Alternative swaption valuation methods

By

Bram van den Hoek - 66.41.58

A thesis submitted in partial fulfillment of the requirements for the degree of

Master in Science in Quantitative Finance and Actuarial Science

Faculty of Economics and Business Administration

Tilburg University

Supervised by:

Prof. Dr. J.M. Schumacher (Tilburg University)

I. Langeraert (Ilfa)

Date:
5/4/2012
Abstract

The subject of this thesis is the pricing of European plain-vanilla interest rate swaptions. The Black-76
model is considered as the accepted model to value these products. The Black-76 model can actually be
regarded as a quoting convention since the only unknown factor is the observable implied volatility.
Therefore the model simply inverts implied volatilities to prices, nevertheless it will be referred to as a
model. Unfortunately the model cannot always be applied. The Black-76 model depends on quoted
implied volatilities. However, not for every possible swaption an implied volatility is quoted. This thesis
focuses on the valuation of non-quoted swaptions. For this purpose use is made of three stochastic
interest rate models; the Vasicek, the Hull and White one-factor and the G2++ model. Before these
models are applied the relevant background is covered thoroughly. Furthermore use is made of a
change of numéraire technique. The calculations can be simplified when performed with a particular
zero-coupon bond as numéraire.
An empirical survey confirmed that the Vasicek model cannot be used to price swaptions. Since
the model is unable to fit the observed yield curve it is useless to price swaptions with this model.
Although the Hull and White one-factor model is not capable of reproducing a large volatility surface or
a volatility curve satisfactorily it is shown that the model can still be useful when pricing non-quoted
swaptions. To overcome the discussion about calibration instruments and minimization objectives a
limited number of obvious calibrations has been performed. Next, shocks in the average of these
parameters are considered resulting in price bounds. The results of the G2++ model are satisfactory.
This model can easily be used to price non-quoted swaptions. Finally, it has been shown that there are
cases in which it makes little difference whether one prices non-quoted swaptions by means of the G2++
model or makes use of a much easier technique. Namely, use linear interpolation to obtain the required
non-observable volatilities and invert these into prices by means of the Black-76 model.

II
Contents

Abstract .................................................................................................................................................. II
Contents ................................................................................................................................................ III
1. Introduction..................................................................................................................................... 1
2. Swaptions ........................................................................................................................................ 4
2.1 Preliminaries .............................................................................................................................. 4
2.1 Swaptions ................................................................................................................................... 9

3. Swaption valuation with the Black-76 model .............................................................................. 12

3.1 Black Scholes option pricing model ......................................................................................... 12

3.2 Risk-neutral valuation .............................................................................................................. 15
3.3 Black-76 model for swaptions.................................................................................................. 18
3.4 Construction of the yield curve................................................................................................ 19
4. Short-term interest rate models ................................................................................................... 21

4.1 Vasicek model .......................................................................................................................... 23

4.2 Hull and White one-factor model ............................................................................................ 25
4.3 G2++ model .............................................................................................................................. 26
5. Data................................................................................................................................................ 29
6. Swaption valuation ....................................................................................................................... 33

6.1 At-the-money strike rates ........................................................................................................ 34

6.2 The Black-76 model.................................................................................................................. 35
6.3 Short-term interest rate models: the choice of a convenient numéraire ............................... 35
6.3.1 The Vasicek model ........................................................................................................ 37
6.3.2 The Hull and White one-factor model .......................................................................... 37
6.3.3 The G2++ model ............................................................................................................ 38
6.4 Calibration ................................................................................................................................ 38
7. Results ........................................................................................................................................... 40

7.1 The Vasicek model ................................................................................................................... 41

7.1.1 Calibration of the swaption volatility surface ............................................................... 41
7.1.2 Calibration of the initial yield curve .............................................................................. 42

III
 7.2 The Hull and White one-factor model ..................................................................................... 45
7.2.1 Calibration of the swaption volatility surface ............................................................... 45
7.2.1 The minimization objective........................................................................................... 47
7.3 The G2++ model ....................................................................................................................... 50
7.4 A practical application: valuing non-quoted swaptions........................................................... 54
8. Conclusions and recommendations.............................................................................................. 63

References............................................................................................................................................ 67
Appendix A – Deriving the forward curve........................................................................................... 68

Appendix B – Explicit solutions for stochastic differential equations ............................................... 70

Appendix C – Interest rates ................................................................................................................. 71

Appendix D – Implied volatilities ........................................................................................................ 72

Appendix E – At-the-money strike rates ............................................................................................. 74

Appendix F – Swaption prices according to the Black-76 model ....................................................... 76

Appendix G – Change of numéraire .................................................................................................... 78

Appendix H – Results of the Vasicek model ....................................................................................... 85

Appendix I – Swaption prices according to the Hull and White one-factor model ........................... 88

IV
 1. Introduction

This thesis is concerned with the pricing of swaptions. Swaptions are financial derivatives that can cover
interest rate risk or serve other purposes. The underlying reason of the swaption is not of interest in this
thesis. For various reasons financial products like swaptions have to be valued. Different valuation
techniques can be used for this purpose. The most common model to value swaptions is the Black-76
model. This model is popular because of its simplicity. The model actually has only one unknown
parameter namely the volatility. Since swaptions are classified amongst the most complex products in
the field of interest rate coverage one will immediately start to question the validity of a model with
only one unknown parameter. As stated, the value of a swaption considered by the Black-76 model
depends on the volatility. Hence the performance of the model depends on the reliability of this
volatility parameter. One should note that swaptions with different maturities have different volatilities.
If there is a liquid market on which a particular swaption is heavily traded then the swaption volatility
that is quoted in the market seems reliable and the Black-76 model can be implemented. But what if this
is not the case? How to deal with situations in which no reliable volatility can be observed from the
markets.

The performance of the Black-76 model depends on the reliability of the implemented volatility. If the
required volatility is unknown or one has to rely on a quoted volatility from an illiquid market the Black-
76 model should not be implemented1. Of course, most swaptions that are bought are straightforward
in the sense that their maturities coincide with the swaptions that are actively traded. Hence these
swaptions can be valued according to the Black-76 model. The question remains how to value swaptions
for which no quoted swaption volatility is available. The answer is stochastic interest rate models. Many
one-factor, two-factor and multiple factor interest rate models are at hand to value swaptions. It should
be noted that these models can also be used to value other interest rate products like caps, swaps and
captions. The purpose of this thesis is to compare swaption valuation under the relatively easily
implementable Black-76 model with stochastic interest rate models that are able to generate term
structures. The interest rate models that will be considered are the Vasicek, the Hull and White one-
factor and the G2++ model. The G2++ model is proposed by Brigo and Mercurio; they show that their
model is equivalent to the well-known Hull and White two-factor model.

The choice for these models can be motivated as follows. The Vasicek model is regarded as the pioneer
model in the field of stochastic interest rate models. Hence this model is important for historical
reasons. More important is the simplicity of this model. Through its simplicity it is easier to understand
the modeling of the term structure and the valuation of swaptions. Furthermore it eases the
introduction of more complex models. The Hull and White one-factor model is an extension of the
Vasicek model. The difference with the Vasicek model is that in case of the Hull and White one-factor

1
This thesis is not concerned with the discussion of observed volatilities. There will not be a discussion of reliability
of quoted swaption volatilities. For simplicity it is assumed that the quoted swaption volatilities that are available
in Thomson Reuters are liquid.

1
model the drift term is time-dependent. Therefore the Vasicek model belongs to the equilibrium models
whereas the Hull and White one-factor model is a so called no-arbitrage model. More on this in Section
4. Besides the Hull and White one-factor model many more interesting one-factor models are present.
However one should always be cautious when considering more complex models. A complex model
could lead to over fit. Note that the purpose of the models is the pricing of swaptions with illiquid
quotes or swaptions that are not quoted at all. Therefore the models should be interpretable; more
parameters do not seem to contribute. This shifts the focus to multiple-factor models. As we will see
later on, the G2++ model or any other multi-factor model does not imply perfect correlation between
interest rates. Hence these models are capable of reproducing more realistic correlation patterns and
are interesting extensions of the one state variable models. Since the G2++ model is the only considered
model that does not imply perfect correlation between interest rates this is the most promising model.
There has been chosen for the G2++ model as the considered multiple-factor model since it is Gaussian
and analytically tractable as far as European swaptions are considered.

Swaptions are products that are widely available in the market, in that sense they are close to the
market, hence the influence of the model used for valuation will be limited. As a consequence it is
expected, up front, that the impact of the model choice will be limited. This explains the fact that in
practice one opts for the easily implementable Black-76 model. Of course, in addition to the considered
models a variety of other models are present. Many of these models are more complicated and hence
more promising. This thesis attempts to take a first step in the direction of modeling European
swaptions with stochastic interest rate models. One should realize that the valuation of American and
Bermudan swaptions with such models is more interesting but therefore also more challenging. If one is
able to value European swaptions with the stochastic interest rate models presented in this thesis one
should understand the essence of valuing American and Bermudan swaptions and also other interest
rate products.

The rest of this thesis is set up as follows. Section 2 is devoted to the introduction of swaptions. This
section will introduce all the necessary notation that is needed to value swaptions and construct
discount and forward curves. Furthermore, at-the-money strike rates will be introduced and different
formulations for the value of a swaption will be presented. Finally a subsection is dedicated to practical
applications of swaptions.
Section 3 introduces the Black-76 model and describes how this model can be used to value
swaptions. Since the Black-76 model is closely related to the Black and Scholes model a first subsection
introduces the latter model. Section 3.1 also introduces the relevant notation, this includes amongst
others Brownian motions, numéraires and stochastic differential equations. An important feature in the
pricing of financial derivatives is risk-neutral valuation; this topic will be covered thoroughly in Section
3.2. Then Section 3.3 presents the Black-76 model for swaptions. Section 3 will be concluded with a
section that introduces the concept of constructing a yield curve. This procedure can be carried out in
different ways. A detailed description of the construction of the forward curve that has been used
throughout this thesis is presented in Appendix A.
Section 4 will elaborate on the stochastic interest rate models, more specifically short-term interest
rate models will be introduced. It will be shown that it is convenient to model the short rate. More

2
specifically it will be shown that by modeling the short rate it is possible to describe the entire yield
curve. Thereafter the Vasicek and the Hull and White one-factor model will be introduced in Section 4.1
and 4.2 respectively. Also the connection between these models will be discussed. In these sections we
will also look at equilibrium and no-arbitrage models. Additionally the G2++ model will be introduced in
Section 4.3. Moreover the importance of a multi-factor model will be stressed.
Section 5 discusses the data. Two datasets are used, 1 July 2008 and 1 July 2011. These dates are
motivated as follows. Two dates allow the opportunity to investigate whether results are time
consistent. More specifically the first date is before the financial crisis that emerged in 2008 whereas the
second date is well after. Also the shape of the yield curve changed during this period, this allows us to
investigate the consequences of different yield curves. With completing the description of the data all
relevant facets for pricing swaptions have been introduced. Although the theory has been discussed no
explicit method to value swaptions has been stated so far.
Section 6 will describe in detail how to value swaptions by means of the introduced theory. First of
all Section 6.1 discusses the at-the-money strike rates. Since no contracts are available the fixed interest
rates that apply to the swaptions are replaced by the at-the-money strike rates. Then Section 6.2
discusses the Black-76 model. This model is straightforward and easy to implement, hence it will only be
discussed briefly. More attention will be paid to the short-term interest rate models. Before such
models can be used to value swaptions or any other interest rate product these models have to be
calibrated to market data. Furthermore it turns out that by using another numéraire the calculations can
be simplified. In more detail, Section 4 introduced the models with the money-market account as
numéraire however calculations will be performed with a particular zero-coupon bond as numéraire.
This change of numéraire will be discussed in detail in Section 6.3. How to calibrate a stochastic interest
rate model will be discussed in Section 6.4. By now all relevant preliminaries are completed and results
can be generated.
The results will be presented in Section 7. This section consists of four subsections. The first three
subsections investigate the capabilities and limitations of the three considered short rate models. In
Section 7.1 the Vasicek model will be considered. We will investigate whether the model is able to
reproduce the initial yield curve and volatility surface. Both the initial yield curve and the volatility
surface consist of many points. Since the model only has three parameters it is not expected that the
model will give a proper fit. Furthermore the consequences of calibrating ( ) will be considered. Then,
the subject of Section 7.2 is the Hull and White one-factor model. This is a so called no-arbitrage model
and fits the initial yield curve by definition. Hence the expectations are more promising. This section will
also discuss the considered minimization objective. Since stochastic interest rate models have to be
calibrated a minimization problem has to be solved. For this purpose an objective has to be chosen.
Thereafter Section 7.3 will discuss the G2++ model. This Gaussian two-factor model is theoretically the
most promising of the considered models. Finally Section 7.4 is concerned with the pricing of non-
quoted swaptions. More specifically, this section considers the pricing of swaptions with a time to
expiration of ten years and a tenor of ten up to fifteen years. Additionally, the results of the G2++ model
are compared with the Black-76 model in case of non-quoted swaptions. To make a comparison with the
G2++ model non-observable implied volatilities are obtained through linear interpolation subsequently
the obtained volatilities are inverted to prices by the Black-76 model. Conclusions and recommendations
are presented in Section 8.

3
 2. Swaptions

This chapter will describe swaptions and introduce the necessary notation. The chapter consists of two
parts. The first part is devoted to the underlying mechanics of swaptions whereas the second part
introduces swaptions and gives examples of practical applications.

2.1 Preliminaries
For years swaptions have been very popular products in the financial world. The reason for this
popularity will be stressed in the next subsection where amongst others practical applications of
swaptions will be discussed. The purpose of this subsection is to explain the underlying mechanics of
swaptions. Therefore the money-market account, the zero-coupon bond, spot rates and forward rates
will be introduced. Furthermore the swap which is actually the underlying of a swaption will be
discussed. It should be noted that towards the definition of a swaption the design and definitions of
Brigo and Mercurio (2006) are used; more specifically this subsection is inspired by Chapter 1 of their
book. This choice has been made since their writing is clear and easy. As a consequence this simplifies
the formulation and understanding of more difficult problems.

Let us start by defining the money-market account. It will prove that the money-market account can be
used as a numéraire when making use of risk-neutral valuation. Section 3.2 describes risk-neutral
valuation and the role of the money-market account in this manner.

Definition 2.1 - Money-market account.

Assume money is put in a money-market account at time . Define the value of this account, at time
, by ( ).The money-market account should be regarded as a savings account where interest is paid
according to the short-term interest rate. Assume that the process of the short-term interest rate is given
and denote it by ( ), additionally assume that ( ) where is naturally required to be larger
than zero. The process for the money-market can be described by the following differential equation

( ) ( ) ( ) . (2.1)

Solving this differential equation is straightforward; as a consequence one can obtain an explicit
expression for the money-market account

( ) (∫ ( ) ). (2.2)

Formula (2.2) gives an explicit expression for the value of the money-market account at time , given
that the initial value at time is . Additionally it can be noticed that the account grows at the
short-term interest rate ( ). The short-term interest rate, which will be referred to as the short rate, is
interpreted as the instantaneous rate of growth or the rate at which one can borrow money for an
infinitesimally short period of time. Note that ( ) can also be interpreted as the interest rate at which a
party can borrow money for a very short period of time at time .

4
Another important theme that has to be discussed is the zero-coupon bond. The zero-coupon bond
plays an important role in describing the term structure of interest rates. More specifically it turns out
that the term structure of interest rates can be expressed in terms of the zero-coupon bond. This useful
relation is applied in Section 4 which explains how short-term interest rate models can be used to
generate a term structure of interest rates. Another important application of zero-coupon bonds is
discounting. Zero-coupon bonds will be used to discount future cash flows which is an important
concept in valuation. In the next subsection it will be shown that the value of a swaption can be
obtained by discounting its future cash flows with the correct zero-coupon bonds.

Definition 2.2 – Zero-coupon bond and continuously compounded interest rate.

Define a function ( ) that represents the price, at time , of a zero-coupon bond that pays off one
unit of currency at time . ( ) for every and it is assumed that ( ) for all values of t
and . The price of this zero-coupon bond is given by the following equation

( )( )
( ) . (2.3)

Here ( ) is defined to be the continuously-compounded interest rate at time that applies to the
period from to . Rewriting the previous equation yields a direct expression for ( ) in terms of
( )

( ) ( ). (2.4)

Note that from the definition of ( ) it directly follows that the short rate can be expressed as
( ) ( ). The definition of ( ) brings us to the term structure of interest rates. The
term structure of interest rates, often referred to as the yield curve, describes the relation between
interest rates and their time to maturity. Time to maturity is defined as the time difference between
and , this time difference will throughout be denoted in years. Naturally, interest rates for different
horizons will vary. It should be noted that a term structure can be presented in several ways. Examples
of representations are the discount curve, the yield curve and the forward curve. The discount curve
describes the relation between zero-coupon bonds and their time to maturity. The yield curve, which is
the most common representation of the term structure of interest rates, plots ( ) against time. In
other words, it shows graphically the relation between interest rates and their time to maturity.
However, a note should be made here. In practice, the yield curve is not only determined by the
continuously-compounded interest rates as denoted by ( ). When constructing a yield curve a
distinction is made between so called money market rates and capital market rates. In this setting the
money market is meant to represent the market on which short term borrowing and lending takes
place; the considered time to maturities are one year or less. In turn the capital market is a market in
which money is provided for periods longer than a year. Now it is market practice to express rates
corresponding to the money market as simply-compounded interest rates. For a detailed description of
the yield curve and the forward curve the interested reader is referred to Appendix A. Also the forward
curve, which has been briefly mentioned above and will be dealt with more thoroughly in the remainder
of this section, is described in more detail in this appendix. Before continuing with the discussion of

5
forward rates the definition of simply-compounded interest rates and its relation to the zero-coupon
bond is presented.

Definition 2.3 – Simply compounded interest rate.

Define by ( ) the simply-compounded interest rate at time that applies to the period from to .
Again the price of a zero-coupon bond can be expressed in terms of the interest rate, here the simply-
compounded rate ( )

( ) . (2.5)
( )( )

Rewriting equation (2.5) yields a direct expression for ( ) in terms of ( )

( )
( ) ( ) ( )
. (2.6)

It is standard practice to denote the simply-compounded interest rates by since this refers to LIBOR
rates. In this thesis not the LIBOR rates but the EURIBOR rates are used as money market rates, hence
the choice for 2.

The next topic is the introduction of forward rates. Before we move to the introduction of forward rates
first of all the forward-rate-agreement (FRA) is introduced. Herewith the design of Brigo and Mercurio is
followed, this is done to simplify the introduction and understanding of the forward rates. Both forward
rates and FRA’s are defined by three moments of time. As is the case for time differences also time
instants will be measured in years. First of all, the current time should be defined. Additionally the
time to expiration and the time to maturity have to be set, where . A FRA is an over-
the-counter contract in which two parties agree to make payments at the maturity time . The holder
of a FRA has to make an interest payment that is based on a fixed rate . In return the holder receives a
floating interest payment that is based on the spot interest rate. The spot rate is usually set two
business days prior to and has maturity , hence it can also be written as ( ). Finally a FRA
contract should specify the principal on which interest is paid and the day-count conventions that apply
to both sides of the contract. For simplicity it assumed that no day-count conventions apply and that the
principal amount, defined by , is equal to one. The holder can use an FRA to hedge against interest rate
exposure. The holder hedges against the risk of rising interest rates, on the other hand the seller is
protected against possibly declining interest rates. It is easily seen that the cash flow at from the
buyer’s perspective is

( ( ) )( ). (2.7)

One is usually interested in the value of the contract at the current time . To obtain the value of the
FRA at time one has to discount the cash flow occurring at back to . This will be done in two steps.

2
The London Interbank Offered Rate (Libor) is the averaged interest rate at which leading banks in London lend
money to other banks. Similarly the Euro Interbank Offered Rate (Euribor) is the averaged interest rate at which
banks in the Eurozone lend money to other banks. A detailed description of these rates can for example be found
on the websites of the European Banking Association and the British Banking Association.

6
First the cash flow that is presented in (2.7) will be discounted to time and the ( ) will be
replaced by expression (2.6). Finally, the herewith obtained expression will be multiplied by ( ) to
obtain the value of the FRA at time . The value of the FRA at is given by

( )( ( ) )( ). (2.8)

By substituting the expression (2.6) for ( ) and multiplying equation (2.8) with ( ) the value
of the FRA at time is obtained and can be expressed by

( ) ( ) ( )( ) . (2.9)

Now that the introduction of a FRA has been completed we can move to the simply-compounded
forward rate and the instantaneous forward interest rate.

Definition 2.4 – Simply-compounded forward interest rate.

The simply-compounded forward interest rate is the simply-compounded interest rate which is set such
that the value of the FRA as defined by equation (2.9) is exactly zero. Hence it can be determined by
solving equation (2.9) to zero for , this yields

( )
( ) ( )
( ( )
). (2.10)

The simply-compounded forward rate at time is thus defined by ( ), here denotes the time
to expiry and denotes the time to maturity, as usual

The limit of the just defined forward interest rate will be referred to as the instantaneous forward
interest rate. The instantaneous forward rate is the interest rate agreed at time at which an
instantaneous loan can be made at .

Definition 2.5 – Instantaneous forward interest rate.

The instantaneous forward interest rate is the forward interest rate for an infinitesimal time period, in
other words the time difference between the time to expiry and the time to maturity is infinitesimal.
Denote the instantaneous forward interest rate as

( )
( ) ( ) . (2.11)

Continuing on the introduction of a FRA we will now move to interest rate swaps. Contrary to a FRA a
swap consists of a series of payments. Again two parties are involved that exchange a fixed and a
floating payment. There are two different types of swap contracts, a swap payer and a swap receiver.
Those contracts are exactly each other’s opposite. The holder of a swap payer pays the fixed leg and
receives the floating leg at every payment date . The payment dates are pre-specified and will be
denoted by . Where denotes the number of annual payments that are made according to
the contract. If the considered swap contract obliges the owners to make annual payments then will
be equal to one for example. The time to maturity of the swap will be denoted by . Hence the final
payment will be made at . The modalities of the contract are set at the contract date, before the
effective date. For simplicity day-count conventions and interest rate conventions are ignored. The fixed

7
interest rate will be denoted by , the principal amount by and the floating interest rate by
( ). The floating interest rate, ( ), that has to be paid at is always set at .
Therefore the floating interest rates are in succession set at . Moreover, this thesis will only
consider swaps in which the length of the floating leg equals the length of the fixed leg. In practice it
often occurs that the fixed leg makes annual payments whereas the floating leg makes semi-annual
payments. Formally the payoff for the holder of a swap payer can be defined as follows

∑ ( )( ( ) ). (2.12)

More often one is interested in the value of the swap, for this purpose the cash flows have to be
discounted. The value of respectively a swap payer and a swap receiver at time are defined as follows

∑ ( ) ( )( ( ) ). (2.13)
∑ ( ) ( )( ( )). (2.14)

From (2.13) it can be observed that the value of a swap payer can be seen as a series of FRA’s. Hence the
value of a swap payer can also be written as follows

∑ ( )( )( ( ) ). (2.15)

Note here that it is assumed that the FRA’s are fairly priced, hence ( ) is replaced by
( ). By substituting the expression for ( ) as given in equation (2.10) and noting that
∑ ( ) ( ) ( ) ( ) since it is a telescope sum it follows that the value of
a swap payer can be written as

( ) ( ) ∑ ( )( ) . (2.16)

Hence the value of a swap receiver can be expressed as

∑ ( )( ) ( ) ( ). (2.17)

With expressions for the value of a swap payer and receiver the definition of the forward swap rate is
straightforward.

