Analytic Swaption Pricing in the Black-Karasinski Model

Colin Turfus

Initial Version: March 26, 2018

Current Version: February 1, 2020

Abstract
We present a Green’s function solution to the Black-Karasinski (lognormal) short rate model as a perturbation
expansion valid in the limit of small deviations of the rates from the forward curve. We use this to derive analytic
formulae for the prices of European swaptions to second order accuracy.

1 Introduction
It is now more than 25 years since Black and Karasinski (1991) proposed their eponymous mean-reverting lognormal
short rate model for interest rates as an alternative to the normal model of Hull and White (1990) which, although
relatively tractable, does not guarantee positive rates. As Brigo and Mercurio (2006) observed, “the rather good fitting
quality of the model to market data, and especially to the swaption volatility surface, has made the model quite popular
among practitioners and financial engineers.” However, as they also note, the model turns out to be rather less tractable,
which fact “renders the model calibration to market data more burdensome than in the Hull and White (1990) Gaussian
model, since no analytical formulas for bonds are available.” For this reason the Black-Karasinski model has been used
rather less than the more tractable Hull-White model—and the CIR model of Cox, Ingersoll and Ross (1985).
This shortcoming was first addressed by Tourrucôo et al. (2007) who considered a family of models which
incorporates the Hull-White and Black-Karasinksi models as special cases, as well as a square root model closely
related to CIR. Using a small volatility assumption and an approach borrowed from geometrical optics similar to that
used in the derivation of the asymptotic expansion for the SABR model—see Hagan et al. (2015)—they were able to
derive approximate expressions for the conditional prices of zero coupon bonds. They produced explicit second order
approximations for the square root model but not the Black-Karasinski case.
Antonov and Spector (2011) extended this work addressing explicitly the Black-Karasinski case and deriving a
Green’s function solution (aka Arrow-Debreu pricing formula) for the associated PDE as well as zero coupon bond
prices. They produced explicit expressions for both up to second order terms. They also demonstrated the effectiveness
of their small volatility approximation by comparing European swaption prices calculated by means of a first order
approximation for a two-factor Black-Karasinski model with those obtained from a Monte Carlo simulation of the
same model.
Capriotti and Stehlíková (2014) went further again addressing explicitly the Black-Karasinski case and deriving
a Green’s function solution as well as zero coupon bond prices. Their expression was based on an assumption of
constant volatility and short time of evolution of the bond price (short maturity option pricing). Using an exponent
expansion technique borrowed from Chemical Physics, they produced an explicit expression for the Green’s function
up to sixth order terms. They compared results for zero coupon bond prices with those obtained by the method of
Antonov and Spector (2011) for maturities of up to 3 years. They find comparable results using their second order
expansion and report four-figure accuracy in comparison with Monte Carlo results when the full sixth order expansion
is used. They are also able to extend their technique to longer maturities by splitting the calculation into several time
intervals; this approach further allows them to consider piecewise constant volatility. They do not consider option
pricing and indeed it is not clear how tractable the splitting technique would be in this context. They note that the
explicit zero coupon bond formulae are of great utility, particularly when the Black-Karasinski model is employed as
a credit model, in computing (risky) discount factors in Monte Carlo simulations performed for CVA/DVA purposes.

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It has been noted by Brigo and Mercurio (2006) that the Black-Karasinski model is particularly attractive as a credit
model in that it ensures positive credit intensities (unlike the Hull-White model) and does not suffer from only being
able to give rise to moderate-size lognormal implied volatilities of around 40% as with the CIR model.
Yet another approach, based on the Karhunen-Loève representation of the Ornstein-Uhlenbeck process using
Hermite polynomials, was proposed by A. Daniluk, R. Muchorski (2016). They obtain an exact expression for zero
coupon bond prices in the Black-Karasinski model but in the form of the limit of an infinitely nested integral, which is
not particularly tractable. However, by employing the simplification of working with only the leading order eigenvalue
of the Karhunen-Loève expansion they are able to deduce a more tractable formula which turns out to yield good
accuracy. More interestingly, they are able to extend their approach to swaption pricing and produce in particular
implied volatility values with errors in the tens of bp compared to Monte Carlo simulations for volatility levels of
25%.
More recently, Horvath et al. (2017) have shown how analytic expressions for a Green’s function can be derived
for a slightly different family of models which includes both Hull-White and Black-Karasinski under an assumption
that deviations of the short rate from its forward curve are asymptotically small in absolute terms. The compute the
expansion explicitly up to second order terms and illustrate how this can be used to obtain second-order accurate
expressions for caplet prices, which allow caps and floors to be valued extremely efficiently and to good accuracy,
even in the case of long maturities and high volatility levels. We extend this work here to address the important further
case of swaption prices under the Black-Karasinski model.

