade 1: existing model vs proposed model.

Figure 25: Funding leg coupon values of Trade 1: existing model vs proposed model.

32

Figure 26: Equity deltas of funding leg coupons of Trade 1: existing model vs proposed model.

Figure 27: Equity deltas of funding leg coupons of Trade 1: existing model vs proposed model.

33

Figure 28: Equity gammas of structured leg coupons of Trade 1: existing model vs proposed model.

Figure 29: Equity gammas of structured leg coupons of Trade 1: existing model vs proposed model.

34

Figure 30: Structured leg coupon values of Trade 2: existing model vs proposed model.

Figure 31: Funding leg coupon values of Trade 2: existing model vs proposed model.

35

Figure 32: Equity deltas of funding leg coupons of Trade 2: existing model vs proposed model.

Figure 33: Equity deltas of funding leg coupons of Trade 2: existing model vs proposed model.

36

Figure 34: Equity gammas of structured leg coupons of Trade 2: existing model vs proposed model.

Figure 35: Equity gammas of structured leg coupons of Trade 2: existing model vs proposed model.

37