Definition 2.6 – Forward swap rate.

Analogous to the simply-compounded forward interest rate, the forward swap rate is the rate that
should be set for the fixed leg such that the value of the swap, either payer or receiver, as defined by
equation (2.16) or (2.17) is exactly zero. Hence it can be determined by solving equation (2.16) or (2.17)
to zero for , this yields

( ) ( )
( ) ( )( )
. (2.18)
∑

The forward swap rate at time is thus defined by ( ), here and denote respectively the
first reset date and the date at which the final payment of the swap will be made, naturally

8
 2.2 Swaptions
With the necessary preliminaries done we can now move to the main topic of this thesis. This subsection
will introduce swaptions. At the end of this section examples of practical applications will be given. A
swaption is an option on a swap. By definition an option gives the owner the right but not the obligation
to enter in the underlying asset. Swaptions give the owner the right to enter in the underlying swap, for
this right a premium is paid up front. There are two types of interest rate swaptions, namely payer
swaptions and receiver swaptions. A payer swaption is referred to as a swaption that gives the owner
the right to enter into a swap where the fixed leg is paid. A receiver swaption gives the owner the right
to enter into a swap where the fixed leg is received. Let us settle some notation now. The swaption
maturity is defined as the future time at which the option expires. The length of the underlying swap will
be denoted by the tenor of the swaption, formally the tenor of the swaption equals . It can
easily be seen that the value of a payer swaption at time equals

( ) ( ) ∑ ( )( ) . (2.19)

A swaption, either payer or receiver, is said to be at-the-money if the value of the swaption is exactly
zero. For a swaption to be at-the-money the fixed rate should be set such that the value equals zero.
In other words solve equation (2.16) or (2.17) to zero for , this yields

( ) ( )
∑ ( )(
.
)
(2.20)

Note that this equals the forward swap rate as defined by equation (2.18).

Before we continue with the discussion of swaptions an alternative expression for the value of a
swaption will be derived. This alternative expression will be used in Section 6 which describes the
valuation of swaptions. Note from equation (2.15) that the value of an annual payer swaption at time
can also be written as

∑ ( ) ( ) . (2.21)

Using this alternative expression consider the value of a payer swaption at time

∑ ( ) ( ) . (2.22)

Equation (2.21) represents the value of a swaption payer at time . To obtain the value of a swaption
payer at time we simply discount the value from to . Note however that ( ) is stochastic
at time ; therefore the value of a swaption at time has to be expressed as an expectation. More
specifically, it will be expressed as the expectation with the money-market account as numéraire. This
concept will be dealt with thoroughly in the subsequent chapters, for now we focus on the mechanics of
swaptions. An alternative expression for the value of a swaption payer at time is given by the following
equation.

∑ ( ) ( ) . (2.23)

9
Finally, by recalling the definition of the simply-compounded forward interest rate (2.10) and the
forward swap rate (2.18) and applying straightforward calculus it can be shown that (2.23) equals

∑ ( ) ( ) . (2.24)

Equation (2.24) will turn out to be useful in Section 6 which describes in detail how swaptions can be
valued using different models. Let us now continue with the discussion of swaptions. More specifically,
this thesis considers European plain-vanilla interest rate payer swaptions. Hence only the value of a
payer swaption has been defined above. As mentioned before, different types of swaptions exist. Next
to European swaptions the best known are American and Bermudan swaptions. These styles indicate
the days on which the option may be exercised. In the case of a European swaption the holder has the
right to exercise the option at the maturity date. In return an American swaption may be exercised at
any business day before the swaption maturity. Moreover a Bermudan option allows the holder to
exercise the swaption at a pre-specified set of business days. Hence a Bermudan option is intermediate
between a European option and an American option. The valuation of American and Bermudan
swaptions is more complicated than the valuation of European swaptions.
Since a swaption is an option it offers the owner more flexibility than a swap, this flexibility comes at
the cost of a premium. Hence both parties also have to agree upon a premium that the owner of the
swaption will have to pay to the counterparty. The height of the premium depends on how deep the
swaption is in-the-money at the time of issuance but also on the volatility of the interest rates. Whether
a swaption is in-the-money or not depends on the agreed fixed rate and the current term structure of
interest rates. A good reference point for the height of a swaption premium is the value of the swaption.
One should realize that banks usually apply margins. As a consequence the premium is likely to be
higher than the current market value of the swaption. If the holder of the swaption chooses not to
exercise the option the maximal loss that can be made is the height of the premium.

There can be various reasons to enter into a swaption contract. Most parties that enter into a swaption
want to cover future interest rate risks. Other possibilities are speculating on increasing or decreasing
future interest rates. Today a wide variety of parties enters into swaptions. For instance corporations,
banks, hedge funds, financial institutions, building corporations but also universities, hospitals and
smaller companies. Many examples of situations in which parties want to eliminate their future interest
rate risks can be given. One can think of almost any party that makes loans or roll-over loans which
oblige them to make variable interest rate payments on these loans. The reason and the purpose of the
loan are not of interest in this context. The focus lies on the variable interest payments that result from
these loans. Most parties don’t want to face increasing variable interest payments arising from possibly
increasing interest rates. To eliminate this risk the corporation could enter into a payer swaption. If the
maturity and the principal of the swaption coincide with the maturity of the loan this swaption
completely eliminates the risk of rising interest rates at the cost of a premium. Often it is seen that the
corporation chooses to enter into a swap for the first years and covers the potential interest rate risk in
subsequent years with a swaption. Consider for example the case where a corporation is obliged to
make variable interest payments for the coming twenty years. In this case the corporation could choose
to buy a swap that covers the first ten years and a swaption that covers the last ten years. Note that for

10
a complete match the principal and the interest rate conventions of both the swap and the swaption
contract should coincide to that of the loan. Since the premium arising from the swaption is usually a
substantial amount of money, counterparties in these types of constructions sometimes offer to
increase the fixed rate of the swap. As a consequence of the increased fixed rate no swaption premium
has to be paid. This is beneficial for the corporation since there is no substantial cash out up front. Other
reasons for entering into swaption contracts could be of speculative nature. If an institution would like
to speculate on decreasing interest rates then it could buy receiver swaptions.

The focus of this thesis will be the valuation of swaptions. Since a swaption is an option on a swap, a
swaption will only be exercised in case the swaption is in-the-money. A swaption is said to be in-the-
money in case is lower than the forward swap rate that applies to the contract under
consideration. The value of the swaption depends on the strike rate, the length of the underlying swap,
the time to expiration and the implied volatility of interest rates. To value swaptions practitioners either
use complex term structure models or the Black-76 model. The Black-76 model is fast and easily
implementable. In this model, the volatility of interest rates is a two-dimensional3 input parameter
which is observed from the swaption market. The implied volatility is an important factor in the
valuation of swaptions according to the Black-76 model. For a lot of practitioners and banks the Black-76
model is the accepted standard. However, theoretically a more comprehensive approach of future
interest rates can be made by the use of term structure models. Since swaptions are financial derivatives
that possibly generate cash flows in the future their payments depend on future interest rates. These
future interest rates can be generated by various stochastic interest rate models. An important part of
this thesis consists of discussing different stochastic interest rate models.

3
Two dimensional in the sense that it depends on the remaining time period and length of the underlying swap.

11
 3. Swaption valuation with the Black-76 model

The simplest model to value swaptions is the Black-76 model which has been introduced by Black
(1976). A lot of banks and consultancy companies use this model daily. Advantages of the model are that
it is widely known and it has been heavily used. Moreover, this model has the advantage that it has only
two input parameters, namely forward swap rates and the implied volatility. The forward swap rates are
calculated on the basis of tradable, and hence observable interest rates. The implied volatility is
available for a broad class of swaptions in for example Thomson Reuters. Besides the Black-76 model
swaptions can be valued using stochastic interest rate models. These models require the input of more
variables. In the case of stochastic interest rate models the modeler is, in some sense, free to choose
which input parameters to use. These parameters are needed for the calibration of the model. Section
6.4 will describe in detail how a model can be calibrated and which parameters can be used for this
purpose. The point here is that when using stochastic interest rate models there can be discussion about
which input parameters to use. As a consequence, different practitioners can find different swaption
values while using the same model. A non-negligible advantage of the Black-76 model is that, when
using the correct input parameters, every practitioner will find the same swaption value. The rest of this
section will describe the Black-76 model and its relation to the Black Scholes option pricing model. Since
the Black-76 model is closely related to the Black Scholes model the first subsection is devoted to the
Black Scholes model. Another important feature is risk-neutral valuation, this concept will be described
in Section 3.2. Finally Section 3.3 discusses how the Black-76 model can be used to value swaptions.

3.1 Black Scholes option pricing model

Black and Scholes (1973) introduced an option pricing model that changed the world of option pricing.
Their model became the widely accepted model for pricing options and is still heavily used today. The
importance of the model has been recognized. Robert Merton and Myron Scholes received the Nobel
Prize for economics in 1975 for the importance of the model. Black died by the time the prize was
awarded. Merton was awarded the prize for his contribution to the model, which is also referred to as
the Black-Scholes-Merton model. In the context of the thesis one should immediately note that the
Black Scholes model has been developed to price options. In particular, non-dividend paying call and put
options on stocks. In subsequent years, the model has been extended to price a broader class of stock
options. Note however that this thesis is interested in the pricing of swaptions and not in the pricing of
stock options. Later on the link between the Black Scholes option pricing formula and the pricing of
swaptions will be explained. The rest of this subsection will discuss the Black Scholes model.

To introduce the model the notation and description of Hull (2008) is followed. The Black Scholes model
assumes that the relative stock price change over a small time horizon is approximately normally
distributed. Introduce as the stock’s expected return and as the volatility of the stock. It immediately
follows that for small time horizons the expected return on the stock is and the standard deviation
of the return is , where denotes the time difference over a small horizon. Since the price of a
stock is a variable whose change over time is uncertain it can be represented by a continuous time
stochastic process. Modeling the stock price as a stochastic process is the first important step in the

12
derivation of the Black Scholes option pricing formula. In a stochastic process, which is sometimes
referred to as a normal random walk, variables can change at any time. The path that the variable will
take is never predetermined. It is assumed that stock prices in the Black Scholes model satisfy the
Markov property. In a Markov process the past and the future are independent. These processes are
also referred to as memoryless processes. Thus, given the present, stock prices at any particular time in
the future are independent of the stock price in the past. As a result the underlying probability functions
are independent as well. A process that is almost surely continuous and whose independent increments
follow a normal distribution is known as a Brownian motion.

Definition 3.1 – Brownian motion.

A continuous time-process ( ) is said to be a Brownian motion if it satisfies the following
properties:
1. .
2. If then the increments and are independent.
3. has independent increments with distribution ( ) for

The Brownian motion that has been described above has a drift rate of zero, as a consequence the
expected value of the Brownian motion at any future time is equal to its current value. As argued before
the expected return of stock prices is and the drift of stock prices is . To cope with this drift we
have to consider a stochastic differential equation (SDE). In a SDE at least one of the terms is a stochastic
process. Hence the solution of a SDE is a stochastic process as well. In this thesis the stochasticity in the
SDE will be driven by a Brownian motion, it should be noted that there are other possibilities but they
are beyond the scope of this thesis. The SDE’s that will be considered can be written in the following
form

( ) ( ) , . (3.1)

The SDE as defined above consists of a deterministic part and a stochastic part. The stochastic part is
driven by the Brownian motion , this is the part that drives the process and provides the process with
its uncertainty. and are functions that represent respectively the volatility and the drift of the
process. The solution of a SDE as defined by (3.1) can be found by taking integrals, this yields the
following expression

∫ ( ) ∫ ( ) . (3.2)

To make sure the solution of (3.1) is well defined, more specifically that the integrals in (3.2) are well
defined the process has to be adapted to . This means that at time the process can only
depend on information that is available up until this time, informally the process cannot see into the
future.

The assumption in the Black Scholes model is that the price of a non-dividend paying stock follows a SDE
of the following form

(3.3)

13
where is a Brownian motion. With a straightforward application of Itô’s lemma4 it can be shown that
( ) follows the following process

( ) ( ) (3.4)

The process followed by the stock price as presented in equation (3.3) is known as a Geometric
Brownian motion. With a logarithmic application the process has been reduced to a linear process, see
equation (3.4). It should be noted that ( ) has a constant drift and a constant volatility. It directly
follows that

( ) ( ( ) ( ) ) (3.5)

Here denotes the stock price at some future time and represents the price of the stock at time
zero. From equation (3.5) it is seen that ( ) is normally distributed, as a consequence follows a
lognormal distribution, in more detail5

( ( ) ( ) ) (3.6)

( ) (3.7)

( ) ( ) (3.8)

Almost all of the important basics of the Black Scholes model have been discussed. It has been shown
that the stock price follows a continuous time stochastic process, more particularly a Geometric
Brownian motion and that the stock price at any particular future time follows a lognormal distribution.
One important feature in the Black Scholes model has not yet been discussed, namely risk-neutral
valuation. A thorough description of risk-neutral valuation will be given in the next subsection. One
should note that valuation under the Black Scholes model is usually done under a risk-neutral measure.
For this purpose any numéraire and its corresponding risk-neutral measure can be used. These features
will be explained in detail in the next subsection. For now we leave this part and continue with the
presentation of the famous Black Scholes option pricing formula.

4
For a description of Itô’s lemma see for example Brigo and Mercurio (2006), Hull (2008) or Schumacher (2010).
5
If ( ) ( ) then ( ).

14
Consider a European call option on a non-dividend paying stock, the payoff of this option at time is
given by ( ), where denotes the strike. Black and Scholes (1973) show that, under a
6
number of assumptions , the fair price, at time zero, of a call option with time to maturity is given by
the following set of equations.

( ) ( ) (3.9a)

( ) ( )
(3.9b)
√

√ (3.9c)

denotes the cumulative normal distribution.

3.2 Risk-neutral valuation

The last important feature of the Black Scholes world was skipped in the previous subsection. Let us now
move to risk-neutral valuation, which is an important concept in the pricing of financial derivatives like
swaptions. This paragraph will start by intuitively explaining the concept of risk-neutral valuation,
afterwards a formal introduction will be given. To come to correct prices for derivatives in the Black
Scholes model risk-neutral valuation is used. When using risk-neutral valuation it is assumed that the
world is risk neutral, risk-neutral valuation will then lead to correct prices in all worlds. In a risk-neutral
world all investors are insensitive to risk. This means that investors are indifferent to the risks that are
involved in their investments, investors are only interested in the expected return on their investments.
Since all investments with the same expected return are valued equally by risk-neutral investors they
require no additional risk compensation for more risky investments. As a consequence the risk-free
interest rate, which will be denoted by throughout, is the expected return on every investment. It is
important to realize that this only holds when the money-market account is used as a numéraire.
Furthermore, in that case, the calculations that are performed in the risk-neutral world are also valid in
the normal world. In the normal world it is assumed that people are risk-averse. For example, investors
require additional risk-premiums for risky investments and would not be satisfied with a risk-free return
in case the considered investment is not completely riskless.

Formally, risk-neutral valuation is done under the risk-neutral measure. A risk-neutral measure actually
is an equivalent martingale measure. The fundamental theorems of asset pricing imply that in a
complete market the price of a financial derivative is the discounted expected value of all the future

6
Hull (2008) p.286-287 states that the following assumptions are required to derive the Black and Scholes option
pricing formula:
1. The risk-free interest rate, , is known and is constant through time.
2. The stock price follows the process as has been described in this section, more in particular the process in
equation (3.6). It should be noted that does not necessarily has to be constant.
3. The stock pays no dividend.
4. There are no transactions costs or taxes in buying or selling the stock or the option.
5. Short selling is allowed.
6. Arbitrage opportunities are absent.
7. Security trading can be carried out continuously.

15
payoffs under this risk-neutral measure. In succession the concepts above will be dealt with in more
detail. Let us first of all motivate the use of risk-neutral valuation. The value of a financial derivative or
any other asset depends on its future cash flows and the risk associated with these payoffs. Since the
payoffs of financial derivatives are uncertain the holder of such an asset faces risk. Since investors are
generally assumed to be risk-averse the value of a financial derivative, in case of a call option, is usually
lower than its expectation. Here the expectation of the financial derivative is the discounted value of the
future payoffs. Since investors do not have the same level of risk-aversion the value of a particular
financial derivative is different in the eyes of every investor. The fundamental theorem of asset pricing
implies that this issue can be overcome by valuing financial derivatives under the risk-neutral measure.
Moreover, in the case of an arbitrage-free market it is possible to adjust the probabilities that investors
assign to future outcomes of amongst other financial derivatives such that financial derivatives can be
valued fairly in the eyes of every investor. More specifically these adjusted probabilities are reflected by
the risk-neutral measure. Once this risk-neutral measure has been established it can be used to value
assets free of arbitrage by discounting the future payoffs according to the risk-neutral probabilities.
Before continuing, first the definition of an arbitrage opportunity and the fundamental theorems of
asset pricing will be presented.

To come to the definition of an arbitrage opportunity let us first of all consider a self-financing trading
strategy. A portfolio of assets is called self-financing if no money is added or withdrawn from this
portfolio, not even when transactions take place. In particular the purchase of a new asset must be
financed by the sale of other assets. Denote the value of a self-financing portfolio at time by . An
arbitrage opportunity arises when an investor has the possibility to make a risk-free profit at zero cost.
Formally an arbitrage opportunity can be defined as a self-financing portfolio that generates a
nonnegative cash flow with probability one and where the probability that the value of will be
nonzero is greater than zero. Mathematically this can be defined as follows,

(a)
(b)
(c) P( ) .

Before stating the first fundamental theorem of asset pricing (FFTAP) numéraires and martingales have
to be discussed. A numéraire can be any asset or self-financing portfolio whose price is always positive.
A numéraire can be seen as a basic asset by which the value of another asset or portfolio of assets is
measured. When pricing financial derivatives it is common to use the money-market account as a
numéraire, this topic will be dealt with in more detail later on. Furthermore it is important to realize that
a self-financing trading strategy remains self-financing in case it is normalized by a numéraire. Next we
move to martingales, which play a role in the arbitrage-free modeling of financial derivatives. The FFTAP,
stated below, requires that relative price processes are martingales with respect to some probability
measure. A process is said to be a martingale if it is measurable and the conditional expectation, given
all past observations, is equal to the last observation. Let be a process and let denote all available
information up till time . Then for each a martingale can be defined as follows

(a) ( )

16
 (b) E( ) .

A martingale can be interpreted as a driftless process. The formulation of the FFTAP as presented by
Schumacher (2010) is slightly adjusted below.

Definition 3.2 – First fundamental theorem of asset pricing (FFTAP).

A market specified by an objective probability measure and a collection of asset price processes
is arbitrage-free under the probability measure if and only if given any numéraire , there
exists a probability measure such that:

i. and are equivalent probability measures7.

ii. The discounted price processes are martingales under .

Let us now continue with risk-neutral valuation. As stated before, risk-neutral valuation is done under
the risk-neutral measure. A risk-neutral measure is an equivalent martingale measure. Such an
equivalent martingale measure can be any probability measure that satisfies property i. and ii. of the
FFTAP. However as mentioned before, we are looking for a unique risk-neutral measure since a unique
risk-neutral measure implies a unique arbitrage-free price for all contingent claims. Note that the FFTAP
implies that all attainable contingent claims are priced free of arbitrage under the risk-neutral measure.
This however does not imply that all contingent claims can be attained. This is only possible in a
complete market. Let us for this purpose present the second fundamental theorem of asset pricing
(SFTAP) below. From this an important property in valuing financial derivatives follows, namely if the
market is complete then the price of every financial derivative will be uniquely determined.

Definition 3.3 – Second fundamental theorem of asset pricing (SFTAP).

A market specified by an objective probability measure and consisting of a collection of asset prices
and a risk-free bond is complete if and only if there exists a unique risk-neutral measure that
is equivalent to and has a numéraire .

With the motivation of risk-neutral valuation done the question remains which equivalent martingale
measure should be used as the risk-neutral measure. For this purpose the following pricing formula,
which is referred to as the numéraire dependent pricing formula (NDPF) by Schumacher, is introduced

( )
. (3.10)

Here denotes the value of the attainable contingent claim at time , ( ) represents the payoff
of the contingent claim at time , represents any numéraire and is the expectation under the
probability measure corresponding to this numéraire . As usual denotes all available information up
till time . By taking the money-market account as a numéraire the NDPF becomes

7
Two probability measures and are called equivalent if they agree on which events can occur and cannot
occur. More specifically, any event A that occurs with positive probability under also has to occur with positive
probability under . Note that the probability that A occurs may very well differ under and .

17
 ( ) ∫
[ | ] [ ( )| ]. (3.11)

Note that denotes the expectation, at time , under the probability measure corresponding to the
money-market account. As a consequence the price of a financial derivative with payoff ( ) is the
discounted expected value of the payoffs of the contingent claim under the considered risk-neutral
measure. However it should be stressed that is possible to use other numéraires. Moreover, the Black-
76 model which is the topic of the next paragraph uses a portfolio of zero-coupon bonds as numéraire.

3.3 Black-76 model for swaptions

As discussed previously the Black Scholes formula is an elegant and useful way for pricing stock options.
Fisher Black extended the model such that it can cope with interest rate derivatives. One should note
that the pricing of interest rate derivatives is more complex than the pricing of stock options. To be able
to price interest rate derivatives forward swap rates have to be determined. Moreover, interest rates
have to be used not only to price the option but also to discount the future payoffs. Various interest rate
derivatives like caps, floors and swaptions can be valued using the Black-76 model. This model is closely
related to the Black Scholes model as was presented in Section 3.1. The Black-76 model makes use of
one extra assumption. For the valuation of swaptions it is assumed that the underlying forward swap
rate at the swaption maturity follows the lognormal distribution.

