Fixed Income and Credit Risk

Prof. Michael Rockinger

D - 3 - Libor Market Model:

Caps and Floors

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Interest rate forwards under forward risk-neutral measure
Consider now a forward contract on the n−times compounded LIBOR rate
rn (Ti , Ti+1 ). The contract pays at Ti+1

XTi+1 = N∆ (rn (Ti , Ti+1 ) − fn (t, Ti , Ti+1 )) ,

where fn (t, Ti , Ti+1 ) is the delivery rate, i.e., Ti+1 − Ti ≡ ∆−maturity forward LIBOR
rate at Ti agreed upon at inception t, and N is the notional amount.
As before, forward risk-neutral pricing implies that
T∗
fn (t, Ti , Ti+1 ) = Et i+1 [rn (Ti , Ti+1 )] .

Recall that rn (Ti , Ti+1 ) = fn (Ti , Ti , Ti+1 ): the forward rate with immediate start is
simply a spot rate. Therefore,
T∗ 
fn (t, Ti , Ti+1 ) = Et i+1 fn (Ti , Ti , Ti+1 ) .

(1)

The forward rate fn (t, Ti , Ti+1 ) is a martingale under a Ti+1 −forward measure.

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Dynamic of forward LIBOR rate

In what follows, we simplify our notations a bit:

ft,i ≡ fn (t, Ti , Ti+1 ),

keeping in mind that the forward LIBOR rate ft,i applies to the period from Ti
to Ti+1 and has some compounding frequency n unless specified explicitly.

Since ft,i is a martingale under the Ti+1 −forward measure, it must have a
driftless dynamic. In the world where rates were supposed to be positive (not
anymore!), the natural candidate for such dynamic was a GBM without drift:

dft,i ∗
= σi dW Ti+1 , (2)
ft,i

where σi is the volatility of the forward rate, which we will assume to be

constant over [t; Ti ].

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Distribution of forward LIBOR rate

The dynamic (2) implies that

√
rn (Ti , Ti+1 ) = f (Ti , Ti , Ti+1 ) ∼ eln ft,i − 2 σi (Ti −t)+σi
1 2
Ti −t·
,

where  ∼ N(0, 1).

In other words, rn (Ti , Ti+1 ) has a log-Normal distribution

 
rn (Ti , Ti+1 ) ∼ ln N m, s2 ,

where
1
m = ln ft,i − σ2i (Ti − t),
2
s = σi Ti − t.
p

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Price of caplet

Consider a caplet with maturity Ti+1 that pays at maturity

XTi+1 = N∆ (rn (Ti , Ti+1 ) − k)+ .

Apply Ti+1 −forward pricing technique to obtain the price of caplet:

T∗ 
Vt = N∆ · Z(t, Ti+1 ) · Et i+1 (rn (Ti , Ti+1 ) − k)1rn (Ti ,Ti+1 )≥k =

 ∗ 
T T∗
= N∆ · Z(t, Ti+1 ) · Et i+1 [Y · 1Y≥k ] − kPt i+1 [Y ≥ k]

 
where Y ≡ rn (Ti , Ti+1 ) ∼ ln N m, s2

Computation of the expectations are like in BS model

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Black formula for Caplet price

By computing Ti+1 −forward expectation and probability, you get an explicit

formula for the price of the caplet (assuming that Z(t, Ti+1 ) is observed):

Vt = N∆ · Z(t, Ti+1 ) · ft,i Φ(d1 ) − k Φ(d2 )

ft,i σ2
ln + 2i (Ti − t)
d1 = √
k
σi Ti − t
d2 = d1 − σi Ti − t
p

Φ(·) is the CDF of the standard Normal distribution.

This is a version of Black’s formula in the case of interest rates.

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Forward volatility in the Black formula
In the Black formula, some parameters are observed as market prices of
traded instruments: Z(t, Ti+1 ), ft,i ; some are specified by the option contract:
k, Ti , Ti+1 ;
Forward rate volatility σfwd (Ti+1 ) ≡ σi is not readily available
Thus, you can view Black’s formula as something that links forward
volatilities and caplet prices:

Pcaplet (Ti+1 ) = P(Ti+1 ; σfwd (Ti+1 )) =

h      i
= N∆ · Z(t, Ti+1 ) · ft,i Φ d1 σfwd (Ti+1 ) − kΦ d2 σfwd (Ti+1 ) .

Note an obvious analogy with implied vols in the Black-Scholes formula:

they are essentially used to quote European stock options prices.

In practice: individual caplets are rarely traded. Caps, i.e., baskets of

caplets with the same exercise rate (strike) but different maturities, are
traded much more actively. One can bootstrap a volatility curve from Caps

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Bootstrapping forward vols: Flat and forward volatilities
Consider a 1-year quarterly cap, i.e., a collection of 3 caplets with maturities 0.5,
0.75, and 1. It has the value of

Pcap (1) = Pcaplet (0.5) + Pcaplet (0.75) + Pcaplet (1).

If you plug the same volatility in Black’s formula to price each of these
caplets, such volatility is called 1-year flat volatility σflat (1):
 
Pcap (1) = Pcaplet 0.5; σflat (1) +
   
+Pcaplet 0.75; σflat (1) + Pcaplet 1.0; σflat (1) .
The market convention is to quote cap prices in flat volatility.
Note the difference with the forward volatility:
 
Pcap (1) = Pcaplet 0.5; σfwd (0.5) +
   
+Pcaplet 0.75; σfwd (0.75) + Pcaplet 1.0; σfwd (1) .

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Flat and forward volatilities: illustration

You need to know one of the three: cap prices, flat volatilities, or forward
volatilities, to bootstrap the other two objects.
Since there’re many maturities with different flat and forward volatilities
attached, we essentially talk about the term structure of flat and forward
volatilities.
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Term structure of flat and forward volatilities: example

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