To understand the link between pricing swaptions and stock options consider a payer swaption. It is not
hard to see that a swaption can be regarded as an option on the forward swap rate. Assume that the
current swap rate corresponding to the considered swaption proves to be ( ). Since the
considered swaption is a payer swaption the holder of the swaption would have to pay the fixed leg if
the option is exercised. Hence the holder will only receive money in case ( ) exceeds .
Because swaption holders have the choice of exercising the option they will only do so if it is profitable.
Note that one particular payoff arising from a payer swaption can be seen as the following option

( ) . (3.12)

Note that the notional has to be divided by the number of payments per year. As a consequence a
swaption can be seen as a series of cash flows equal to the cash flow presented in equation (3.12). More
in particular, a swaption can be written as a series of European call options on the swap rate. This is
comparable to the valuation of a stock option that has been considered in Section 3.1. Below, the idea
of a series of European call options on the swap rate will be elaborated formally when the risk-neutral
measure is introduced. The last thing that has to be discussed before the formulas can be presented is
this risk-neutral measure. As pointed out in the previous subsection the Black-76 does not necessarily
have to make use of the money-market account as numéraire. For calculations under the Black-76
model

∑ ( ) (3.13)

18
is used as numéraire, expectations at time corresponding to this measure are denoted by . Recall
that the value of a payer swaption is8

( ) ( ) ∑ ( )( ) . (3.14)

To ease notation let us denote the value of a payer swaption by . As a consequence the NDPF teaches
us that the normalized price of a payer swaption at time is

( ) ( ) ∑ ( )( )
∑ ( ) ∑ ( )
(3.15a)

( ) ( )
∑ ( ) ∑ ( )( )
(3.15b)

∑ ( )
( ) . (3.15c)

The last expression shows us that a swaption can indeed be seen as a European call option on the swap
rate when ∑ ( ) is taken as numéraire. Furthermore, one can observe that the forward swap
rate is a martingale under the specified numéraire. Note that the forward swap rate is defined as

( ) ( )
( ) . (3.16)
∑ ( )( )

( ) ( )
Observe that this can be regarded as a tradable asset, namely ( )
, divided by the
numéraire as specified in equation (3.13).

Having in mind the Black Scholes model it is now easy to formulate the Black-76 model which is widely
used for the valuation of swaptions. Note that we can rewrite equation (3.15c) to obtain a direct
expression for the value of a payer swaption

∑ ( ) ( ) . (3.17)

Hence, under the assumption that the forward swap rate follows a Geometric Brownian Motion under
and the volatility is constant throughout time, the formula for a payer swaption under the Black-76
model can be stated as follows

∑ ( ) ( ) ( ) ( ) (3.18a)

( ( ) )
(3.18b)
√

√ (3.18c)

8
Note that this thesis considers annual swaptions, hence .

19
Compared to the Black Scholes option pricing formula there is an extra term included in equation
(3.18a), this term discounts the cash flows.

3.4 Construction of the yield curve

As has been discussed in the previous subsections the valuation of swaptions according to the Black-76
model depends amongst others on the calculation of forward swap rates and discount factors. To
calculate these values offered interest rates for a wide range of maturities are obtained from Thomson
Reuters. More on this in detail in Section 5 which is devoted to the description of the data. The obtained
interest rates are transformed through a number of operations to form a forward curve. All calculations
that are needed to determine the value of a swaption under the Black-76 model are performed using
this forward curve. The forward curve is a curve which is constructed from forward rates. Forward rates
are interest rates for a certain period of time that are implied by today’s term structure of interest rates,
more specifically the zero curve. In turn, the zero curve is the curve that is constructed from interest
rates that correspond to zero-coupon paying bonds. A detailed description of the construction of the
zero curve, the forward curve and the determination of the forward rates hereof is presented in
Appendix A.

20
 4. Short-term interest rate models

Section 3.3 introduced the Black-76 model; as has been discussed in the introduction alternative
methods for swaption valuation exists. The alternative swaption valuation methods that will be
discussed in this thesis are based on short rate models. Short rate models model the short-term interest
rate. Below it will be shown that by modeling the short rate it is possible to describe the entire yield
curve. In this section three short rate models will be described; the Vasicek model, the Hull and White
one-factor model and the Two-Additive-Factor Gaussian model. Each model will be presented in a
different subsection. Furthermore, the link between these models and the concepts of equilibrium and
no-arbitrage models will be described. Section 6 explains in detail how these models can be used to
value swaptions.

First of all let us motivate why it is convenient to model the short rate. Recall the definition of a zero-
coupon bond and that of the continuously compounded interest rate as given in Definition 2.2.
Moreover, in Section 3.2 is has been shown that in case of the existence of a risk-neutral measure the
value of a claim ( ), given any numéraire , is given by

( )
. (4.1)

When taking the money-market account as the numéraire and denoting the corresponding risk-neutral
measure by the equation above can be formulated as

∫ ( )|
[ ]. (4.2)

Since the payoff of a zero-coupon bond at time equals one9 it follows that the price of a zero-coupon
bond at time is

∫
( ) [ | ]. (4.3)

In Section 2.1 it has been stressed that the yield curve can be presented in terms of zero-coupon bonds.
From equation (4.3) it can be seen that by modeling the short-term interest rate one is able to compute
the price of every zero-coupon bond. Hence by modeling the short-term interest rate it is possible to
describe the entire yield curve. As a consequence the yield curve only depends on the specification and
the evolution of the short-term interest rate. In case of the Vasicek model and the Hull and White one-
factor model the short rate will be described by the following process

( ) ( ) ( ) . (4.4)

In equation (4.4) refers to the motion or the drift of the short rate and refers to the standard
deviation. These models are driven by a Brownian motion and have one state variable, the short-term
interest rate. The Vasicek and the Hull and White one-factor model will be introduced in Section 4.1 and

9
Recall that by definition ( ) for every .

21
4.2 respectively. The Hull and White one-factor model is an extension of the Vasicek model. Hull and
White extend the Vasicek model in the sense that they allow the drift term to be time-dependent
whereas Vasicek assumes the drift term to be constant over time.

As was briefly mentioned, a third model will be considered and presented in Section 4.3. This Two-
Additive-Factor Gaussian model is proposed by Brigo and Mercurio and is equivalent to the Hull and
White two-factor model. For brevity this model will be referred to as the G2++ model, this abbreviation
is also used by Brigo and Mercurio. Unlike the Vasicek and the Hull and White one-factor model this
model has two state variables. Let us briefly stress the importance of a multiple state model in this
introductory paragraph. For this purpose recall equation (2.4)

( ) ( ). (2.4)

From this equation it should be noted that the entire yield curve can be described in terms of zero-
coupon bonds. Short-term interest rate models allow us to model ( ). Note from equation (4.3) that
zero-coupon bonds are determined by the evolution of ( ). So the yield curve is indirectly modeled by
( ). Hence the performance of the model depends on the goodness of the model for ( ). As we have
seen, the Vasicek and the Hull and White one-factor model are one state variable models. It is
questionable whether these one state variable models are capable of modeling a complex issue like the
yield curve. To motivate this statement the correlation between interest rates has to be considered.

It is widely accepted that there is some correlation between interest rates. However, one state variable
models imply a perfect correlation between interest rates. As we will see in the following sections, both
in the Vasicek as in the Hull and White one-factor model we can write

( ) ( ) ( )
( ) . (4.5)

From this it follows that we can state equation (2.4) as

( ) ( ) ( ) ( ) . (4.6)

From equation (4.6) it is possible to calculate the correlation between two interest rates. Consider three
random time instants and where is unequal to . denotes the time at which the yield curve
is considered, and represent two random maturities. It is now straightforward to verify that the
correlation between ( ) and ( ) is equal to one. Since and are random maturities this
holds for all possible combinations of and . Note that this implies a perfect correlation between
any two interest rates. For example between the one-month interest rate and the fifty-year interest
rate. Of course this is a very unrealistic feature. As we will see later on, the G2++ model or any other
multi-factor model does not imply perfect correlation. Hence these models are capable of reproducing
more realistic correlation patterns and are interesting extensions of the one state variable models. Since
the G2++ model is the only considered model that does not imply perfect correlation between interest
rates this is the most promising model.

22
All considered models and their results can be presented both in the objective world and the risk-
neutral world. Since this thesis is considered with the pricing of swaptions all formulations in this section
will be made in terms of the risk-neutral world. It should be noted that one is able to move to the
objective world by a change of measure, this can be done by Girsanov’s theorem. Since this is not of
interest for the purpose of this chapter the objective world is ignored. More specifically, the results in
this section will be presented with the money-market account as the considered numéraire. Herewith
the models are presented in their most general form. However we will see in Section 6 that the money-
market account might not be the most suitable numéraire to price swaptions. It will turn out that the
valuation of swaptions can be simplified with a change of numéraire. This change of numéraire
technique and the consequences for swaption valuation will be discussed thoroughly in Section 6.

4.1 Vasicek model

One of the first to develop a stochastic interest rate model is Vasicek (1977). Vasicek constructed an
interest rate model that is driven by one state variable, the short rate. This one-factor short rate model
assumes that the short rate is the fundamental source of uncertainty. To deal with this uncertainty
Vasicek assumes a stochastic process for ( ). More specifically, Vasicek assumes that ( ) follows a
Markov process and assumes the short rate to be a continuous function over time. The Vasicek model
specifies ( ) by means of the following stochastic differential equation

( ) ( ) ( ) . (4.7)

Note that the equation above specifies ( ) in the risk-neutral world with the money-market account as
the corresponding risk-neutral measure. denotes a Brownian motion under this risk measure,
represents the volatility of the interest rates and and are positive constants. The process in equation
(4.7) is known as an Ornstein-Uhlenbeck process. This process has the property to be mean-reverting,
hence the parameters can be interpreted as follows. is a constant that the process will revert to, all
trajectories will evolve around this long term mean level, characterizes the reversion speed and is
the instantaneous volatility and is therefore a measure of the randomness. Since interest rates cannot
increase or decrease indefinitely, the mean-reverting property introduced by Vasicek has been an
important step in modeling the term structure of interest rates.

Equation (4.7) represents the short-term interest rate in terms of a stochastic differential equation. By
integrating an explicit expression for ( ) can be obtained, for each we find that

( ) ( ) ( ) ( )
( ) ∫ . (4.8)

From this it can be seen that ( ) is normally distributed conditional on . For the expectation and the
variance use is made of Schumacher (2010) who presents explicit solutions to stochastic differential
equations of this type. The relevant formulas are presented in Appendix B. Using these formulas the
mean and variance can easily be determined

( ) ( ) ( ) (4.9)

23
 ( ) ( ). (4.10)

Note that and respectively denote the expectation and the variance when the money-
market account has been used as the numéraire. From equation (4.9) the mean reverting property can
be seen as well. Note that for very large the expectation of ( ) tends to . Additionally from equation
(4.7) it can be seen that the drift of the process is positive if the current value of the short rate is lower
than and that the drift is negative in case the value of the short rate is higher than . Hence the
process tends to drift towards its long-term mean . The expectation of the short-term interest rates
also implies a major drawback of the model. Namely, the model allows negative interest rates, which is
off course an undesired property. Advantages of the Vasicek model are that its stochastic differential
equation can be solved explicitly, the short rate is normally distributed and zero-coupon bond prices can
be obtained easily. This last feature will be stressed in the next paragraph.

Vasicek (1977) shows that the price of a zero-coupon bond that pays off one unit of currency at time T
can be written by the following set of equations. For simplicity and clarity the notation follows Hull.

( ) ( ) ( )
( ) (4.11)

( ) ( ( )) ( )( ( ) ) (4.12)

( )
( ) (4.13)

Using the above equations it is now possible to describe the yield curve in terms of the Vasicek model as
follows10

( ) ( ) ( ) ( ) . (4.14)

It can be seen that once the parameters of the Vasicek model have been chosen the complete yield
curve can be determined as a function of ( ). The Vasicek model can be characterized as a so called
equilibrium model. Equilibrium models generate the current term structure. Despite the fact that the
complete yield curve can be determined, equilibrium models are not necessarily consistent with the
current term structure. Note that an equilibrium model generates a term structure, hence it is not by
definition capable of replicating today’s term structure. As described by Hull and White (2008) there are
cases where it is not possible to fit equilibrium models reasonably to the current term structure of
interest rates. This undesirable property led to the introduction of no-arbitrage models. No-arbitrage
models can be constructed such that they are consistent with the current term structure.
Mathematically the main difference between equilibrium models and no-arbitrage models is that in no-
arbitrage models the drift term in equation (4.4) is allowed to be time-dependent. It should be noted
that pricing derivatives under a no-arbitrage model does not imply arbitrage free prices. The models are
called no-arbitrage models since they perfectly replicate the term structure of interest rates at some

10
Note that ( ) ( ).

24
given point in time. Nevertheless a perfect replication of today’s term structure is a desired property.
Next to the earlier mentioned disadvantage of the Vasicek model one should always bear in mind that
this model is not always able to reproduce today’s term structure of interest rates. One can then
question the usefulness of this model.

Note from equation (4.7) that the Vasicek model can also be written as follows

( ) ( ) . (4.15)

Here ( ) denotes the drift. As stated, a difference between equilibrium models and no-
arbitrage models is that in equilibrium models the drift term is not time-dependent whereas in case of
no-arbitrage models it is. The expectation of the future term structure varies over time, hence it seems
reasonable to allow (some of) the parameters to be time-dependent. The Vasicek model is an example
of an equilibrium model that can be extended to a no-arbitrage model by allowing the drift term to be
time-dependent. Indeed, if the drift term is allowed to be time-dependent one obtains the Hull and
White one-factor model. It should be noted that the Vasicek model can only describe a limited range of
term structures. This stems from the fact that two time-independent parameters have to describe an
entire term structure. Section 6 will describe in detail how the Vasicek model and the models that will
be described hereafter can be used to value swaptions.

4.2 Hull and White one-factor model

As mentioned before, the Vasicek model can be extended by making the drift parameter time-
dependent. By doing this one obtains the Hull and White one-factor model as was introduced by Hull
and White (1990). When taking the money-market account as the risk-neutral measure the model can
be formulated as follows

( ) ( ) ( ) . (4.16)

Note that the Hull and White one-factor model can also be written as

( ) ( ) ( ) . (4.17)

This model can be interpreted as follows, the parameter is chosen such that the model is consistent
with the current term structure of interest rates. As usual and are positive constants and
denotes a Brownian motion under the probability measure corresponding to the money-market
account. will be defined below. Since the Hull and White one-factor model is a no-arbitrage model it
fits the current term structure by definition. is the mean level of reversion and the reversion speed is
. Note that the standard deviation of the short rate and the reversion speed are still constant over
time. By letting be time-dependent one obtains the Extended Vasicek model. In the Hull and White
one-factor model negative interest can occur as is also the case in the Vasicek model. An example of a
model that does not allow negative interest rates is the Black-Karasinski model.

25
Before an explicit expression for ( ), its expectation and variance are presented let us first of all define
. For this purpose recall the definition of the instantaneous forward interest rate11. Let us now assume
that the instantaneous forward rate that follows from the interest rates that are currently observed in
the market is denoted by ( ). Additionally denote the zero-coupon bonds that are currently
observed in the market by ( ). To fit the model to the current term structure of interest rate
should be defined as follows

( )
( ) ( ). (4.18)

Equation (4.16) represents the short-term interest rate in terms of a stochastic differential equation. By
integrating this equation an explicit expression for ( ) can be obtained, for each we find that

( ) ( ) ( ) ( ) ( )
∫ ∫ . (4.19)

From this it can be seen that ( ) is normally distributed conditional on . For the expectation and the
variance again use is made of Schumacher who presents explicit solutions for stochastic differential
equations of this type. The relevant formulas are presented in Appendix B. Using the relevant formulas
the mean and variance under the specified risk-neutral measure are easily determined

( ) ( )
( ) ∫ (4.20)

( ) ( ). (4.21)

Note that also the Hull and White one-factor model allows negative interest rates, which is of course an
undesired property. Compared to the Vasicek model an advantage is that the model is able to fit the
entire term structure of interest rates. Similar to the Vasicek model the stochastic differential equation
can be solved explicitly, the short rate is normally distributed and zero-coupon bond prices can be
obtained easily. The price of a zero-coupon bond in case of the Hull and White model is given by the
following set of equations. For clarity in the notation Hull is followed

( ) ( ) ( )
( ) (4.22)

( ) ( )
( ) ( )
( ) ( ) ( ) ( ) (4.23)

( )
( ) . (4.24)

4.3 G2++ model

The importance of a two-factor model has been stressed in the introduction of this section. As stated,
the one state variable models that have been considered in the previous two subsections imply perfect
correlation for all possible combinations of maturities at every moment in time. Truly this is a very
unrealistic assumption. However this does not imply that these models are useless. The capabilities of

11 ( )
Recall equation (2.11): ( ) ( )

26
the short rate models will be discussed in Section 6. Anyhow, two-factor models or multi-factor models
in general are a step forward. These more general models have the capability of generating more
realistic volatility structures.

The choice for the G2++ model can be motivated as follows. Besides the Hull and White one-factor
model other interesting one-factor models are present. For example the Black-Karasinski model which
excludes the possibility of negative interest rates. As we have seen that is one of the drawbacks of the
Vasicek and the Hull and White one-factor model. Another possibility is introducing an extra time-
varying parameter. By letting be time-dependent in the Hull and White one-factor model one obtains
the Extended Vasicek model. Extra time-varying parameters however could lead to overfitting. Of
course, extra parameters will lead to better fitting capabilities but more parameters also have
drawbacks. The model might for example lose some of its interpretability. And one should question
whether the model is still capable of valuating non-quoted swaptions. This and the importance of
considering a model that does not imply perfect correlation between interest rates led to the choice for
a multi-factor model instead of another one-factor model. Still many possibilities exists. The choice fell
on the Two-Additive-Factor Gaussian model. This model is Gaussian and is still analytically tractable as
far as European swaptions are considered. A drawback remains that the model does not exclude the
theoretical possibility of negative interest rates. Moreover Brigo and Mercurio showed that the G2++
model is equivalent to the Hull and White two-factor model.

Brigo and Mercurio (2006) present the G2++ model in Section 4.2 of their book, the relevant formulas
are taken from there. When taking the money-market account as the risk-neutral measure the model
can be formulated as follows

( ) ( ) ( ) ( ) ( ) ( ) . (4.25a)

Under the money-market account as the numéraire the processes ( ) and ( ) respectively satisfy the
following stochastic differential equations

( ) ( ) ( ) (4.25b)

( ) ( ) ( ) . (4.25c)

Note that the equation above specifies ( ) in the risk-neutral world with the money-market account as
the corresponding risk-neutral measure. and are positive constants. and denote
Brownian motions under this risk measure, their instantaneous correlation is given by , we can write

. (4.25d)

The parameter ( ) is chosen such that the model is consistent with the current term structure of
interest rates and is for that reason defined as

( ) ( ) ( ) ( ) ( )( ). (4.25e)

27
Equation (4.25b) and (4.25c) presents the processes for ( ) and ( ) in terms of a stochastic
differential equation. By integrating this equation the following expression for ( ) can be obtained, for
each we have

( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ).
∫ ∫ (4.26)

From this it can be seen that ( ) is normally distributed conditional on . The mean and variance
under the specified risk-neutral measure are as follows

( ) ( ) (4.27)

( ) ( )
( ) ( ) ( ). (4.28)

Note that also the G2++ model allows negative interest rates, which is of course an undesired property.
Similar to the previously considered models the stochastic differential equation can be solved explicitly,
the short rate is normally distributed and zero-coupon bond prices can be obtained easily. The price of a
zero-coupon bond in case of the G2++ model is given by the following set of equations

( )
( ) ( )
( ) (4.29a)

( ) ( )
( ) ( ) ( ) ( ) ( ) ( ) (4.29b)

( ) ( ) ( ) ( )
( ) [ ] [ ]

( ) ( ) ( )( )
[ ]. (4.29c)

28
 5. Data

This section is devoted to the description of the data. As explained in Section 2 interest rates and
swaption volatilities are needed for the calculation of swaption values. The interest rates are needed to
construct a forward curve from which the required forward swap rates and discount factors can be
calculated. The implied volatilities are used as an input parameter in the Black-76 model. Furthermore
the implied volatilities can be used as calibration instruments, more on this in Section 6. A detailed
description of the calculation of forward rates can be found in Appendix A. The data that is used in this
thesis is obtained from Thomson Reuters DataStream.

Swaption values are calculated for two pre-specified days, namely 1 July 2008 and 1 July 2011. The
choice for these days is motivated as follows. By picking two dates it can be investigated whether the
results are consistent over time. Moreover the financial world has somewhat changed since 1 July 2008.
For this reason there has been chosen to pick one date before the financial crisis that emerged in 2008
and to pick another recent date after the financial crisis. As a consequence the models can be analyzed
in two different states of the economy. After the financial crisis interest rates decreased significantly and
implied swaption volatilities increased. Figure 1 below shows the evolution of the three-months Euribor
and the ten-year IRS. From this graph the significant decrease of the interest rates late 2008 can be
observed.

Figure 1 The Euribor 3-month offered rate and the 10-year Euro versus Euribor interest rate swap
middle rate are plotted against time. The considered time period is 1 January 2007 to 18 July 2011. The
blue line represents the 3-month Euribor and the black line the 10-year IRS.

The 3-month Euribor and the 10-year IRS are commonly used as indicators for the term structure of
interest rates. Figure 1 indicates that the term structure of interest rates has changed as a consequence
of the financial crisis. Figure 2 below shows the zero curve of 1 July 2008 and 1 July 2011. It should be

29
noted that the zero curve is often referred to as the yield curve. A yield curve describes the relation
between interest rates and their time to maturity. As can be seen from Figure 2 the interest rates for all
maturities have decreased significantly. Moreover, both term structures have different shapes. The zero
curve of 2008 is upward-sloping whereas the zero curve of 2011 is inverted. In an upward-sloping yield
curve the interest rates are higher for longer maturities. An explanation of an upward-sloping yield
curve could be that investors have to be compensated for the risk of securing funds for a longer time
period. Investors require a risk premium since longer maturities imply greater risks. Another explanation
for the upward-sloping yield curve could be that investors expect the short-term interest rate to rise. In
other words, investors expect the risk-free interest rate to rise in the future hence they want to be
compensated for this fact by demanding higher rates on their long term investments. On the other hand
we have the inverted yield curve that occurred in July 2011. A property of the inverted yield curve is that
short-term interest rates are higher than long term interest rates. Inverted yield curves are known
indicators for recessions as has been the case in the late 2000’s. The explanation behind an inverted
yield curve is as follows. In a normal situation the yield for longer maturities is higher than the yield for
shorter maturities. In the case of the inverted yield curve of 1 July 2008 the yield of the 6-month Euribor,
the 12-month Euribor and the 1-year IRS was higher than the yields corresponding to maturities of six
years or more. Although the yields for shorter maturities are higher than the yields for longer maturities
the investors prefer the lower yield on the investments with a longer maturity. This is due to the fact
that investors expect the economy to slow down in the next years. As a consequence yields in the next
years will drop below the yields that investors can earn on a longer time horizon.

Figure 2 The zero curve of 1 July 2008 and 1 July 2011 are plotted. The zero curve consists of zero rates,
a detailed description of zero rates and how these have been calculated can be found in Appendix A.
Both curves start in the origin, the horizontal axis displays the time to maturity of the interest rates. The
black line represents the zero curve of 1 July 2008 and the blue line represents the zero curve of 1 July
2011.

30
Interest rates are an import input factor in the calculation of swaption values. By selecting two different
types of yield curves the influence of these yield curves on short-term interest rate models and swaption
values can be investigated. The observed rates are extracted from Thomson Reuters DataStream and are
presented in Appendix C.

The other part of the data consists of the implied volatilities for the swaptions. The implied volatility is
the volatility that is implied from the swaption price by the Black-76 model for an at-the-money
swaption. More specifically, the implied volatility for a given swaption is the volatility which ensures that
the theoretical swaption price that is obtained by means of the Black-76 model matches the market
price of the specified date. The Black-76 model requires several input parameters to compute the
theoretical price of a swaption. All parameters except the implied volatility are fixed in the sense that
there is no discussion about these parameters. For example the time to expiration, the discount factors
and the forward swap rate are given. Once all these parameters are known the implied volatility is set
such that the theoretical value of the swaption equals the market price. Hence the implied volatility is
affected by the time to expiration, the price of the swaption, the current yield curve and the strike level
of the swaption. Swaptions with maturities of one to ten, fifteen and twenty years and a time to
expiration of one month, two months, three months, six months, twelve months, eighteen months and
two to ten years are considered. The implied volatilities for these swaptions are obtained from Thomson
Reuters DataStream for 1 July 2008 and 1 July 2011. The implied volatilities can be found in Appendix D.
In general implied volatilities are higher in a bear market than in a bull market. This is due to the fact
that investors face more risk in a bear market. This can also be seen from Figure 3 and Figure 4 which
plot the volatility surface of 1 July 2008 and 1 July 2011 respectively. From these figures it can be
observed that the implied volatility for an at-the-money swaption increases as the time to expiration of
the swaption decreases. Furthermore it can be seen that the implied volatility increases as the maturity
of the underlying swap decreases. It should be noted that for both dates the implied volatility decreases
when a swaption has a very short time to expiration in combination with a short maturity. Note that the
implied volatilities from 1 July 2011 are higher than those of 1 July 2008 for all possible combinations of
time to expiration of the swaption and the maturity of the underlying swap.

31
 Figure 3 The volatility surface of 1 July 2008. The surface consists of a finite number of mid implied
volatilities for at-money-swaptions. Mid implied volatilities are computed based on the mid-point
between the bid and the ask prices. The volatilities can be found in Appendix C. The x-axis denotes the
time to expiration of the swaption, the y-axis represents the time to maturity of the underlying swap
and the z-axis indicates the height of the implied volatility. It should be noted that the z-axis starts at ten
percent.

Figure 4 The volatility surface of 1 July 2011. The surface consists of a finite number of mid implied
volatilities for at-money-swaptions. Mid implied volatilities are computed based on the mid-point
between the bid and the ask prices. The volatilities can be found in Appendix C. The x-axis denotes the
time to expiration of the swaption, the y-axis represents the time to maturity of the underlying swap
and the z-axis indicates the height of the implied volatility. It should be noted that the z-axis starts at ten
percent.

32
 6. Swaption valuation

The previous chapters introduced the relevant background. We are now able to move the discussion
forward towards the calculation of swaption values. This section will describe in detail how swaptions
can be valued using the different short rate models that have been discussed. The first model that was
introduced in Section 3.3 is the Black-76 model. In practice this model is heavily used to value swaptions.
Since this model has been treated thoroughly and its application is straightforward the model will only
be discussed briefly in this section. Furthermore, Section 4 introduced short-term interest rate models.
These models can also be used to value swaptions. Application of these models is however less
straightforward. Before such a model can be used it has to be calibrated to market data. This topic will
be discussed in section 6.4. Another theme that needs to be dealt with is the risk-neutral measure.
Section 3.3 derived straightforward formulas for the Black-76 model in case a portfolio of zero-coupon
bonds is used as numéraire. Note however that results for the short-term interest rate models in Section
4 have been derived with the money-market account as the numéraire. Now the numéraire dependent
pricing formula tells us that the price of an attainable contingent claim can be calculated under any
numéraire, given the numéraire is competent. Moreover, we are free to choose which numéraire to use.
Note however that a change of numéraire has consequences for the expectation and the variance of the
short-term interest rate. It turns out that the valuation of swaptions can be simplified by choosing a
different numéraire. The choice of a convenient numéraire will be the topic of Section 6.3.

This section will discuss how each model will be used to value swaptions. As stated before day count
conventions, bank holidays and leap years are ignored for simplicity. The derivation of a forward curve
and the relevant formulas can easily be extended such that these features can be taken into account. In
Section 3.4 it has been stressed that a forward curve is needed for the calculation of swaption values.
The forward curves that have been used in this thesis are derived as explained in Appendix A. The at-
the-money swaption strike rates are calculated according to the definition that is presented in Section
2.2, more on this in section 6.1. Results of the various calculations are presented in Section 7.

The rest of this section is set-up as follows. Section 6.1 will discuss the at-the-money strike rates. In
practical cases the strike rate is specified in the contract. In this thesis however the at-the-money strike
rates are used to value swaptions. Note that the strike rates are an input factor in both the Black-76
model and in the stochastic interest rate models. Since the forward curve has been derived the Black-76
model can be applied once the at-the-money strike rates are known. Exactly this is the subject of Section
6.2. The section shows how to value the swaptions in the considered datasets; for brevity the results
have been moved to the appendix. Then we also want to value swaptions with stochastic interest rate
models. As hinted, application of such models is however less straightforward. Before these models can
be applied we have to deal with the choice of the numéraire and the calibration of the model. Both
topics will be dealt with in respectively Section 6.3 and 6.4. Application of the short rate models is
postponed to the next chapter.

Before commencing this section with the determination of the at-the-money strike rates first of all the
used computation techniques will be discussed. This thesis covers various calculations like the

33
computation of the market implied forward curve and the valuation of swaptions under the Black-76
model and under short-term interest rate models. Once chosen how to derive a forward curve its
derivation is straightforward. This also applies to the valuation of swaptions under the Black-76 model.
Hence these calculations are not very challenging. However the valuation of swaptions under a
stochastic interest rate model is more complicated. Section 6.3 will show that in case of the G2++ model
a closed form solution for the price of a swaption is present; in case of the Vasicek and the Hull and
White one-factor model the price of a swaption is obtained by means of simulation. Hence, once the
parameters for these models are set one can make use of Monte Carlo simulation. But then first these
parameters have to be determined, this is done by means of calibration; more on this in Section 6.4.
Calibration of a stochastic interest rate model is far more time consuming than the actual computation
of a swaption value. During computations it turned out that calibrating these models by means of the
Monte Carlo method yields disproportionate calculating times. Numerical integration turned out to be a
solution to this problem. Therefore the calibration is done by means of numerical minimization. For this
purpose use is made of the function NMinimize which is available in Mathematica12. In turn the
calculation of swaption values is done by simulation. Use is made of the Monte Carlo method with
100.000 runs for each swaption value.

6.1 At-the-money strike rates

Both the Black-76 model and the short-term interest rate models require the input of the fixed rate. As
was briefly mentioned before, this thesis is not concerned with the pricing of certain contracts but with
the pricing of swaptions in general. For this purpose swaptions with different maturities and tenors have
been valued. Since there is no contract that specifies the fixed rate that would apply to a particular
swaption the at-the-money strike rates have been calculated. Recall that the at-the-money fixed rate for
a swaption can be calculated as follows

( ) ( )
∑ ( )(
.
)
(6.1)

As stated in Section 5 swaptions with maturities from one to ten, fifteen and twenty years and a time to
expiration of one month, two months, three months, six months, twelve months, eighteen months and
two to ten years are considered. The at-the-money strike rates for these swaptions have been calculated
for both datasets; 1 July 2008 and 1 July 2011. The rates can be found in Appendix E. From the tables in
the appendix one can immediately see the impact of the change in interest rates. In Section 5 it was
observed that the interest rates decreased significantly between 1 July 2008 and 1 July 2011. As a
consequence the at-the-money strike rates have decreased dramatically as well. Note that the decrease
of interest rates had a more significant influence on the strike rates for swaptions with a shorter time to
expiration and a shorter tenor. From a practical viewpoint this change can be analyzed as follows. In
most cases clients are the owner of a payer swaption and hence will be obliged to make fixed interest
payments if they exercise the option. The drop of interest rates from July 2008 to July 2011 resulted in

12
For each calibration different algorithms and combinations of algorithms have been used. Every optimization is
performed once without specifying an algorithm. Mathematica will then use the (combination of) algorithm(s) that
it thinks is most suitable. Then it is tried to improve this optimal value. For this purpose a Simulated Annealing
algorithm is used and different starting values for the parameters are considered.

34
payer swaptions that are deeply out-of-the money. Owners are stuck with swaptions that have relatively
high strike rates.

6.2 The Black-76 model

The Black-76 model has been discussed extensively in Section 3.3 hence here only a brief overview of
the model will be given. The Black-76 model that is used to value swaptions can be stated as follows

∑ ( ) ( ) ( ) ( ) (6.2a)

( ( ) )
(6.2b)
√

√ . (6.2c)

The application of this model is easy and straightforward, which is an important advantage of the model.
Once one has constructed a forward curve the price of the zero-coupon bonds and hence also of the
forward swap rate can be determined. The volatility can for example be extracted from Thomson
Reuters and the fixed rate is normally specified in the contract. However this thesis is not concerned
with the pricing of swaption contracts hence at-the-money strike rates have been calculated and these
will serve as the fixed rates. The model as specified above is applied to both datasets, 1 July 2008 and 1
July 2011. The implied volatilities have been discussed in Section 5 and are presented in Appendix D, the
at-the-money strike rates are calculated according to equation (6.1). The prices of the swaptions with
maturities from one to ten, fifteen and twenty years and a time to expiration of one month, two
months, three months, six months, twelve months, eighteen months and two to ten years are presented
in Appendix F, the corresponding volatility surface can be found in Section 5.

6.3 Short-term interest rate models: the choice of a convenient numéraire

Let us now move the discussion to the short-term interest rate models. As stated in the introduction of
this section two important issues have to be discussed, calibration and the choice of a convenient
numéraire. This subsection will deal with the choice of the numéraire that will be used during the
calculations. As was hinted in the introduction of this section and more thoroughly in Section 3.2 the
numéraire dependent pricing formula allows us to use any numéraire to value an attainable contingent
claim. As a consequence we are free to choose a numéraire, hence it is advisable to choose a numéraire
that simplifies the calculations. Recall that the NDPF and the value of a payer swaption are respectively
given by
( )
(6.3)
( ) ∑ ( ). (6.4)

Here denotes the value of the attainable contingent claim at time , ( ) represents the payoff
of the contingent claim at time , represents any numéraire and is the expectation under the
probability measure corresponding to the numéraire . Of course the value of the payer swaption at
time is given by equation (6.4). Therefore we want to choose a numéraire that simplifies the

35
calculation of (6.3) given that the attainable claim is a payer swaption. Below the choice of a convenient
numéraire for the considered models will be stated separately. Note that the derivations in Section 4
have been done with the money-market account as the numéraire. As a consequence the expectation
and the variance of short-term interest rate that have been stated in Section 4 are derived with the
money-market account as the numéraire. Next to the money-market account the zero-coupon bond and
a portfolio of zero-coupon bonds similar to the numéraire that was used to obtain the value of a
swaption in the Black-76 model will be considered. Before continuing let us take a closer look at
equation (6.3) and (6.4). Recall the definition of the money-market account13. When using the money-
market account as the numéraire we are left with an integral in equation (6.3). It is still possible to
compute this expectation but it turns out that things can be simplified by taking a zero-coupon bond or
a portfolio of zero-coupon bonds as the numéraire.

Let us focus on taking the zero-coupon bond as the numéraire, ( )14. As a consequence
equation (6.3) becomes15

( ) ( ) ∑ ( ). (6.5)

Here denotes the probability measure that corresponds with the numéraire ( ). From the
equation above it can be seen that the value of a payer swaption, under this numéraire, depends solely
on the value of zero-coupon bonds.

Let us now focus on the zero-coupon bonds. In Section 4 analytical formulas for the price of a zero-
coupon bond under the different models have been stated. Note that in case of the Vasicek and the Hull
and White one-factor model the value of a zero-coupon bond depends on the short-term interest rate
whereas this is not the case in case of the G2++ model16. Since the price of a zero-coupon in case of the
G2++ model does not depend on the short-term interest rate a closed form solution is present. However
in case of the Vasicek and the Hull and White model the value of the short-term interest rate has to be
known, for this purpose use is made of simulation. The values for the short-term interest rate are drawn
from a normal distribution. It is important to realize that the expectation and the variance of the short-
term interest rate change with a change of numéraire. Hence, when using the zero-coupon bond as the
numéraire one has to determine the expectation and the variance of the short-term interest rate under
this numéraire. It turns out that taking a portfolio of zero-coupon bonds as the numéraire, as was done
in the derivation of the Black-76 model, does not further simplify the price of a payer swaption. Hence
calculations for the short-term interest rate models will be performed with the zero-coupon bond as the
numéraire. The corresponding probability measure will be denoted by . Before it is possible to
perform calculations the dynamics under have to be calculated. A detailed description of the
derivation of these quantities is presented in Appendix G. More on this in the subsections below that

13
Recall equation (2.2): ( ) (∫ ).
14
Note that denotes the date at which the floating interest rates that applies to payment date is set. In other
words, is exactly one period before .
15
Note that ( ) for every .
16
See equations (4.11), (4.22) and (4.29a).

36
will elaborate on the derivation of the dynamics under a different numéraire. Note that in case of the
Vasicek and the Hull and White one-factor model we have to determine the expectation and the
variance of the short rate under . Whereas in case of the G2++ model we are interested in explicit
solutions for the processes ( ) and ( ) under .

6.3.1 The Vasicek model

Our interest is in calculating the expression given by equation (6.5). The values of the necessary zero-
coupon bonds can be determined with equations (4.11), (4.12) and (4.13). Note from equation (4.11)
that the value of the zero-coupon bond depends on the value of the short-term interest rate. As a
consequence the value of the short-term interest rate at every payment date of the underlying swap has
to be known. The values for the short-term interest rate are drawn from a normal distribution, the mean
and variance will be stated below. Before this mean and variance can be stated one has to realize that
the expectation and variance that have been stated in Section 4.1 have been derived with the money-
market account as the numéraire. Hence they are not applicable to the current situation, as stated
above ( ) is used as the numéraire. This has consequences for the expectation and the variance of
the short-term interest rate. To come to the correct expectation and variance a change of numéraire
from the money-market account to the zero-coupon bond has to be made. The expectation and the
variance of the short rate when ( ) is used as the numéraire are

( ) ( ) ( )
( ) ( )( ) ( ) (6.6)

( ) ( ). (6.7)

The derivation has been moved to Appendix G for brevity.

6.3.2 The Hull and White one-factor model

Like the Vasicek model the Hull and White one-factor model is a short-term interest rate model hence
the valuation of swaptions is similar. The only difference with the Vasicek model is that the price of a
zero-coupon bond is determined by different formulas, see equations (4.22), (4.23) and (4.24). Again the
values for the short-term interest rate are drawn from a normal distribution. These values can then be
used to determine the prices of the zero-coupon bonds. Once the price of the zero-coupon bond on
every payment date of the underlying swap is known the value of the swaption is calculated according
to equation (6.5). As has been stressed in case of the Vasicek model it is not possible to use the
expectation and the variance of the short-term interest rate that have been stated in Section 4.2 since a
different numéraire is used. The expectation and the variance that are found in case of the Hull and
White one-factor model after a change of numéraire is performed are as follows

( ) ( ) ( ) ( )
( ) ( ) (6.8)

( ) ( ). (6.9)

The derivation has again been moved to Appendix G for brevity.

37
 6.3.3 G2++ model
As was hinted the valuation of swaptions with the G2++ model is not the same as in case of the Vasicek
and Hull and White one-factor model. In case of the G2++ model the price of a zero-coupon bond
depends on the value of ( ) and ( ). Hence the expectation and the variance of the short-term
interest rate under does not necessarily need to be derived. Instead we are interested in explicit
solutions for the processes ( ) and ( ) under . With these explicit solutions at hand the prices of
the relevant zero-coupon bonds can be determined and the value of a swaption can be calculated
according to equation (6.5). The price of a zero-coupon bond in case of the G2++ model and the
dynamics of ( ) and ( ) under the money-market account can respectively be found in equations
(4.29a), (4.25a) and (4.25b). The solutions for ( ) and ( ) under are as follows

( ) ( ) ( ) ( )
( ) ( )
( ) ( )( )
( )
∫ (6.10)

( ) ( ) ( ) ( )
( ) ( )
( ) ( )( )
( )
∫ . (6.11)

The derivation has again been moved to Appendix G for brevity.

6.4 Calibration
The previous sections elaborated on the valuation of swaptions under short-term interest rate models.
As a consequence it is possible to calculate the value of a variety of swaptions. With this in mind the
concept of calibration will be discussed. So far the discussion about the choice or determination of the
parameters in a stochastic interest rate model has been postponed. Previously it has been assumed that
the model parameters are given. This subsection will discuss how these parameters can be determined;
this process is referred to as calibration. The purpose of the calibration is to fit the model as closely as
possible to observable market data. Usually cap or swaption volatilities are taken into account but also
the initial term structure can be used for this purpose. In a sense the user of the model is free to choose
which data is used for the calibration. To fit the model as closely as possible to the chosen market data
one has to minimize the errors. Of course there are several possibilities; here it was decided to follow
Hull and to minimize the sum of squared errors. The errors are defined as the difference between the
calculated swaption value resulting from the short-term interest rate model under consideration and
the Black-76 model. The sum runs from one to a total of calibration instruments. A calibration
instrument in this setting should be interpreted as a piece of market information. For example, in case
the model is calibrated against five quoted swaption volatilities there are a total of five calibration
instruments. The model parameters will then be set such that the sum of squared errors is minimized.
To solve this minimization use is made of Mathematica. Formally this can be formulated as follows

∑ ( ) . (6.12)

38
Here denotes the value of payer swaption that has been valued according to the
Black-76 method, in turn denotes the value of payer swaption that has been valued
according to the stochastic interest rate model under consideration. The parameters found by the
calibration can then be used to price different swaptions. Of course there are many possibilities to
calibrate the model. In Section 7 results of different calibrations will be presented, moreover the
consequences of calibrating with different data will be analyzed and it will turn out that there exists a
more promising minimization objective.

39
 7. Results

So far the theoretical background and the models have been discussed. Finally the models can be used
to price swaptions. In the previous sections the Black-76, the Vasicek, the Hull and White one-factor and
the G2++ model have been introduced. In this section we will investigate the capabilities of these
models to price swaptions. Each stochastic interest rate model is discussed in its own subsection. In
these sections the capabilities and the limitations of these models are investigated. A fourth subsection
is concerned with the pricing of non-quoted swaptions.

For a number of swaptions the implied volatilities are quoted in for example Thomson Reuters. Here, for
simplicity, it is assumed that swaptions that have a quoted volatility are actively traded. Hence for these
swaptions the Black-76 model is assumed to give correct market prices. Moreover, the swaption prices
resulting from the quoted swaptions that are obtained by the Black-76 model for the stated swaptions
will be used as reference prices and calibration instruments; more on this later on. This section will not
only investigate the capabilities and the limitations of the models but also the ability to price non-
quoted swaptions. As stated the implied volatilities for a broad class of swaptions is known. However
the number of quoted implied volatilities is limited. For example, a swaption with a maturity of ten or
fifteen years is quoted but no intermediate quotes exist. How to value a swaption with a tenor of eleven
or twelve years? Since no implied volatility is quoted we can no longer directly apply the Black-76
method. Of course one could take some sort of intermediate point between the quotes of a swaption
with a maturity of ten and fifteen years. This method could even be extended by taking into account
more quoted implied volatilities and by using a first or even a second order derivative. However one
could also use a stochastic interest rate model for this purpose. Applying stochastic interest rate models
to such a situation is the subject of Section 7.4.

The rest of this section is structured as follows. Section 7.1 will investigate the capabilities, or rather the
limitations of the Vasicek model. For this purpose different calibrations are performed. Then Section 7.2
and 7.3 will respectively investigate the capabilities of the Hull and White one-factor model and the
G2++ model. Ultimately Section 7.4 will investigate the pricing of non-quoted swaptions. For this
purpose swaptions with a time to expiration of ten years combined with a tenor of ten up to fifteen
years are considered.

Before continuing with Section 7.1 a few last remarks. Two datasets are used, namely the yield curve
and the swaption volatility surface of 1 July 2008 and 1 July 2011. For a detailed description of the data
one is referred to Section 5. Furthermore, valuations and calibrations can be done with and without
calibrating ( ). One can discuss whether ( ) should be a free parameter or not. If one does not
calibrate ( ) the parameter can be set equal to the EONIA or one of the Euribors. Since ( ) is
interpreted as the interest rate at which one can borrow money for an infinitesimally short period of
time ( ) will be set equal to the EONIA if it is not calibrated to market data.

40
 7.1 The Vasicek model
As stated in the introduction the capabilities of the interest rate models will be investigated before they
are used to price non-quoted swaptions. Before the Vasicek model can be applied it first has to be
calibrated to market data. In this subsection the results of different calibrations will be presented. The
Vasicek model has three parameters , and . Additionally ( ) can be calibrated, this would result in
four model parameters. To investigate the capabilities of the Vasicek model different calibrations will be
performed. For each scenario the calibration will be performed twice, once the calibration will include
( ) and once ( ) will be set equal to the EONIA before the calibration is performed. One should note
that the Vasicek model is limited due to its number of model parameters. The purpose of this subsection
is to show the limitations of the Vasicek model. Because of its limited number of model parameters the
Vasicek model cannot be expected to give a proper fit to the market data. At least not when the entire
yield curve or swaption volatility surface is regarded. Before presenting the results two calibration
scenarios will be described. Since this thesis considers the pricing of swaptions the model will be
calibrated with the entire swaption volatility surface. In a second scenario the model is calibrated to the
initial yield curve.

The following two subsections will confirm the expectations regarding the Vasicek model. The model is
unable to fit the observed market data. This is the reason why all calibrations have been performed
twice. In a second run ( ) has been used as an extra model parameter. Calibrating ( ) however
results in new issues as we will see below. More scenarios than will be presented have been carried out.
For example calibrations to different sets of discount factors and implied volatilities as well as
combinations of these have been performed. The reason for the limited presentation is that the
conclusion of the different calibrations is the same, the model is incapable of fitting the initial yield
curve properly. Since the model is not able to fit the initial yield curve it is useless to price swaptions or
any other interest rate product. Both forward rates and discount factors would deviate and this results
in unsatisfactory results. The purpose of the two subsections below is to illustrate the limitations of the
Vasicek model.

7.1.1 Calibration of the swaption volatility surface

In this subsection the Vasicek model is calibrated to the observed swaption volatility surface. Actually
this section consists of four different scenarios. Two datasets are considered, that of 1 July 2008 and 1
July 2011. For both volatility surfaces two calibrations are performed. Once ( ) is used as a model
parameter, in the other scenario ( ) is set equal to the EONIA. A total of 192 implied volatilities are
observed for both data sets. These volatilities are then used as calibration instruments, the calibration
error is minimized by the sum of squared errors. Since the results are illustrative the resulting tables and
figures have been moved to Appendix H. The results of the different calibrations can be found in Table 8.
Furthermore yield curves have been generated and compared to the initial yield curves; plots can be
found in Figures 3 and 4. From these figures it can be observed that the fitting is poor. The simulated
yield curves for both datasets are not even close to the actual observed yield curve. From this it can be
concluded that the Vasicek model is not able to value swaptions satisfactory if its calibrated to the
swaption volatility surface. Moreover another known limitation of the model can be observed from

41
Figure 3. The Vasicek model is unable to reproduce an inverse yield curve. Of course 192 calibration
instruments are far too much for the Vasicek model, exactly this is what illustrated by these calibrations.

7.1.2 Calibration of the initial yield curve

In this subsection the Vasicek model will be calibrated to the initial yield curve. As discussed before, the
model is limited due to its amount of parameters. Therefore it is useful to discuss which points of the
yield curve should be used as reference points. In other words, how many calibration instruments
should be used. This subsection will investigate four different scenarios. First of all the model will be
calibrated with a total of twenty calibration instruments17. These twenty points coincide with the points
that are used to construct the initial yield curve. For a detailed description of these points and the
construction of the yield curve one is referred to Appendix A. As will be concluded later on, the model is
not capable to give a proper fit to the data when twenty calibration instruments are used. Hence in the
latter three scenarios the model is calibrated with fewer instruments. An interpretation of the current
yield curve is commonly obtained by observing the 3-month Euribor and the 10-year IRS. Exactly those
two points will be the calibration instruments in the second scenario. In the third scenario the 30-years
IRS is added as a third calibration instrument. Finally, in scenario 4 the model will be calibrated to five
points of the initial yield curve; namely the EONIA, the 3-month Euribor and the 1, 10 and 30-year IRS.
The calibration instrument that will be used in the four different scenarios can be summarized as follows

I. All twenty maturities that coincide with the construction of the yield curve18.
II. 3-month Euribor and 10-year IRS.
III. 3-month Euribor, 10-year IRS and 30-year IRS.
IV. 3-month Euribor, 1-year IRS, 10-year IRS, 30-year IRS and 50-year IRS.

The results are presented in four different tables. The results for the yield curve of 1 July 2008 and 1 July
2011 are presented in different tables. Also the calibrations are performed with ( ) as an extra
calibration instrument, these results are presented in other tables. Again, for brevity and due to the
illustrative nature of these calibrations the results are presented in Appendix H. Table 9 and 10 contain
the results of the four different scenarios for the 2008 dataset where ( ) has been calibrated to market
data and set equal to the EONIA respectively. Furthermore Table 11 and 12 contain the results of the
four different scenarios for the 2011 dataset where ( ) has been calibrated to market data and set
equal to the EONIA respectively. Furthermore these results have been used to simulate yield curves. For
each scenario in both datasets a yield curve has been generated and has been compared to the initial
yield curve. The results are presented in Figures 5, 6, 7 and 8 below; note that the corresponding model
parameters are presented in Appendix H.

17
Note again that the number of model parameters is limited and the model cannot be expected to give a proper
fit to the data.
18
For a detailed description see Chapter 5 and Appendix A.

42
 Figure 5 The zero curve of 1 July 2008 and simulated zero curves based on the calibration results
presented in Table 9. r(0) has been calibrated to market data. The black line represents the zero curve of
1 July 2008. The other lines represent zero curves according to the Vasicek model. The blue, red, green
and yellow line are respectively based on scenario I, II, III and IV.

Figure 6 The zero curve of 1 July 2008 and simulated zero curves based on the calibration results
presented in Table 10. r(0) is set equal to the EONIA. The black line represents the zero curve of 1 July
2008. The other lines represent zero curves according to the Vasicek model. The blue, red, green and
yellow line are respectively based on scenario I, II, III and IV.

43
From the calibrations various observations can be made. First of all recall the different shapes of the
yield curves of both datasets. Figure 5 and 6 confirm that the Vasicek model is unable to reproduce an
inverse shaped yield curve. Moreover it can be concluded that the results of the calibrations are
unsatisfactory. The simulated yield curves exhibit gross abnormalities compared to the observed yield
curves. Next consider the calibration of ( ) to market data. From Figures 7 and 8 it can be seen that the
calibration results for the yield curve of 2011 are almost similar. This implies that it makes little
difference whether ( ) is calibrated or set equal to the EONIA when a humped shaped yield curve is
considered. This observation is more or less confirmed by the results of the calibrations. The calibration
results of ( ) are close to the EONIA. However when we regard the results for the inverse shaped yield
curve of 2008 different results are observed. From Figures 5 and 6 it can be seen that the results for all
four scenarios are very different when ( ) is calibrated to the market data. Table 9 that presents the
calibration results of 2008 when ( ) is used as a model parameter shows that the resulting parameter
values of ( ) are high. In Scenario 2 and 4 ( ) is even higher than the long term average. Observe in
Figure 5 that this leads to unsatisfactory results due to a high starting point of the yield curve caused by
the high value of ( ).

Figure 7 The zero curve of 1 July 2011 and simulated zero curves based on the calibration results
presented in Table 11. The black line represents the zero curve of 1 July 2011. The other lines represent
zero curves according to the Vasicek model. The blue, red, green and yellow line are respectively based
on scenario I, II, III and IV.

44
 Figure 8 The zero curve of 1 July 2011 and simulated zero curves based on the calibration results
presented in Table 12. The black line represents the zero curve of 1 July 2011. The other lines represent
zero curves according to the Vasicek model. The blue, red, green and yellow line are respectively based
on scenario I, II, III and IV.

7.2 The Hull and White one-factor model

Similar to the previous subsection this section will investigate the capabilities of the Hull and White one-
factor model. Compared to the Vasicek model however there are some differences. First of all, the Hull
and White one-factor model fits the initial yield curve by definition of . Hence points of the initial yield
curves do not have to be used as additional calibration instruments. Moreover, since the model has a
time-varying parameter its capabilities are more promising. In Section 7.2.1 the model will be calibrated
to the swaption volatility surface; again a calibration for both datasets will be executed. Unlike in case of
the Vasicek model ( ) will not be used as an additional calibration parameter. First of all, one extra
model parameter will not greatly enhance the fitting capabilities of this model. Moreover results from
the Vasicek model showed that the fitting is not necessarily improved by calibrating ( ) to market data.
In more detail, from Figure 5 in Appendix H it can be observed that calibrating ( ) in case of an inverse
yield curve leads to a high value for ( ) while this is not desirable. These findings have led to a
calibration without ( ). Instead ( ) has been set equal to the EONIA for the same reasons as
mentioned before. A second subsection will then investigate the minimization objective. So far the sum
of squared errors of the difference between swaption prices calculated with the Black-76 model and the
stochastic interest rate model under consideration has been the minimization objective. Section 7.2.2
investigates an alternative minimization objective.

7.2.1 Calibration of the swaption volatility surface

This subsection discusses the calibration of the Hull and White one-factor model to the entire swaption
volatility surface. Two calibrations have been performed, one for each dataset. The sum of squared
errors of the difference between swaption prices calculated with the Black-76 model and the Hull and

45
White one-factor model is minimized. In both cases all swaptions in the database have been used. The
at-the-money strike rates and the swaption prices according to the Black-76 model can respectively be
found in Appendix E and F. The value of the swaptions are calculated according to equation (6.5); the
expectation and the variance of the short-term interest rate can be found in Section 6.3.2. The results of
the calibrations are stated in Table 13.

Table 13 Calibration results for the Hull and White one-factor model. The top row indicates the
parameters as specified in Section 4.2. In the most left column the dataset is specified. The model has
been calibrated with the entire swaption volatility surface. For a detailed description of the considered
volatility surface the reader is referred to Section 5.

Dataset a σ
1 July 2008 0,08723 0,03202
1 July 2011 0,09426 0,03603

Since the model fits the initial yield curve by construction it is superfluous to simulate a yield curve with
the calibrated model parameters. Meanwhile these parameters have been used to simulate swaption
prices. For both datasets the parameters in Table 13 have been used to value all swaptions in the
dataset. The swaptions have been valued using equation (6.5), the expectation and the variance of the
short-term interest rate can be found in equations (6.8) and (6.9) respectively. Due to the enormous
amount of swaptions, solely for this purpose, the number of Monte Carlo simulations has been reduced
by a factor ten resulting in 10.000 Monte Carlo simulations per swaption. The simulated swaption values
are presented in Appendix I. Table 14 and 15 respectively contain the simulated swaption values
according to the parameters as presented in Table 13 for the 2008 and 2011 dataset. These simulated
swaption values have been used to analyze the capabilities of the Hull and White one-factor model. For
this purpose the deviation between the Hull and White one-factor simulated price and the
corresponding Black-76 model price for every swaption has been calculated. The results for the 2008
and 2011 dataset are respectively presented in Figure 9 and 10 below. One should note the layout of the
z-axis which represents the deviation in percentages of the simulated price from the price that is implied
by the Black-76 model. From these figures it can be observed that the prices are matched accurately for
most of the swaptions. However both for swaptions with a short tenor and for swaptions with a short
time to expiration the results are very poor. From this it can be concluded that the Hull and White one-
factor model is not capable of reproducing an entire swaption volatility surface. This does not need to
imply that the model itself is useless as we will see below. The poor fit of the swaptions with a short
tenor and those with a short time to expiration could be caused by the minimization objective; exactly
this will be investigated in the next subsection.

46
Figure 9 This figures presents the deviation of the simulated swaption prices from the prices implied by
the Black-76 model in percentages for the 1 July 2008 dataset. Swaption prices are simulated with the
Hull and White one-factor model, the considered parameters are stated in Table 13.

Figure 10 This figures presents the deviation of the simulated swaption prices from the prices implied by
the Black-76 model in percentages for the 1 July 2011 dataset. Swaption prices are simulated with the
Hull and White one-factor model, the considered parameters are stated in Table 13.

7.2.2 The minimization objective

In this section we will investigate the consequences of and the alternatives for the current minimization
objective. Before a stochastic interest rate model can be applied it has to be calibrated to market data.
When calibrating such a model some kind of error has to be minimized. As discussed in Section 6.4 and
in the previous paragraph the sum of squared errors of the difference between swaption prices
calculated with the Black-76 model and the considered stochastic interest model is minimized. Now
observe from Figure 9 and 10 that the simulated swaption prices for swaptions with a short tenor and
for swaptions with a short time to expiration are unsatisfactory. The poor results for these swaptions

47
could be caused by the minimization objective. Notice from Table 6 and 7 in Appendix F that the
swaption prices from swaptions with a short tenor and for those with a short time to expiration are very
low compared to those with long tenors and a longer time to expiration. Of course, with the current
minimization objective, the error on a swaption with a low price will only have a small impact on the
total sum of squared errors. On the other hand, the error on a swaption with a high price will have a
large impact on the total sum of squared errors. Hence, the minimization objective focusses on setting
the model parameters such that swaptions with a higher price are perfectly matched. This influences the
fit of the swaptions with a lower price. Exactly this can be observed from Figure 9 and 10. Therefore I
want to investigate the consequence of another minimization objective than the one that is suggested
by Hull (2008).

Hull states that the sum of squared errors of the difference between the market price and the model
price is a popular goodness-of-fit measure. However the previous analysis questions the choice of this
minimization objective. As a counter proposal the sum of squared errors of the percentage difference
between the swaption prices implied by the Black-76 model and the Hull and White one-factor model
can be minimized.
In this subsection the influence of the minimization objective will be investigated. The ‘new’
minimization objective that minimizes the sum of squared errors of the percentage difference will be
referred to as the alternative minimization objective. Two different analysis have been made. The
results are presented in Table 16 and 17 and Figure 11 and 12 below.
First of all the Hull and White one-factor model has been calibrated with the entire swaption
volatility surface and by making use of the alternative minimization objective. The results are presented
in Table 16, in order to compare the results the calibrated model parameters from the previous
subsection are presented as well. From Table 16 it can be observed that the choice of the minimization
objective has serious consequences for the resulting model parameters.

Table 16 Calibration results for the Hull and White one-factor model. The top row indicates the
parameters as specified in Section 4.2. In the most left column the dataset is specified. (alternative)
indicates that the alternative minimization objective has been used. The model has been calibrated with
the entire swaption volatility surface.

Dataset a σ
1 July 2008 0,08723 0,03202
1 July 2011 0,09426 0,03603
1 July 2008 (alternative) 0,11527 0,03961
1 July 2011 (alternative) 0,10472 0,04165

In addition to the analyses of the entire swaption volatility surface an alternative analysis has been
performed. For this purpose a smaller set of swaptions is used. Swaptions with a time to expiration of
one year and with a tenor of one to ten, fifteen and twenty years are considered. Again both datasets
are considered. Four calibrations and simulations have been performed. For both datasets the Hull and
White one-factor model is calibrated twice. Once the minimization objective is the sum of squared
errors of the difference between swaption prices calculated with the Black-76 model and the Hull and

48
White one-factor model and once the minimization objective is sum of squared error of the percentage
difference between the swaption prices implied by the Black-76 model and the Hull and White one-
factor model. This results in four sets of model parameters. These parameters are presented in Table 17
below.

Table 17 Calibration results for the Hull and White one-factor model. The top row indicates the
parameters as specified in Section 4.2. In the most left column the dataset is specified. (alternative)
indicates that the alternative minimization objective has been used. The model has been calibrated with
swaptions with a time to expiration of one year and with tenors of one to ten, fifteen and twenty years.

Dataset a σ
1 July 2008 0,09771 0,03907
1 July 2011 0,05152 0,03521
1 July 2008 (alternative) 0,12206 0,04211
1 July 2011 (alternative) 0,12944 0,04781

From Table 17 it can again be observed that the alternative minimization goal leads to different model
parameters. Of course varying model parameters have consequences for the model and hence also for
the valuation of swaptions. Furthermore the presented model parameters from Table 17 have been
used to value the exact same set of swaptions. This time the swaption prices are not presented,
alternatively the swaption prices have been inverted to implied volatilities; the results are presented in
Figure 11 and 12. Note that due to the fact that only swaptions with a time to expiration of one year are
considered this results into a curve instead of a volatility surface.

Figure 11 Implied volatilities of swaptions with a time to expiration of one year and a maturity of one to
ten, fifteen and twenty years from 1 July 2008. The black line represents the market volatilities whereas
the blue and the red line represent the implied volatilities implied by the Hull and White one-factor
model. The model is calibrated to the exact same set of swaptions. The blue and the red line represent
calibration with different minimization objectives.

49
Figure 12 Implied volatilities of swaptions with a time to expiration of one year and a maturity of one to
ten, fifteen and twenty years from 1 July 2011. The black line represents the market volatilities whereas
the blue and the red line represent the implied volatilities implied by the Hull and White one-factor
model. The model is calibrated to the exact same set of swaptions. The blue and the red line represent
calibration with different minimization objectives.

From Figure 11 and 12 a few observations can be made. First of all note that for both datasets the Hull
and White one-factor model is not capable of reproducing high implied volatilities for swaptions with
short tenors. However the results from the model that is calibrated with the alternative minimization
objective are slightly better for swaptions with a short tenor. Although the results are far from
satisfactory they are indeed better than in the original case. Furthermore it can be observed that the
results are not very different in case of the 2008 dataset. In case of the 2011 dataset however the
results are clearly improved. Not only are the differences between the market volatilities and the
volatilities that are implied by the model smaller for almost every tenor, also the shape of the curve is
matched better by the model that has been calibrated with the alternative minimization objective. From
these results combined with the theoretical motivation it can be concluded that it is more satisfactory to
calibrate a stochastic interest rate model with the alternative minimization function. That is, minimize
the sum of squared errors of the percentage difference between the swaption prices implied by the
Black-76 model and the stochastic interest rate model under consideration. Hence, from here on the
stochastic interest rate models will be calibrated with the alternative minimization objective.

7.3 G2++ model

In this section the capabilities of the G2++ model will be investigated. Unlike the Vasicek and the Hull
and White one-factor model the G2++ model is a two-factor model. The advantage of a two-factor
model is that it does not imply perfect correlation between interest rates. Moreover, the G2++ model
has five model parameters which improves the possibility that a large set of data points can be fit
properly. Especially the fact that the G2++ model allows for a more realistic correlation structure
increases the expectation of the model capabilities. Still, calibrating an entire volatility surface consisting
of 192 points could be a bit too much for the model to cope with. Furthermore, it turns out that
calibrating a model with five parameters to such a large dataset yields non-negligible calculation times.
This is mainly caused by the fact that it is harder to find the global minimum. Due to this fact and since it
is also interesting to discuss the humped shape of the volatility structure the model will not be

50
calibrated to the entire volatility surface. Instead two different scenarios are considered. In the first
scenario the model will be calibrated to swaptions with a time to expiration of one month. This will
show whether the model is capable of reproducing a humped shaped volatility curve. Second, the model
will be calibrated to a larger set of data. This larger set which will consist of swaptions with varying time
to expiration and tenors allows us to investigate the correlation between interest rates. More
specifically, we can verify whether is unequal to one. If this turns out to be the case then the G2++
model seems a worthy improvement compared to the considered one-factor models.

In both scenarios both datasets will be considered. As minimization objective the sum of squared errors
of the percentage difference between the swaption prices implied by the Black-76 model and the G2++
model is used. The at-the-money strike rates and the swaptions prices according to the Black-76 model
can respectively be found in Appendix E and F. The value of the swaptions are calculated according to
equation (6.5), a detailed description of the model can be found in Section 4.3, solutions for ( ) and
( ) under are presented in Section 6.3.3. Note that just like the Hull and White one-factor model
the G2++ model also fits the initial yield curve by construction.

In our first scenario the G2++ model is calibrated with swaptions with a time to expiration of one month;
all tenors are taken into account. Therefore the model is calibrated with twelve calibration instruments.
Since the model has five parameters a reasonable fit can be expected. A calibration has been carried out
for both datasets, the resulting parameters can be found in Table 18. These parameters have been used
to value the same set of swaptions. Then these swaptions prices are inverted to implied volatilities.
Finally, these volatilities are plotted against the market volatilities. The results are presented in Figures
13 and 14 below.

Table 18 Calibration results for the G2++ model. The top row indicates the parameters as specified in
Section 4.3. In the most left column the dataset is specified. The model has been calibrated to swaptions
with a time to expiration of one month.

Dataset a σ b ρ
1 July 2008 0,00001 0,02032 0,60584 0,19081 -0,45486
1 July 2011 1,09163 0,13374 0,04738 0,04192 0,99097

51
Figure 13 Implied volatilities of swaptions with a time to expiration of one month and a maturity of one
to ten, fifteen and twenty years of 1 July 2008. The black line represents the market volatilities whereas
the blue line represents the implied volatilities implied by the G2++ model. The model is calibrated to
the exact same set of swaptions.

Figure 14 Implied volatilities of swaptions with a time to expiration of one month and a maturity of one
to ten, fifteen and twenty years of 1 July 2011. The black line represents the market volatilities whereas
the blue line represent the implied volatilities implied by the G2++ model. The model is calibrated to the
exact same set of swaptions.

From Figure 13 and 14 different observations can be made. First of all the volatilities are matched
reasonably accurate. Especially when the results are compared to those of the Hull and White one-
factor model, see Figure 11 and 12. However it should be noted that different data is considered.
Furthermore the fit to the 2008 dataset is more satisfactory. More important is to observe that in both
cases the G2++ model produces a so called humped shape volatility structure. One should note that the
volatility curve that is observed in the market is humped shaped as well.

To investigate the capabilities of the model a second scenario is considered. This time more data points
are considered. The reason that this model is not calibrated against the entire swaption volatility surface

52
is the resulting computation time. Hence the model is calibrated with a smaller set of swaptions. The set
of swaptions is chosen so that it is possible to investigate the correlation between interest rates. For this
purpose swaptions with a time to expiration of one up to five year combined with a tenor of one up to
five years are considered. Again calibrations have been performed for both datasets. The model
parameters are presented in Table 19. These parameters have been used to price the swaptions that
have been used as calibration instruments. Then the percentage difference of the swaption prices
implied by the G2++ model and the Black-76 model have been calculated. The results are presented in
Table 20 and 21 below.

Table 19 Calibration results for the G2++ model. The top row indicates the parameters as specified in
Section 4.3. In the most left column the dataset is specified. The model has been calibrated to swaptions
with a time to expiration of one up to five years with tenors of one up to five years.

Dataset a σ b ρ
1 July 2008 0,32729 0,12201 1,03558 0,37824 -0,81011
1 July 2011 0,32752 0,09246 2,76103 0,69744 -0,49835

Table 20 Calculated percentage difference between swaption prices implied by the G2++ model and the
Black-76 model. The table contains results for the 1 July 2008 dataset. The used calibration instruments
correspond to the valued swaptions. In the most left column the time to expiration of the swaption is
presented, furthermore the top row shows the maturity of the underlying swap.

1Y 2Y 3Y 4Y 5Y
1Y 17,07% 4,99% -2,85% -5,83% -5,77%
2Y 0,32% 2,35% 0,91% 1,97% 3,58%
3Y -3,96% 5,75% 1,79% 3,99% 6,25%
4Y -9,33% -2,84% -0,77% 1,89% 3,04%
5Y -14,86% -7,88% -4,83% -2,61% -1,47%

Table 21 Calculated percentage difference between swaption prices implied by the G2++ model and the
Black-76 model. The table contains results for the 1 July 2011 dataset. The used calibration instruments
correspond to the valued swaptions. In the most left column the time to expiration of the swaption is
presented, furthermore the top row shows the maturity of the underlying swap.

1Y 2Y 3Y 4Y 5Y
1Y 26,25% 2,54% 2,17% 1,29% -2,05%
2Y -6,16% 1,91% 7,17% 8,98% 9,74%
3Y -11,69% -2,71% 1,68% 7,70% 6,48%
4Y -19,01% -10,71% -0,74% 1,56% 1,01%
5Y -26,43% -12,79% -7,08% -5,05% -5,80%

From these results several observations can be made. First of all note that the majority of the swaption
prices are matched quite accurately. Furthermore it can be observed that in general the worst fit is

53
obtained for swaptions with a short time to expiration and tenor; these are respectively the first row
and the first column. Recall that this was observed in case of the Hull and White one-factor model as
well. Also it can be seen that the results are better for the 2008 dataset.
It is important to note from Table 19 that is unequal to one. The purpose of these calibrations was
to investigate whether there is perfect correlation between interest rates or not. Since is unequal to
one this is not the case. This means that, despite the fact that the one-factor models imply perfect
correlation between interest rates this is not case. Observe that for both datasets is negative.

7.4 A practical application: valuing non-quoted swaptions

In this subsection an example of a practical application of stochastic interest rate models will be
discussed. In many practical cases one can apply the Black-76 model. There are however situations in
which application of the Black-76 model is not straightforward. As discussed in the introduction of this
section the number of quoted implied volatilities is limited. That is, quotes are available for a large set of
swaptions but not for all possible combinations of time to expirations and tenors. Thomson Reuters for
example presents implied volatilities for swaptions with a time to expiration of ten years combined with
a tenor of ten or fifteen years. But no implied volatility for a swaption with a time to expiration of ten
years and a tenor of twelve years is available. This is just one of many examples. One could also consider
a situation in which the time to expiration of the swaption is for example three years and five months or
any other intermediate time point. For such a swaption no quoted volatility is available while during the
lifetime of the swaption many similar situations will occur. In this subsection we will focus on swaptions
with a time to expiration of ten years and a tenor of ten up to fifteen years. Since the Black-76 cannot be
applied to such situations directly it will be investigated how a stochastic interest rate model can be
applied to this case. Moreover, the results of the G2++ model will be compared to a case in which linear
interpolation is used to determine non-quoted volatilities.

First of all one needs to choose which stochastic interest rate models one wants to use. As we have seen
in the Section 7.1 the capabilities of the Vasicek model are very limited. Also the results of the Hull and
White one-factor model are not completely satisfactory when the swaption volatility surface is
considered. However, the performance of the model is likely be improved in case a smaller set of
swaptions is considered. As we have seen, the results of the G2++ are the most promising. Therefore in
this subsection the G2++ model and the Hull and White one-factor model are considered. The results of
the Vasicek model are simply too poor, therefore it would be inconvenient to apply the model to a
practical case.
Once a model has been chosen other interesting choices have to be made. Before the model can
be used it has to be calibrated to market data. The modeler is free to choose to which data the model is
calibrated. Of course, this choice influences the outcome of the model. Hence such a choice should be
made with great care. Then there is also the choice of the minimization objective. In Section 7.2.2 it was
shown that choosing a different objective results in evident different model parameters. Since the
influence of the selected market data and the choice of the minimization objective on the model
outcome is so large this section prefers a different approach. With this choice the discussion about
which market data should be chosen is avoided.

54
 Since different minimization objectives can be used and there is no given set of calibration
instruments which should be used in a particular case one should focus on price ranges instead of prices.
When estimating one should present a range or a confidence interval instead of a point estimate. The
question is how to determine such a price range. One can combine all sorts of calibration instruments
and those can even be combined with different minimization objectives. This would result in large sets
of model parameters. As a solution to this problem a limited number of calibrations is performed. The
considered minimization objective is in all cases the percentage difference of the swaption prices
implied by the considered short rate model and the Black-76 model. This is due to the fact that this
objective seems to be the most promising; also this has been confirmed by the empirical test of Section
7.2.2 although it should be noted that this survey has been very limited. Finally, to come to price ranges
shocks in the parameters are considered.

The dataset of 1 July 2011 is considered. For both models, the Hull and White one-factor model and the
G2++ model, five calibrations have been performed. The calibration instruments that have been used in
the different scenarios are the following:

I. The entire swaption volatility surface19.

II. Swaptions with a time to expiration of ten years, all available tenors have been used.
III. Swaptions with a time to expiration of ten years and a tenor of ten and fifteen years.
IV. Swaptions with a time to expiration of five up to ten years and a tenor of ten and fifteen
years.
V. Swaptions with a time to expiration of five up to ten years and a tenor of five up to ten,
fifteen and twenty years.

Let us first of all consider the results of the Hull and White one-factor model. The model has been
calibrated to the five different scenarios that are stated above. The resulting model parameters are
presented in Table 22. These are just five possible calibrations one can think of when pricing swaptions
with a time to expiration of ten years and tenors of ten up to fifteen years. As a consequence other
calibrations could be considered as well. This would result in even more model parameters and
consequently in more swaption prices. In order to prevent one from executing more calibrations the
most likely calibrations have been performed. Then the average of the determined model parameters
has been calculated. It can be readily verified that ̅ and ̅ . Subsequently
shocks in the average parameters are considered; thus taking into account a range of model parameters.
For both and ceteris paribus shocks of 5%, 10% and 25% are considered. The results are presented in
Figures 15 and 16 below.

19
Note that in case of the G2++ model the model has been calibrated with a limited volatility surface.

55
 Table 22 Calibration results of the Hull and White one-factor model. The top row indicates the
parameters as specified in Section 4.2. In the most left column the scenario is specified.

Scenario a σ
I 0,10472 0,04165
II 0,09540 0,03465
III 0,04607 0,02519
IV 0,05396 0,02392
V 0,06645 0,02903

Figure 15 Calculated prices according to the Hull and White one-factor model of swaptions with a time
to expiration of ten years and a tenor of ten up to fifteen years. The two green dots represent the
swaption price that is implied by the Black-76 model, in other words the market price. Additionally
seven different scenarios are considered, all represent swaption prices implied by the Hull and White
one-factor model with different model parameters. The black line represents prices implied by the
averaged parameters of Table 22. The blue, orange and red line respectively represent the cases in
which has been shocked with ± 5%, 10% and 25%.

From Figures 15 and 16 several observations can be made. First of all consider the swaption prices for a
swaption with a time to expiration of ten years and a tenor of respectively ten and fifteen years implied
by the Black-76 model. These prices are indicated by the green dots. In both graphs these prices lie
within the price bounds. Note however that in the case where has been shocked the prices implied by
the Black-76 model lie within the boundaries implied by the 10% deviation; whereas in the case where
has been shocked these prices lie within the 5% deviation boundaries. Moreover note that the price

56
bounds implied by the shocks in are tighter than the bounds implied by . The figures also show that
the 25% deviation boundaries are so wide that they do not imply reasonable price bounds. The price
boundaries are so wide that it is questionable to what extent they would be useful in practical
situations. Next consider the direction of the price bounds compared to the green dots. All implied price
bounds are steeper than the imaginary line that one could draw between the green dots (assumed that
this would be more or less a straight line).
Finally it can be concluded that the proposed technique can be useful. Although this would
require some refinement. First of all the price bounds implied by shocks of 25% in the averaged
parameters turn out to be useless. Moreover the bounds implied by shocks of 5% in are reasonable.
This is also the case for the bounds implied by shocks of 10% in . Additionally one can investigate what
causes the direction of the lines to be steeper than the imaginary line between the prices that are
implied by the Black-76 model. Price bounds whose direction is closer to the direction of the line that is
imposed by the Black-76 model are likely to be an improvement. Naturally the price bounds can also be
converted to implied volatilities.

Figure 16 Calculated prices according to the Hull and White one-factor model of swaptions with a time
to expiration of ten years and a tenor of ten up to fifteen years. The two green dots represent the
swaption price that is implied by the Black-76 model, in other words the market price. Additionally
seven different scenarios are considered, all represent swaption prices implied by the Hull and White
one-factor model with different model parameters. The black line represents prices implied by the
averaged parameters of Table 22. The blue, orange and red line respectively represent the cases in
which has been shocked with ± 5%, 10% and 25%.

57
 Table 23 Calibration results of the G2++ model. The top row indicates the parameters as specified in
Section 4.3. In the most left column the scenario is specified.

Scenario a σ b ρ
II 1,66027 0,43726 0,12257 0,03385 0,91038
III 0,60303 0,00474 0,16478 0,05617 -1
IV 0,12142 0,04842 0,50836 0,23595 -0,74962
V 0,66975 0,40475 0,16890 0,08908 -0,96324

Similar to the analysis that has been made for the Hull and White one-factor model an analysis for the
G2++ model has been made. This time four instead of five scenarios are considered. The first scenario is
not included in the analysis because there are no calibration results for the entire swaption volatility
surface. Also, the considered swaptions in the selected volatility surface that has been used to illustrate
the non-perfect correlation between interest rates in Section 7.3 does not correspond with swaptions
with a time to expiration of ten years and tenors of ten up to fifteen years.
The calibration results for the remaining four scenarios are presented in Table 23 above. A
somewhat different analysis will be made in case of the G2++ model; the reason is threefold. First of all,
in contrast to the Hull and White one-factor model the G2++ model has five parameters. If we would like
to consider shocks in the model parameters then we would have to consider more scenarios resulting in
considerably more calculations. Second, from Table 23 it can be observed that there is no clear pattern
in the model parameters. For a moment consider the calibration results from the Hull and White one-
factor model in Table 22. The resulting model parameters for both and in all scenarios are
reasonably close to each other. As a consequence it is justified to average these parameters and to
consider shocks in the averaged parameters. However, in case of the G2++ model the model parameters
are not that close to each other. For example consider the value of and in the different scenarios.
The value of in the second scenario would have a significant influence on the average, it is
questionable whether this is desirable. Finally, it will turn out that some of the calibration results are so
satisfying that it might not even be necessary to consider shocks in the determined parameter values.
The results in Table 23 have been used to value swaptions with a time to expiration of ten years
and tenors of ten up to fifteen years. The results are presented in Figure 17 below. From this figure
several observations can be made. First of all note that the results of the G2++ model are much more
satisfactory than those of the Hull and White one-factor model. Furthermore, the purple and the cyan
line (corresponding to scenario IV and V) clearly deviate from the green dots. Recall that the green dots
represent the swaption prices implied by the Black-76 model for a swaption with a time to expiration of
ten years and a tenor of ten and fifteen years respectively. More importantly, one should note that the
results corresponding to scenario II and III are satisfactory. Especially the results of scenario III can be
regarded as good. Recall that in this scenario only two calibration instruments are used; namely a
swaption with a time to expiration of ten years and a tenor of ten and fifteen years. Note that both
calibration instruments are priced perfectly by the G2++ model. Of course this was expected since we
use five model parameters to price two instruments. Finally observe that the blue line is curved. This can
be regarded as the correct shape of the line since similar results are found by Brigo and Mercurio.

58
 In the end, based on the results of this section it can be concluded that the G2++ model can be
used to value non-quoted swaptions. Moreover, if one wants to value swaptions with a time to
expiration of ten years and a tenor of ten up to fifteen years the best calibration instruments are
swaptions with a time to expiration of ten years and a tenor of ten and fifteen years. Although it is the
only considered minimization objective considered for this case, the most suitable minimization
objective for valuing non-quoted swaptions is likely to be the sum of squared errors of the percentage
difference between the swaption prices implied by the Black-76 model and the stochastic interest rate
model under consideration.

Figure 17 Calculated prices according to the G2++ model of swaptions with a time to expiration of ten
years and a tenor of ten up to fifteen years. The two green dots represent the swaption price that is
implied by the Black-76 model. Additionally four different scenarios are considered, all represent
swaption prices implied by the G2++ model with different model parameters. The black, blue, purple
and cyan line represents prices implied by the parameters of scenario II, III, IV and V of Table 23
respectively.

Now that it has been concluded that the G2++ model can be used to value non-quoted swaptions we
would like to compare its performance to the Black-76 model. As has been discussed, the Black-76
model cannot be applied directly to price non-quoted swaptions. Since no quote is available the model
cannot be used to convert the implied volatility into a price. In order to be able to use the Black-76
model some method has to provide us with the necessary implied volatilities. Thomson Reuters only
presents a grid of implied volatilities whereas we are also interested in the intermediate points. To
determine these intermediate points one can consider a variety of methods; think for example of simple

59
linear interpolation, cubic spline or other interpolation methods. For simplicity straightforward linear
interpolation will be considered here.
Next we have to consider with which data we would like to compare the techniques. Note that
in the first part of this section swaptions with a time to expiration of ten years and a tenor of ten and
fifteen years have been considered. The corresponding implied volatilities for 1 July 2011 as observed
from Thomson Reuters DataStream are respectively 16,8% and 16,5%. Since these volatilities are close
to each other it is expected that the influence of the chosen technique will be small. Hence we are
interested in cases where the difference between the observed implied volatilities is larger. Note that in
practical cases the tenors of swaptions are usually fixed. That is, it is very unlikely that a swaption with a
tenor of eight and a half or nine and a half year is traded. However, the time to expiration of a swaption
is variable, it will even change every day. Therefore we will now focus on swaptions with a time to
expiration between three months and six months. The considered tenor is one year, this is due to the
fact that the difference between the observed volatilities is largest for swaptions with short tenors.
To compare the results of the Black-76 model and the G2++ model the following calculations
have been performed. The G2++ model has been calibrated with swaptions with a time to expiration of
three months and six months combined with a tenor of one year. Note that this technique is similar to
the technique that was applied in scenario three above and yielded the best results. The model
parameters resulting from this calibration are presented in Table 24 below. Then these model
parameters have been used to price swaptions with a tenor of one year and a time to expiration of
respectively three, three and a half, four, four and a half, five, five and a half and six months. Besides,
linear interpolation has been used to determine volatilities for this set of swaptions. Thereafter the
Black-76 model has been used to determine the prices corresponding to the linear interpolated
volatilities. The results are presented in Table 25 and Figure 18 below. Note that the 2011 dataset is
considered.

Table 24 Calibration results of the G2++ model. The top row indicates the parameters as specified in
Section 4.3. The model has been calibrated with swaptions with a tenor of one year and a time to
expiration of three and six months. The 2011 dataset has been considered.

Dataset a σ b ρ
1 July 2011 0,64270 0,18749 0,58238 0,12131 -0,70428

Table 25 Percentage difference in swaption prices implied by the G2++ model and the Black-76 model.
The top row indicates the time to expiration in months of a swaption with a tenor of one year. The
percentage deviation has been expressed in terms of the swaption price implied by the G2++ model.

Time to expiration 3 3,5 4 4,5 5 5,5 6

Price difference 0,00% 1,05% 1,55% 1,63% 1,35% 0,79% 0,00%

From Table 25 it can be observed that calibration of the G2++ model with swaptions with a time to
expiration of three months and six months combined with a tenor of one year and using the Black-76

60
Figure 18 Calculated prices according to the G2++ model compared to the Black-76 model of swaptions
with a time to expiration of three up to six months and a tenor one year. For the time to expirations for
which no implied volatility is observable the volatilities have been obtained by means of linear
interpolation; finally the Black-76 model has been used to invert these volatilities into prices. These
prices are represented by the black line. The blue line represents prices implied by the G2++ model, the
corresponding model parameters are presented in Table 24.

model to determine prices of the volatilities obtained by applying linear interpolation to the quoted
implied volatilities of the same two swaptions leads to more or less the same results. More specifically,
the resulting errors expressed in terms of the prices implied by the G2++ model are small. This implies
that it makes little difference whether one applies the G2++ model or uses linear interpolation to the
observable quotes in this case. Note from Table 25 and Figure 18 that the prices implied by the G2++
model are higher than the prices obtained through linear interpolation for all time to expirations. Note
that the swaptions with a time to expiration of three and six months are perfectly matched by the G2++
model. Again it can be observed that the line corresponding to the prices implied by the G2++ model is
curved. Contrary, it can be seen from Figure 18, that the line corresponding to the Black-76 prices is
straight since linear interpolation has been used to determine the intermediate volatilities. Therefore,
the results are likely to be improved when in addition a first or even a second order derivative is used to
determine the intermediate volatilities. Note that a curved line is regarded as the correct shape. This can
be motivated by taking into account the shape of the volatility surface. Note from Figure 4 in Section 5
or Table 3 in Appendix D that the 1 July 2011 volatility surface is concave at the considered interval20.

20
Note that swaptions with a time to expiration of three up to six months and a tenor of one year are considered.

61
Therefore using linear interpolation in this case leads to lower implied volatilities than would be the case
when using a more refined interpolation method. Finally recall that higher volatilities correspond with
higher swaption prices. Note that exactly this is what the G2++ model does. The line of prices generated
by the G2++ model has a concave shape and can therefore be regarded as the correct shape. Future
research could investigate whether the G2++ model is also capable of reproducing convex shaped
volatility surfaces. Note from Figure 3 and Figure 4 in Section 5 that some parts of the volatility surface
are convex shaped.

62
 8. Conclusions and recommendations

This thesis examined how swaptions can be valued. In general most swaptions can be valued with the
Black-76 model. However, this model is not capable of valuating all possible swaptions. The Black-76
model is popular because of its simplicity. Once functions for zero-coupon bonds and forward swap
rates are available the application of the model is straightforward. One can obtain the quoted implied
volatilities from, for example, Thomson Reuters and can plug it in to the closed form solution for the
price of a swaption. Another important advantage of the Black-76 model is its uniformity. That is, when
inserting the correct model parameters every practitioner will find the same swaption price. Therefore
there cannot be any discussion about the height of the premium or the set fixed rate. Since the Black-76
model is easily implementable and widely accepted this is the model to be used whenever possible. This
brings us to the cases where the Black-76 cannot be applied directly. Because there are situations in
which we cannot apply the Black-76 model there is a need for other models, stochastic interest rate
models.
For a number of swaptions the implied volatilities are quoted. As discussed, quoted swaptions
should be valued with the Black-76 model. In case of non-quoted swaptions it is worthwhile to consider
stochastic interest rate model. Furthermore, in practice, not all swaptions are traded frequently. Hence
not every quoted implied volatility can be regarded as liquid. It is known that some market quotes are
illiquid due to the fact that these products are traded infrequently. This phenomenon is beyond the
scope of this thesis. However one should note that this is another interesting field for the application of
stochastic interest rate models. The stochastic interest rate models that have been considered are the
Vasicek, the Hull and White one-factor and the G2++ model. Actually all of these models are short-term
interest rate models. Next to the considered models many more models exist. This thesis attempts to
explain how stochastic interest rate models can be used to value European swaptions. One should note
that these models can also be used to value American and Bermudan swaptions. The valuation of these
types of swaptions is more interesting but therefore also more challenging. However, if one fully
understands the concepts treated in this thesis then one should be able to value American and
Bermudan swaptions.

Let us now discuss the results of the models. First of all, the capabilities of the mentioned short-term
interest rate models have been investigated. For this purpose two datasets have been used. This allow
us to investigate the consistency of the results. The Vasicek model, which is regarded as the pioneer
model in the field of stochastic interest rate models, is a so called equilibrium model. This means that it
does not fit the initial yield curve by construction. Various calibrations have been performed to
investigate the capabilities of the model. It turned out that the Vasicek model is not capable of
reproducing the observed yield curve. Moreover, the simulated yield curves that correspond to the
determined model parameters exhibit gross abnormalities compared to the observed yield curves. Since
the model is unable to fit the observed yield curve it is useless to price swaptions with this model. Both
forward rates and discount factors would deviate and this would result in unsatisfactory results.
Similarly, the capabilities of the other models have been investigated. Compared to the Vasicek
model an important improvement of the Hull and White one-factor model and the G2++ model is that

63
these latter models are so called no-arbitrage models. This means that these models fit the initial yield
curve by construction. Therefore, discount factors and swap rates are reproduced perfectly. Hence
these models are far more promising than equilibrium models. Since the observed yield curve is
perfectly matched by construction the model parameters can be used to reproduce the volatility
surface. Note that one does not necessarily need to consider a volatility surface but can also take into
account just a few calibration instruments.
To investigate the capabilities of the Hull and White one-factor model the model has been
calibrated with the entire swaption volatility surface. The resulting parameters have been used to value
all swaptions in the dataset and it turned out that the prices are matched quite accurately for a large
part of the considered swaptions. However, both for swaptions with a short tenor and with a short time
to expiration the results are very poor. This trend was observed in case of the G2++ model as well. Since
the results for swaptions with a short tenor and with a short time to expiration were so poor this called
for additional research. It seemed that the poor results for these swaptions could be caused by the
minimization objective. Note that these swaptions have a relatively low price compared to swaptions
with longer tenors or a longer time to expiration. The applied minimization objective was the one
proposed by Hull (2008). Hull states that the sum of squared errors of the difference between the
market price and the model price is a popular goodness-of-fit measure. Note however, that this
objective is in favor of swaptions with longer tenors and a longer time to expiration. Therefore, as a
counter proposal the sum of squared errors of the percentage difference between the market price and
the model price was proposed. A small survey confirmed the thoughts. The results of the Hull and White
one-factor model were improved when the errors are minimized with the alternative minimization
objective. This, together with the theoretical motivation led to the conclusion that it is more convenient
to use the proposed minimization objective.
Next to the Hull and White one-factor model another no-arbitrage model has been considered,
the G2++ model. Note that the G2++ model has been shown to be equal to the Hull and White two-
factor model by Brigo and Mercurio. There is however an important difference between one- and two-
factor models. One-factor models imply a perfect correlation between any two interest rates. Of course
this is a very unrealistic feature. On the other hand the G2++ model or any other multi-factor model
does not imply perfect correlation. Hence these models are capable of reproducing more realistic
correlation patterns and are interesting extensions of the one state variable models. Since the G2++
model is the only considered model that does not imply perfect correlation between interest rates this is
the most promising model. The performed calibrations showed that there is indeed no perfect
correlation between interest rates. Moreover the G2++ model has also been investigated empirically.
The results of the model were more promising than those of the Hull and White one-factor model.
Especially, when a volatility curve was considered the performance of the G2++ model was much more
promising. The G2++ model is able of reproducing humped shape volatility curves. Whereas the Hull and
White one-factor model is not even able of reproducing high volatilities for swaptions with a short tenor
and a volatility curve at the same time. Note however that these poor results of the Hull and White one-
factor model do not make the model completely useless. The model is still capable of reproducing
smaller sets of swaptions.

64
The most interesting application of the models has been the valuation of non-quoted swaptions. The
capabilities of the Vasicek model are simply too poor to apply it to practical cases. This leaves us with
the Hull and White one-factor and the G2++ model. The thesis focused on valuating swaptions with a
time to expiration of ten years and a tenor of ten up to fifteen years. Thomson Reuters presents quoted
implied volatilities for swaptions with a time to expiration of ten years and a tenor of ten and fifteen
years; no intermediate quotes are available. One can discuss which calibration instruments and which
minimization objective should be used. In case of the G2++ model it turned out that the results of the
model are very good when the model is calibrated with two instruments: swaptions with a time to
expiration of ten years and a tenor of ten and fifteen years. In this scenario, naturally, the calibration
instruments are priced perfectly. Moreover, the volatility curve drawn between the swaptions that we
want to price has a curved shape which is a desirable property. Therefore it can be concluded that we
can satisfactorily price non-quoted swaptions with the G2++ model.
For the pricing of non-quoted swaptions by means of the Hull and White one-factor model use is
made of a different approach. The aim of this approach is to overcome the discussion about calibration
instruments and minimization objectives. As was hinted before the outcome of the model is influenced
by these features. There is no general rule of thumb that states which calibration instruments should be
used in particular situations. Also there is no generally accepted minimization objective although I would
propose to minimize the sum of squared errors of the percentage difference between the market price
and the model price in all occasions. Nevertheless the modeler still has to choose which calibration
instruments to use. To overcome this discussion shocks in the averaged model parameters of a limited
number of obvious calibrations are considered. These shocks, performed ceteris paribus, then result in
price ranges. Finally, it was concluded that the proposed technique can be useful although this would
require some refinement. Especially the direction of the resulting volatility curve could be improved. In
more detail, the direction of the found price bounds is steeper than the direction of the volatility curve
that would be implied by the Black-76 model.
In the end it has been investigated how much the results of the G2++ model differ from the
Black-76 model in case of non-quoted swaptions. The valuation of non-quoted swaption with the G2++
model is as straightforward as the valuation of quoted swaptions. Unfortunately this is not the case
when considering the Black-76 model. To obtain prices for non-quoted swaptions by means of the Black-
76 model one has to come up with a method to determine the volatilities for the considered swaptions.
For this purpose one has to apply some sort of interpolation method. For simplicity straightforward
linear interpolation has been applied in Section 7.4. This method could even be extended by taking into
account more quoted implied volatilities and by using a first or even a second order derivative;
alternatively one could apply cubic spline. In this case, swaptions with a time to expiration of three and
six months and a tenor of year are considered. The difference between the implied volatilities
corresponding to these swaptions is relatively large; this allows us to investigate the different models.
Five swaptions with time to expirations between three and six months and a tenor of one year have
been valued with both techniques. It was concluded that there is only a minor difference between the
determined prices. As a consequence it can be concluded that for this case it makes little difference
whether one prices such swaptions by means of the G2++ model or uses the Black-76 model to invert
the volatilities obtained through linear interpolation into prices. Note that the difference between the
found prices is likely to be reduced when a more refined interpolation technique is considered.

65
Finally, it can be concluded that the G2++ model can be used to value non-quoted European swaptions.
This is also true for the Hull and White one-factor model although I would recommend to refine the
proposed technique. Furthermore the presented formulas should be extended such that day count
conventions, bank holidays and leap years are taken into account. This would only require minor
adaptions. Additionally it should be investigated what causes the poor performance of the models when
swaptions with a short time to expiration and a short tenor are considered. Furthermore it should be
investigated whether interpolation of observable volatilities yields consistent results. In more detail,
whether the results obtained by applying interpolation to quoted implied volatilities correspond with
the results of the G2++ model in more cases. Finally, it can be investigated whether the G2++ model is
able to produce convex shaped volatility curves. If one wants to consider a more complex and therefore
also more promising model to value swaptions it is advisable to consider the Lognormal Forward-Swap
Model described by amongst others Brigo and Mercurio (2006).

66
References

[1] Black, F. (1976). The Pricing of Commodity Contracts. Journal of Financial Economics, vol. 3,
pp. 167-179.

[2] Black, F. and Scholes, M. (1973). The Pricing of Options and Corporate Liabilities. The Journal
of Political Economy, vol. 81, no. 3, pp. 637-654.

[3] Brigo, D. and Mercurio, F. (2006). Interest Rate Models – Theory and Practice With Smile,
Inflation and Credit Second Edition. Springer Finance.

[4] Ho, Th. and Lee, S. (1986). Term Structure Movements and Pricing Interest Rate Contingent
Claims. The Journal of Finance, vol. 41, Number 5, pp. 1011-1029.

[5] Hull, J. (2008). Options, Futures and Other Derivatives 7th Edition. Prentice Hall.

[6] Hull, J. and White, A. (1990). Pricing Interest-Rate-Derivative Securities. Journal of

Derivatives, vol. 3, pp. 26-36.

[7] Hull, J. and White, A. (1994). Numerical Procedures for Implementing Term Structure Models
I: Single-Factor Models. Journal of Derivatives, vol. 2, Number 1, pp. 7-16.

[8] Hull, J. and White, A. (1996). Using Hull-White Interest-Rate Trees. Journal of Financial
Studies, vol. 3, Number 4, pp. 573-592.

[9] Pelsser, A., Schrager, D. (2006). Pricing Swaptions and Coupon Bond Options in Affine Term
Structure Models. Mathematical Finance, Vol. 16, No. 4, pp. 673-694.

[10] Schumacher, J.M. (2010). Financial Models. Tilburg University, the Netherlands.

[11] Vasicek, O. (1977). An Equilibrium Characterization of the Term Structure. Journal of

Financial Economics, vol. 5, pp. 177-188.

67
Appendix A – Deriving the forward curve

This Appendix gives a detailed description of the construction of the forward curve. From this forward
curve forward rates can be extracted which are necessary for the various computations in this thesis. To
transform the interest rates that can for example be obtained from Thomson Reuters into forward rates
a number of assumptions have to be made. Most of the discussion is about the transformation of the
observed rates into a zero curve, this part is also referred to as bootstrapping. The point here is that only
for a finite number of maturities interest rates are available. To construct a curve intermediate points
have to be determined. In this thesis use is made of linear interpolation. Once the zero curve has been
constructed a forward curve can be obtained from this zero curve. Using this forward curve forward
rates for all maturities21 can be determined. The rest of this Appendix will describe the calculation of
forward rates from the observed rates in detail.

First of all we should discuss which observed interest rates should be collected, since there are actually
two possibilities here. It is important to realize that this thesis makes use of interbank rates. An
alternative to interbank rates are government rates. Interbank rates denote the interest rates that are
used by banks when mutual payments are made. Next, these rates are used as an input to finally obtain
the forward curve. The first step is to translate the interbank rates to zero-coupon rates. Note that once
the zero-coupon rates have been determined, the mathematical steps towards deducing a forward
curve are identical for interbank rates and government rates. The interbank interest rates that are
obtained from Thomson Reuters are the following offered middle-rates: EONIA22, Euribor 1-Month,
Euribor 3-Month, Euribor 6-month, 1-Year IRS23, 2-Year IRS, 3-Year IRS, 4-Year IRS, 5-Year IRS, 6-Year IRS,
7-Year IRS, 8-Year IRS, 9-Year IRS, 10-Year IRS, 15-Year IRS, 20-Year IRS, 25-Year IRS, 30-Year IRS, 40-Year
IRS and 50-Year IRS. This set of points is extended with linear interpolation such that the extended set
includes yearly rates for maturities of one up to fifty years. The next step is the calculation of the zero
rates. For this purpose a distinction is made between money market rates and capital market rates. The
money market is meant to represent the market on which short term borrowing and lending takes
place, the considered periods are one year or less. In turn the capital market is a market in which money
is provided for periods longer than a year. As has been stressed in Section 2.1 it is market practice to
denote rates corresponding to the money-market as simply-compounded rates whereas rates
corresponding to the capital market are denoted as continuously-compounded rates. In the current set-
up five points on the curve belong to the part of the curve that corresponds to the money market. The
five points that correspond to the money market are respectively the overnight, the monthly, the three-
months, the six-months and the annual rate. Zero rates for the money market are obtained by applying
the standard formula that transfers interest rates in continuously compounded interest rates. When
performing these calculations one has to take into account the length of the period that corresponds to
the interest rate. The zero rates for the money market are calculated by use of the following formula.

21
In this paper interest rates with maturities up to 50 years are considered.
22
Euro Overnight Index Average
23
Euro vs. Euribor IR Swap 1-Year middle rate

68
 ( ) (A.1)

In equation (A.1) refers to the interest rate that is obtained from the extended set which is obtained
by linear interpolation of the observed rates. Furthermore, denotes the number of periods in a year
that correspond to the considered rate. For example is one in case of the annual zero rate, is two in
case of the 6-month zero rate, etc. The second part of the calculations of the zero rates is concerned
with the zero rates that correspond to the capital market. To calculate these zero rates first of all so-
called discount factors have to be calculated. These discount factors are not to be confused with the
discount curve which has throughout been denoted by ( ). The goal of the discount factors that are
calculated by use of formula (A.2) is solely the determination of zero rates belonging to the capital
market. These discount factors will be denoted by , here the index refers to the discount factor that
corresponds to zero rate . The set of zero rates that will be determined is exactly as large as the set of
observed interest rates that has been extended by use of linear interpolation. Note that the first five
zero rates correspond to the money market and that there are a total of 54 interest rates in the
extended set. Hence and corresponds to the 1-Year IRS or the annual rate.

{ ∑ (A.2)

Once the set of discount factors has been determined the x-year zero rate can be calculated as follows.

( )
(A.3)

Formula (A.3) can be used to calculate all zero rates belonging to the capital market. For example when
calculating the seven-year zero rate equals seven and the corresponding formula is as follows

( )
. (A.5)

Now that the necessary zero rates have been determined the forward rates can be calculated. The zero
rates will be denoted by . The forward rate for the period of time between and can be
calculated according to equation (A.6).

(A.6)

Here and represent the zero rates that correspond to the periods and respectively. When
performing calculations the forward rate for a specific time period is required. Since there is a only a
finite set of 54 zero rates available for a period of 50 years it is not very likely that the desired zero rate
for the requested time period is available. Hence one normally cannot directly apply the formula is
equation (A.6). It requires the zero rates corresponding to the periods and which are computed
by means of linear interpolation of the set of zero rates. It should be noted that day count conventions
and leap years have not been taken into account. By making minor modifications to the presented
formulas these phenomena can be taken into account.

69
Appendix B – Explicit solutions for stochastic differential equations

To obtain an explicit solution for a stochastic differential equation use is made of Schumacher (2010)
who describes explicit solutions for stochastic differential equations. It should be noted that explicit
solutions only exists for a special class of stochastic differential equations. Schumacher describes
solutions for stochastic vector differential equations of the under mentioned form.

( ( )) ( ) (B.1)

Here is a constant matrix, ( ) and ( ) are respectively a matrix and a vector that possibly depend
deterministically on time. An explicit solution of the stochastic differential equation described by
equation (B.1) is given below. Additionally Schumacher presents equations to find the expectation and
the variance of a stochastic differential equation as described in equation (B.1).

( ) ( )
∫ ( ) ∫ ( ) (B.2)

( )
( ) ∫ ( ) (B.3)

( ) ( )
( ) ∫ ( ) ( ) (B.4)

70
Appendix C – Interest rates

Table 1 Extracted interest rates from Thomson Reuters DataStream. These rates are used to construct
the zero curve for 1 July 2008 and 1 July 2011.

Name 1 July 2008 1 July 2011

EONIA – offered rate 3,916 0,909
Euribor 1-month – offered rate 4,448 1,332
Euribor 3-month – offered rate 4,955 1,556
Euribor 6-month – offered rate 5,145 1,797
Euro vs. Euribor 1-year – middle rate 5,356 2,032
Euro vs. Euribor 2-year – middle rate 5,353 2,203
Euro vs. Euribor 3-year – middle rate 5,293 2,468
Euro vs. Euribor 4-year – middle rate 5,217 2,660
Euro vs. Euribor 5-year – middle rate 5,147 2,854
Euro vs. Euribor 6-year – middle rate 5,095 3,035
Euro vs. Euribor 7-year – middle rate 5,064 3,116
Euro vs. Euribor 8-year – middle rate 5,053 3,226
Euro vs. Euribor 9-year – middle rate 5,050 3,323
Euro vs. Euribor 10-year – middle rate 5,057 3,412
Euro vs. Euribor 15-year – middle rate 5,103 3,744
Euro vs. Euribor 20-year – middle rate 5,082 3,852
Euro vs. Euribor 25-year – middle rate 5,019 3,838
Euro vs. Euribor 30-year – middle rate 4,955 3,798
Euro vs. Euribor 40-year – middle rate 4,860 3,757
Euro vs. Euribor 50-year – middle rate 4,790 3,760

71
Appendix D – Implied volatilities

Table 2 Extracted mid implied volatilities (MIV) from Thomson Reuters DataStream of 1 July 2008 for at-the-money swaptions. MIV means the
implied volatilities are computed based on the mid-point between the bid and the ask prices. The implied volatilities are shown in percentages,
1M stands for 1 month, 1Y stands for 1 year, etc. In the most left column the time to expiration of the swaption is presented, furthermore the
top row shows the maturity of the underlying swap.

1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 15Y 20Y

1M 21,4 24,3 23,3 22,4 21,5 20,6 19,7 18,8 15,9 15,7 17,0 17,1
2M 21,7 24,0 22,9 21,9 20,9 19,8 18,7 17,9 17,3 16,6 16,5 16,6
3M 22,1 23,7 22,6 21,5 20,4 19,1 18,0 17,3 16,8 16,4 16,1 16,0
6M 21,8 22,7 21,5 20,5 19,4 18,3 17,4 16,9 16,5 16,1 15,8 15,6
9M 21,8 21,9 20,8 19,8 18,7 17,8 17,0 16,6 16,2 15,9 15,5 15,4
12M 21,7 21,3 20,1 19,1 18,1 17,1 16,5 16,1 15,9 15,7 15,3 15,2
18M 21,0 20,0 19,1 18,2 17,4 16,6 16,1 15,8 15,5 15,3 15,0 14,9
2Y 20,1 19,0 18,2 17,5 16,8 16,2 15,8 15,5 15,2 15,0 14,7 14,6
3Y 18,5 16,9 17,3 16,7 16,0 15,5 15,1 14,8 14,5 14,3 14,0 14,0
4Y 17,4 16,9 16,4 15,8 15,3 14,1 14,4 14,1 13,8 13,7 13,5 13,5
5Y 16,5 16,0 15,4 14,9 14,4 14,1 13,7 13,5 13,3 13,2 13,1 13,1
6Y 15,5 15,0 14,6 14,1 13,8 13,4 13,2 13,0 12,9 12,8 12,8 12,9
7Y 14,5 14,2 13,8 13,5 13,1 12,9 12,7 12,6 12,5 12,4 12,5 12,6
8Y 13,9 13,5 13,1 12,8 12,6 12,4 12,3 12,2 12,2 12,1 12,3 12,5
9Y 13,1 12,8 12,5 12,4 12,2 12,1 12,0 12,0 11,9 11,9 12,2 12,3
10Y 12,7 12,3 12,1 12,0 11,9 11,8 11,8 11,8 11,8 11,8 12,1 12,3

72
 Table 3 Extracted mid implied volatilities (MIV) from Thomson Reuters DataStream of 1 July 2011 for at-the-money swaptions. MIV means the
implied volatilities are computed based on the mid-point between the bid and the ask prices. The implied volatilities are shown in percentages,
1M stands for 1 month, 1Y stands for 1 year, etc. In the most left column the time to expiration of the swaption is presented, furthermore the
top row shows the maturity of the underlying swap.

1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 15Y 20Y

1M 27,4 35,4 34,1 32,1 30,0 27,3 25,6 24,1 23,0 21,7 19,9 19,4
2M 28,6 35,4 33,8 31,7 29,7 27,4 25,8 24,5 23,4 22,5 20,5 20,0
3M 28,9 34,4 32,5 30,4 29,3 27,1 25,6 24,3 23,4 22,5 20,6 20,1
6M 33,7 34,2 32,1 30,3 28,7 27,1 25,7 24,7 23,9 23,1 21,1 20,7
9M 37,0 34,8 32,0 29,9 28,2 26,8 25,7 24,7 23,9 23,2 21,3 20,8
12M 39,0 35,0 31,8 29,5 27,8 26,4 25,2 24,3 23,7 23,1 21,1 20,8
18M 38,5 33,1 30,2 27,9 26,5 25,5 24,7 23,8 23,2 22,7 20,8 20,5
2Y 36,0 30,5 28,2 26,4 25,4 24,6 23,8 23,1 22,6 22,1 20,5 20,3
3Y 31,3 27,1 25,7 24,4 23,6 23,1 22,5 22,0 21,5 21,1 19,8 19,8
4Y 27,3 24,4 23,3 22,5 21,8 21,4 21,0 20,6 20,3 20,1 19,1 19,1
5Y 24,5 22,4 21,6 21,0 20,4 20,0 19,7 19,4 19,3 19,2 18,4 18,4
6Y 22,5 21,0 20,3 19,8 19,3 18,9 18,7 18,6 18,5 18,4 17,8 18,0
7Y 20,9 19,7 19,1 18,7 18,3 18,0 17,8 17,8 17,8 17,8 17,3 17,5
8Y 19,6 18,7 18,1 17,7 17,4 17,3 17,2 17,2 17,3 17,4 16,9 17,1
9Y 18,4 17,6 17,1 16,9 16,7 16,7 16,7 16,7 16,9 17,0 16,7 16,9
10Y 17,2 16,8 16,4 16,4 16,3 16,4 16,4 16,5 16,7 16,8 16,5 16,7

73
Appendix E – At-the-money strike rates

Table 4 Calculated at-the-money strike rates for swaptions based on the yield curve of 1 July 2008. The strike rates are shown in percentages,
1M stands for 1 month, 1Y stands for 1 year, etc. In the most left column the time to expiration of the swaption is presented, furthermore the
top row shows the maturity of the underlying swap. These values are calculated on the basis of formula (6.1). For a detailed description of the
applied forward curve see Appendix A.

1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 15Y 20Y

1M 5,468 5,357 5,284 5,203 5,131 5,079 5,049 5,038 5,035 5,042 5,086 5,063
2M 5,462 5,338 5,259 5,177 5,105 5,055 5,026 5,016 5,014 5,021 5,064 5,041
3M 5,411 5,295 5,218 5,138 5,069 5,021 4,995 4,987 4,986 4,994 5,037 5,014
6M 5,304 5,196 5,115 5,039 4,977 4,936 4,916 4,911 4,915 4,924 4,967 4,943
9M 5,177 5,088 5,010 4,935 4,881 4,848 4,836 4,835 4,842 4,853 4,896 4,872
12M 5,273 5,219 5,139 5,067 5,018 4,992 4,988 4,991 5,005 5,019 5,067 5,040
18M 5,083 5,013 4,941 4,884 4,851 4,839 4,843 4,855 4,871 4,886 4,930 4,901
2Y 5,163 5,066 4,991 4,946 4,927 4,932 4,943 4,963 4,984 5,002 5,043 5,008
3Y 4,964 4,899 4,866 4,861 4,879 4,899 4,929 4,956 4,979 5,000 5,029 4,981
4Y 4,831 4,813 4,823 4,855 4,885 4,922 4,955 4,982 5,005 5,026 5,032 4,968
5Y 4,795 4,819 4,864 4,900 4,943 4,979 5,008 5,032 5,053 5,072 5,048 4,963
6Y 4,844 4,901 4,939 4,985 5,022 5,050 5,073 5,093 5,111 5,103 5,053 4,958
7Y 4,960 4,990 5,037 5,072 5,098 5,118 5,137 5,153 5,139 5,128 5,052 4,948
8Y 5,021 5,079 5,114 5,137 5,156 5,172 5,187 5,168 5,152 5,138 5,037 4,926
9Y 5,139 5,164 5,180 5,194 5,207 5,220 5,194 5,172 5,155 5,140 5,013 4,896
10Y 5,189 5,202 5,214 5,226 5,239 5,204 5,178 5,157 5,140 5,124 4,974 4,854

74
Table 5 Calculated at-the-money strike rates for swaptions based on the yield curve of 1 July 2011. The strike rates are shown in percentages,
1M stands for 1 month, 1Y stands for 1 year, etc. In the most left column the time to expiration of the swaption is presented, furthermore the
top row shows the maturity of the underlying swap. These values are calculated on the basis of formula (6.1). For a detailed description of the
applied forward curve see Appendix A.

1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 15Y 20Y

1M 2,133 2,257 2,511 2,699 2,889 3,059 3,140 3,247 3,342 3,428 3,751 3,854
2M 2,184 2,305 2,549 2,733 2,921 3,081 3,162 3,266 3,359 3,442 3,757 3,855
3M 2,219 2,345 2,581 2,765 2,950 3,099 3,181 3,283 3,374 3,453 3,761 3,854
6M 2,263 2,436 2,656 2,839 3,019 3,140 3,226 3,321 3,408 3,479 3,766 3,847
9M 2,293 2,526 2,727 2,912 3,085 3,176 3,266 3,357 3,439 3,502 3,769 3,838
12M 2,343 2,676 2,869 3,066 3,247 3,311 3,413 3,504 3,588 3,648 3,915 3,978
18M 2,612 2,860 3,040 3,221 3,331 3,403 3,492 3,572 3,638 3,693 3,917 3,957
2Y 3,020 3,144 3,322 3,491 3,524 3,614 3,694 3,769 3,820 3,875 4,073 4,091
3Y 3,271 3,481 3,660 3,662 3,746 3,822 3,893 3,938 3,989 4,044 4,182 4,159
4Y 3,698 3,865 3,802 3,877 3,945 4,011 4,049 4,095 4,148 4,205 4,277 4,211
5Y 4,040 3,857 3,941 4,013 4,082 4,116 4,162 4,215 4,274 4,336 4,341 4,234
6Y 3,667 3,888 4,003 4,093 4,133 4,185 4,244 4,309 4,376 4,364 4,340 4,224
7Y 4,119 4,182 4,248 4,262 4,302 4,356 4,417 4,483 4,459 4,446 4,374 4,240
8Y 4,248 4,316 4,314 4,353 4,409 4,474 4,544 4,511 4,491 4,480 4,366 4,222
9Y 4,388 4,349 4,391 4,454 4,526 4,602 4,556 4,528 4,512 4,506 4,347 4,192
10Y 4,308 4,393 4,478 4,564 4,651 4,588 4,552 4,531 4,522 4,519 4,312 4,149

75
Appendix F – Swaption prices according to the Black-76 model

Table 6 Calculated swaption values based on the yield curve of 1 July 2008. The values are shown in euro’s. 1M stands for 1 month, 1Y stands for
1 year, etc. In the most left column the time to expiration of the swaption is presented, furthermore the top row shows the maturity of the
underlying swap. These values are calculated on the basis of formulas (6.2a) – (6.2c).

1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 15Y 20Y

1M 20.408 42.246 59.777 76.427 90.882 104.057 115.787 126.498 128.154 136.634 178.513 223.827
2M 25.502 52.542 73.738 93.130 109.615 123.811 135.971 148.007 158.627 166.735 213.090 264.623
3M 29.781 60.289 84.360 105.672 123.451 137.825 150.648 163.994 176.097 186.952 238.835 292.880
6M 38.430 76.324 105.865 132.025 153.142 170.870 186.987 204.340 219.977 233.510 301.362 364.716
9M 45.343 87.510 121.453 150.835 174.253 195.292 213.974 234.474 252.231 268.970 347.023 420.243
12M 46.859 89.070 123.058 151.688 175.819 195.954 217.034 237.116 257.446 276.028 360.265 437.842
18M 54.283 100.465 139.966 172.717 201.399 225.975 251.099 275.603 297.740 319.329 419.717 507.912
2Y 55.090 100.979 140.276 175.019 205.514 233.854 260.860 286.629 309.875 333.086 439.820 533.498
3Y 56.478 100.016 148.467 187.080 220.859 252.289 281.763 309.768 335.373 360.063 476.876 581.843
4Y 55.864 105.935 151.381 192.176 229.022 250.752 292.425 321.784 347.695 375.677 500.994 611.376
5Y 55.771 106.487 152.425 193.821 230.968 266.981 297.972 329.189 357.737 386.386 518.061 630.921
6Y 55.202 106.251 152.785 194.177 233.746 268.189 302.322 333.607 364.732 393.780 530.297 648.162
7Y 54.848 105.306 151.365 194.174 231.838 268.575 302.312 335.588 366.360 394.747 534.349 651.553
8Y 53.708 103.205 147.931 189.621 228.672 264.589 299.714 331.951 364.396 392.381 534.093 654.747
9Y 52.338 100.438 144.626 187.113 225.289 262.306 296.052 329.699 359.017 389.287 532.750 647.121
10Y 51.270 97.716 141.004 182.303 220.996 256.067 290.706 323.663 355.031 385.184 525.459 641.959

76
Table 7 Calculated swaption values based on the yield curve of 1 July 2011. The values are shown in euro’s. 1M stands for 1 month, 1Y stands for
1 year, etc. In the most left column the time to expiration of the swaption is presented, furthermore the top row shows the maturity of the
underlying swap. These values are calculated on the basis of formulas (6.2a) – (6.2c).

1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 15Y 20Y

1M 7.734 19.869 31.311 41.322 50.322 55.790 61.247 64.895 68.250 68.899 71.283 82.457
2M 10.725 26.990 42.358 55.882 68.477 77.578 85.663 92.455 98.309 102.688 116.076 136.830
3M 12.934 31.615 49.208 64.832 81.708 93.156 103.272 111.885 120.446 126.559 149.350 177.307
6M 20.406 43.356 67.207 89.477 111.253 130.099 144.954 159.913 173.999 185.290 229.333 276.441
9M 26.923 53.336 81.169 107.128 132.816 156.680 176.578 195.311 213.044 228.625 290.485 349.601
12M 35.815 72.721 104.951 136.686 166.780 190.799 214.111 236.692 258.838 278.134 354.645 434.464
18M 42.905 83.617 121.155 157.181 193.415 224.067 255.283 282.292 309.034 333.702 430.682 526.791
2Y 58.082 101.788 147.387 189.832 226.987 265.057 299.750 331.612 362.055 389.804 507.773 622.482
3Y 64.788 118.614 174.227 217.575 263.977 310.198 351.443 389.263 424.130 458.278 600.507 739.935
4Y 71.717 132.039 183.293 236.153 285.793 335.091 379.536 421.287 462.649 503.375 661.974 811.546
5Y 75.337 130.040 188.743 244.774 296.282 344.643 392.068 437.349 484.304 529.297 695.347 848.816
6Y 66.177 128.945 189.303 246.655 297.670 346.964 397.506 447.774 496.119 537.383 710.920 873.435
7Y 71.863 135.653 196.404 252.295 305.228 357.193 408.178 461.569 507.462 552.163 728.384 891.245
8Y 71.681 136.192 193.894 249.932 304.716 360.247 413.949 461.248 510.085 557.547 731.014 892.101
9Y 70.375 131.122 189.197 247.751 303.835 361.527 410.075 457.420 508.496 555.998 731.939 891.298
10Y 65.320 127.530 186.755 247.767 306.003 357.731 406.497 455.990 507.275 554.907 725.173 881.007

77
Appendix G – Change of numéraire

In Section 6.3 it has been discussed that a change of numéraire can be used to simplify the calculation of
the value of a swaption. In this appendix results under a different numéraire will be deduced for all
three considered short-term interest rate models. One should note that for the Vasicek and the Hull and
White one-factor model the expectation and the variance of the short-term interest rate under ( )
as numéraire will be derived; whereas in the case of the G2++ model closed form solutions for ( ) and
( ) under will be derived. In this section first the derivations for the Vasicek and the Hull and
White one-factor model are considered. Finally, the derivations for the G2++ model will be considered in
its own subsection.

Under the risk-neutral measure associated with the money-market account as the numéraire the short-
term interest rate in the Vasicek model and the Hull and White one-factor model are respectively
specified by the following SDE’s

( ) ( ) ( ) . (E.1)

( ) ( ) ( ) . (E.2)

This appendix will describe in detail what the impact of a change of numéraire is on the expectation and
the variance of the considered process. In particular we are interested in the expectation and the
variance of the short-term interest rate when ( ) is used as numéraire. Before continuing on these
specific cases let us first of all introduce the general case. The general case is copied from Brigo and
Mercurio, the notation has been slightly adapted to remain in line with the rest of the thesis. Start by
defining two arbitrary numéraires and their corresponding risk-neutral measures. To keep the notation
uniform the arbitrary numéraires will be and . We will consider an arbitrary process under both
measures

(E.3)

. (E.4)

Equation (E.3) and (E.4) denote the dynamics of the arbitrary process under respectively and .
is any matrix such that where represents the correlation matrix.

Suppose we know the dynamics of the arbitrary process under and we are interested in the
dynamics of under . To find the dynamics of under Brigo and Mercurio (p.33) give the following
proposition, for a proof see Brigo and Mercurio.

78
Proposition – A change of numéraire.
Assume that two numéraires and evolve under according to

( ) (E.5)

( ) . (E.6)

As usual represents a standard Brownian motion under . Then, the drift of the process under
the numéraire is

( ). (E.7)

This proposition allows us to derive the dynamics of a process under a different numéraire. Once the
dynamics of such a process are known it is possible to determine its expectation and variance. Exactly
this is of our interest since we want to determine the expectation and the variance of the short-term
interest rate under a different numéraire. Note that the expectation and the variance in Section 4.1 and
4.2 have been derived with the money-market account as the numéraire. As stated in Section 6.3 it is
more convenient to use ( ) as numéraire. This appendix will continue with the derivation of the
expectation and the variance of the short-term interest rate for the Vasicek model and the Hull and
White model in case ( ) is used as numéraire. The corresponding probability measure will be
denoted by and is often referred to as the -forward measure.

Vasicek model
To come to the expectation and the variance of the short-term interest rate the proposition that was
stated above will be applied. will denote the money-market account, ( ), will denote the -
forward measure and the process that we are considering is ( ). The dynamics of ( ) under both
numéraires can be represented by the following two equations

( ) (E.8)

( ) . (E.9)

Here and are standard Brownian motions under and respectively. Note that under
( ) and .

The proposition implies that the drift of ( ) under is

( ( )
) (E.10)

Note that , and . The last unknown factor is , we find that24

24 ( ) ( ) ( ) ( )
To arrive at (E.11) note that ( ) . Hence ( ) ( ).
()

79
 ( )
( )
( ) ( ) . (E.11)

Now it is easily seen that

( ) ( ). (E.12)

From here it directly follows that the dynamics of ( ) under the -forward measure are

( ) ( ( ) ( )) . (E.13)

Using the formulas in Appendix B it is now possible to derive the expectation and the variance under
. To apply these formulas note that we can also write (E.13) as

( ) ( ( ) ( )) . (E.14)

Note that (in terms of Appendix B) , ( ) ( ) and ( ) . Now it directly

follows that

( )
( ) ( ) ∫ ( ) (E.15)

( )
( ) ∫ . (E.16)

( )
Recall that in case of the Vasicek model ( ) . Hence we can write (E.15) as

( ) ( ) ( )
( ) ( ) ∫ . (E.17)

Straightforward integration now yields direct expressions for the expectation and the variance in the
Vasicek case

( ) ( ) ( )
( ) ( )( ) ( ) (E.18)

( ) ( ). (E.19)

Hull and White one-factor model

Similarly to the Vasicek case the expectation and the variance of the short-term interest rate will be
derived using the proposition stated above. Again will denote the money-market account, ( ), will
denote the -forward measure and the process that we are considering is ( ). The dynamics of ( )
under both numéraires can be represented by the equations (E.8) and (E.9). Note that under
( ) and . The proposition implies that the drift of ( ) under is given by
equation (E.10). Note that , and . The last unknown factor is , we find that

( )
( )
( ) ( ) . (E.20)

80
Now it is easily seen that

( ) ( ). (E.21)

From here it directly follows that the dynamics of ( ) under the -forward measure are

( ) ( ( ) ( )) . (E.22)

Using the formulas in Appendix B it is now possible to derive the variance under . Note that (in terms
of Appendix B) , ( ) ( ) and ( ) . It directly follows that

( )
( ) ∫ ( ). (E.23)

To derive the expectation of the short-term interest rate under the -forward measure we use an
alternative approach. This approach uses the fact that the short-term interest rate in case of the Hull
and White one-factor model can be expressed in terms of the short-term interest rate in case of the
Vasicek model plus an additional deterministic function of time. This completes the derivation since the
expectation of the short-term interest rate in case of the Vasicek model is derived in the last subsection
and the expectation of a deterministic function of time is known. Let us start by decomposing the short-
term interest rate in case of the Hull and White one-factor model. Formally, it will be shown that

( ). (E.24)

To lighten notation the short-term interest rate in case of the Vasicek and the Hull and White one-factor
model are respectively denoted by and . ( ) denotes a deterministic function of time that will
be specified below.

Consider the price of a zero-coupon bond as observed in the market. Recall equation (4.3) that
expresses the price of a zero-coupon bond when the money-market account is taken as the numéraire.
Mathematically this can be represented as follows

∫ ∫( ( ))
( ) [ | ] [ | ]. (E.25)

Since ( ) is a deterministic function equation (E.25) can also be written as

∫ ( ) ∫
( ) [ | ]. (E.26)

Now denote by the price of a zero-coupon bond under the yield curve corresponding to the
Vasicek model. Note that this yield curve and hence the price of the zero-coupon bond is equal to the
case where ( ) . It immediately follows that we can rewrite equation (E.26) as

∫ ( ) ( )
( )
. (E.27)

81
A direct expression of the function ( ) can now be derived by applying straightforward calculus and
recalling the definition of the instantaneous forward rate25.

( ) ( ) ( ). (E.28)

Now that we have an explicit expression for ( ) the expectation of the short-term interest rate under
the -forward measure can easily be obtained.

| ( )| | ( ) ( ). (E.29)

From equation (E.29) it can be seen that we have almost arrived at a direct expression for under
the -forward measure. The expectation of is known and given by equation (E.18); also the market
instantaneous forward rate is known and can be retrieved from the market curve. The last unknown
expression is ( ). The instantaneous forward rate under the Vasicek model can be obtained by
applying the definition and recalling the definition of the price of a zero-coupon bond under the Vasicek
model26:

( ) ( ( ) ( ) ( ))
( ) . (E.30)

( ) ( ) ( ) ( ) . (E.31)

Inserting the expressions from (E.18) and (E.31) into equation (E.29) yields the final result

( ) ( ) ( ) ( ).
| ( ) (E.32)

G2++ model
The derivations for the G2++ model are somewhat different compared to those of the Vasicek and the
Hull and White one-factor model. Here, it is sufficient to derive closed form solutions for ( ) and ( )
under . For this purpose, again, use is made of the proposition of Brigo and Mercurio.

Recall that under the risk-neutral measure associated with the money-market account as the numéraire
the processes ( ) and ( ) are respectively specified by the following SDE’s

( ) ( ) ( ) (E.33)

( ) ( ) ( ) . (E.34)

25 ( )
Recall equation (2.11): ( ) ( ) .
26
Recall equations (4.11)-(4.13):
( ) ( ) ( )
(4.11) ( )
(4.12) ( ) ( ( )) ( )( ( ) )
( )
(4.13) ( ) .

82
Here and denote Brownian motions under , their instantaneous correlation is given by ,
we can write

. (E.35)

To come to closed form solutions for ( ) and ( ) under the proposition of Brigo and Mercurio will
be applied. will denote the money-market account, ( ), will denote the -forward measure and
the processes that we are considering are ( ) and ( ). Note that the result of the proposition (E.7)
can be stated in vector notation as follows
( ) ( )
( ) ( ) ( ) ([ ]) ([ ])
( ) ( )
([ ]) ([ ]) ([ ]) ( ) . (E.36)
( ) ( ) ( ) ( )

Furthermore we have that

( ) ( ) ( )
([ ]) ([ ]) ([ ]) (E.37)
( ) ( ) ( )

( ) ( ) ( )
([ ]) ([ ]) ([ ]) . (E.38)
( ) ( ) ( )

( ) ( ) ( ) ( )
Note that ([ ]) [ ], , ([ ]) and ([ ]) [ ] . The last
( ) ( ) ( ) ( )
( )
unknown factor is ([ ]). Finally recall that
( )

( )
( ) ( )
( ) (E.39a)

( ) ( )
( ) ( ) ( ) ( ) ( ) ( ) (E.39b)

( ) ( ) ( ) ( )
( ) [ ] [ ]

( ) ( ) ( )( )
[ ]. (E.39c)

Now it can readily be verified that

( ) ( )
( ) ( ) ( )
([ ]) [ ] [ ]. (E.40)
( ) ( ) ( )

( ) ( )

From here it directly follows that the dynamics of ( ) and ( ) under the -forward measure are
respectively given by

83
 ( ) ( )
( ) ( ) ( ) ( ) . (E.41)

( ) ( )
( ) ( ) ( ) ( ) . (E.42)

84
Appendix H – Results of the Vasicek model

Table 8 Results of different calibrations of the Vasicek model. The top row indicates the parameters as
specified in Section 4.1. In the most left column a brief reference to the calibration instruments is given.
The numbers represent the years from which the swaption volatility surface27 from the 1st of July of the
specified year is obtained from Thomson Reuters. The model has been calibrated to the entire swaption
volatility surface. (*) indicates that ( ) has not been calibrated; instead the EONIA is used to represent
( ).

a b σ r(0)
2008 0,38497 0,05641 0,00001 0,03159
2008 (*) 0,25246 0,05709 0,00001 -
2011 0,30364 0,05015 0,00001 0
2011 (*) 0,23564 0,05127 0,00001 -

Figure 3 The zero curve of 1 July 2008 and simulated zero curves based on the calibration results
presented in Table 8. The black line represents the zero curve of 1 July 2008, the blue and the red line
respectively a simulated zero curve according to the Vasicek model. The blue and red line are
respectively based on a calibration which includes ( ) and which does not include ( ).

27
A detailed description of the swaption volatility surface that is used can be found in Section 5.

85
 Figure 4 The zero curve of 1 July 2011 and simulated zero curves based on the calibration results
presented in Table 8. The black line represents the zero curve of 1 July 2011, the blue and the red line
respectively a simulated zero curve according to the Vasicek model. The blue and red line are
respectively based on a calibration which includes ( ) and which does not include ( ).

Table 9 Calibration results for the Vasicek model. The model is calibrated to the yield curve of 1 July
2008 as observed from Thomson Reuters. Scenario 1, 2, 3 and 4 represent the following calibration
instruments respectively: (1) twenty observable interest rates. (2) the 3-months Euribor and the 10-
years IRS. (3) the 3-months Euribor, the 10-years IRS and the 30-years IRS. (4) the EONIA, the 3-months
Euribor, the 1, 10 and 30-years IRS. The top row indicates the parameters as specified in Section 4.1.
( ) has also been calibrated to the data.

a b σ r(0)
Scenario 1 0,00195 0,05009 0,00398 0,04989
Scenario 2 1,17440 0,04908 0,00618 0,05001
Scenario 3 0,72850 0,05933 0,11705 0,05895
Scenario 4 0,22424 0,04662 0,00608 0,05334

Table 10 Calibration results for the Vasicek model. The model is calibrated to the yield curve of 1 July
2008 as observed from Thomson Reuters. Scenario 1, 2, 3 and 4 represent the following calibration
instruments respectively: (1) twenty observable interest rates. (2) the 3-months Euribor and the 10-
years IRS. (3) the 3-months Euribor, the 10-years IRS and the 30-years IRS. (4) the EONIA, the 3-months
Euribor, the 1, 10 and 30-years IRS. The top row indicates the parameters as specified in Section 4.1.
( ) equals the EONIA.

a b σ
Scenario 1 0,11366 0,09482 0,03777
Scenario 2 0,77593 0,08603 0,21467
Scenario 3 0,32083 0,08112 0,08473
Scenario 4 0,85897 0,10593 0,29601

86
 Table 11 Calibration results for the Vasicek model. The model is calibrated to the yield curve of 1 July
2011 as observed from Thomson Reuters. Scenario 1, 2, 3 and 4 represent the following calibration
instruments respectively: (1) twenty observable interest rates. (2) the 3-months Euribor and the 10-
years IRS. (3) the 3-months Euribor, the 10-years IRS and the 30-years IRS. (4) the EONIA, the 3-months
Euribor, the 1, 10 and 30-years IRS. The top row indicates the parameters as specified in Section 4.1.
( ) equals the EONIA.

a b σ r(0)
Scenario 1 0,52052 0,04017 0,00001 0,00936
Scenario 2 1,77382 0,03559 0,00014 0,01104
Scenario 3 0,45888 0,03967 0,00166 0,01437
Scenario 4 0,43105 0,03981 0,00714 0,01575

Table 12 Calibration results for the Vasicek model. The model is calibrated to the yield curve of 1 July
2011 as observed from Thomson Reuters. Scenario 1, 2, 3 and 4 represent the following calibration
instruments respectively: (1) twenty observable interest rates. (2) the 3-months Euribor and the 10-
years IRS. (3) the 3-months Euribor, the 10-years IRS and the 30-years IRS. (4) the EONIA, the 3-months
Euribor, the 1, 10 and 30-years IRS. The top row indicates the parameters as specified in Section 4.1.
( ) equals the EONIA.

a b σ
Scenario 1 0,52609 0,04017 0,00001
Scenario 2 0,74513 0,07693 0,21618
Scenario 3 0,54978 0,04077 0,02623
Scenario 4 0,41705 0,05586 0,07526

87
Appendix I – Swaption prices according to the Hull and White one-factor model

Table 14 Calculated swaption values based on the dataset of 1 July 2008. The values are shown in euro’s. 1M stands for 1 month, 1Y stands for 1
year, etc. In the most left column the time to expiration of the swaption is presented, furthermore the top row shows the maturity of the
underlying swap. These values are calculated on the basis of formula (6.5), the expectation and the variance of the short rate can be found in
Section 6.3.2 and the model parameters are stated in Table 13.

1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 15Y 20Y

1M 13.882 27.325 40.529 55.190 68.548 81.683 93.959 105.791 115.319 123.026 148.685 191.652
2M 14.274 28.689 43.219 59.388 74.444 89.560 103.521 116.989 128.024 137.349 168.519 215.032
3M 14.667 30.072 45.943 63.733 80.369 97.143 112.873 127.992 140.747 151.137 188.081 237.967
6M 15.756 33.870 53.936 76.095 97.859 119.262 140.032 160.191 176.443 192.088 245.317 304.701
9M 16.759 37.475 61.104 87.324 114.056 139.922 166.083 190.269 212.593 230.641 299.114 367.290
12M 15.559 36.037 60.706 87.155 113.819 140.381 166.477 190.319 211.527 231.282 308.098 382.382
18M 17.281 42.479 72.974 106.464 139.955 174.810 208.818 240.135 267.059 293.428 394.874 481.629
2Y 17.012 43.496 74.518 109.666 146.521 182.735 217.252 250.492 280.104 310.092 420.875 518.485
3Y 18.302 46.562 82.061 121.357 164.638 206.300 246.522 284.963 321.809 352.581 487.174 599.531
4Y 18.465 46.902 84.580 128.872 172.209 217.805 261.945 304.170 341.801 379.530 527.547 646.545
5Y 18.339 48.295 87.721 131.719 177.655 223.010 268.587 313.636 353.165 390.009 548.454 668.511
6Y 18.293 48.467 85.598 130.501 177.372 225.226 269.797 311.561 352.058 392.024 554.993 674.062
7Y 18.326 47.566 85.540 127.424 174.315 219.195 265.272 305.706 348.572 387.712 545.638 661.629
8Y 16.704 44.887 81.749 122.656 166.567 210.635 253.684 297.101 336.745 372.523 527.186 638.465
9Y 16.207 43.519 77.352 116.933 157.776 200.157 242.404 282.745 322.190 357.124 504.097 608.225
10Y 15.221 40.586 72.224 109.009 148.442 188.096 228.010 266.797 302.131 334.303 474.169 571.404

88
Table 15 Calculated swaption values based on the dataset of 1 July 2011. The values are shown in euro’s. 1M stands for 1 month, 1Y stands for 1
year, etc. In the most left column the time to expiration of the swaption is presented, furthermore the top row shows the maturity of the
underlying swap. These values are calculated on the basis of formula (6.5), the expectation and the variance of the short rate can be found in
Section 6.3.2 and the model parameters are stated in Table 13.

1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 15Y 20Y

1M 3.111 6.694 10.548 14.249 17.147 17.618 19.822 18.463 16.336 11.515 0 0
2M 3.591 8.386 14.054 19.757 24.966 27.746 32.081 32.914 32.773 29.675 1.447 122
3M 4.221 10.230 17.418 25.292 32.766 37.566 44.242 47.100 48.911 48.081 16.088 8.833
6M 5.938 15.597 27.633 41.615 55.101 66.673 79.588 88.966 95.980 100.493 85.122 85.098
9M 7.889 20.728 37.303 56.418 76.349 93.359 112.522 127.938 141.077 150.067 154.277 165.352
12M 9.192 25.407 46.452 70.906 94.607 120.868 143.472 166.032 183.941 201.728 242.472 286.173
18M 12.216 34.028 63.053 96.563 130.494 167.224 200.697 230.718 257.326 284.376 353.660 416.061
2Y 15.753 42.103 77.353 118.397 161.760 205.858 247.408 284.889 321.711 352.681 467.485 561.817
3Y 19.679 54.481 98.983 151.965 205.096 260.423 314.352 363.586 411.626 451.135 610.548 740.629
4Y 23.631 62.719 113.598 172.011 235.392 294.424 357.970 413.832 466.086 511.810 702.076 861.583
5Y 24.575 65.756 119.008 181.737 248.475 314.615 378.568 437.927 488.425 537.611 750.854 918.912
6Y 24.176 65.614 119.908 183.912 250.474 317.732 381.455 441.684 495.127 549.655 771.648 938.884
7Y 24.515 67.261 121.419 187.483 252.922 319.766 383.011 443.516 500.845 559.455 783.920 954.227
8Y 24.712 65.067 118.718 180.035 245.872 311.879 373.091 435.422 493.956 549.060 774.162 930.989
9Y 23.768 62.826 114.467 175.067 235.429 294.713 361.524 420.340 474.574 525.665 745.477 903.489
10Y 22.143 59.278 109.182 163.512 223.460 283.659 342.796 402.015 454.728 501.220 710.417 858.772

89