2 Modelling Assumptions
2.1 Underlying processes
We consider the mean-reverting lognormal short rate model of Black and Karasinski (1991) for the purpose of pricing
European swaptions. The process they proposed for the short rate rt can following Tourrucôo et al. (2007) be written
in terms of an auxiliary process x̂t = ln rt for t ≥ 0 as:

dx̂t = (θ(t) − α(t)x̂t )dt + σ(t) dŴt , (1)

where Ŵt is a Wiener process for t ≥ 0 under some probability measure P, α : R+ → R+ is the mean reversion rate,
θ : R+ → R+ is the mean reversion level and σ : R+ → R+ is the volatility. All functions are taken to be càdlàg.
Under the Girsanov theorem, we can re-express this as

dx̂t = (µ(t) − α(t)x̂t )dt + σ(t) dWt , (2)

where Wt is now a Wiener process under the equivalent martingale measure Q, for some adjusted drift function µ(t),
as yet unknown. For convenience we consider a shifted process

xt = x̂t − x∗ (t), (3)

for some shift function x∗ : R+ → R. From (2) we obtain

dxt + x0∗ (t)dt = (µ(t) − α(t)(xt + x∗ (t)))dt + σ(t)dWt .

We see that by selecting x∗ (t) such that

x0∗ (t) = µ(t) − α(t)x∗ (t) (4)
we obtain conveniently
dxt = −α(t)xt dt + σ(t)dWt . (5)
Solving (4) we deduce straightforwardly
Z t
x∗ (t) = x∗ (0) + φ(s, t)µ(s)ds, (6)
0

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with
α(t0 )dt0
Rt
φ(s, t) := e− s . (7)
We then have that
rt = ext +x∗ (t) ,
which we re-express for future convenience as

rt = (r(t) + r∗ (t))E(xt ), (8)

where r : R+ → R+ is the instantaneous forward rate, assumed known as of t = 0 from market data (see below),

E(Xt ) = exp Xt − 12 [X]t

is a Doléans-Dade stochastic exponential for a stochastic process Xt (t ≥ 0) with [X]t its quadratic variation over
[0, t] and
r∗ (t) = exp x∗ (t) + 12 [x]t − r(t).

We deduce from (3) by standard means that [x]t = Ir (0, t) where

Z t
Ir (s, t) := φ2 (u, t)σ 2 (u)du. (9)
s

We further define for notional convenience Ir (t) ≡ Ir (0, t). The functional form of µ(t), and by implication of r∗ (t),
is determined by the requirement that rt be compatible with the market-implied term structure of interest rates. The
formal no-arbitrage constraint is expressed as follows:
h Rt i
EQ e− 0 rs ds = D(0, t) (10)

for 0 < t ≤ Tm , where Tm is the longest maturity date for which the model is calibrated, and
R t2
D(t1 , t2 ) = e− t1 r(s)ds
(11)

is the t1 -forward price of the t2 -maturity zero coupon bond, observed or inferred from market data. We will in due
course infer the form of r∗ (t) rather than of µ(t), which is of less use for our purposes. For the moment we note that
the requirement that r0 = r(0) gives rise to r∗ (0) = 0, whence from (8) we must have also x0 = 0 as the initial
condition for (5).

2.2 Governing PDE

We consider the (stochastic) time-t price of a European-style security which pays a cash amount P (xT ) at maturity
T , denoting this by ft = f (xt , t). We note in particular that the price of a T -maturity zero coupon bond is obtained
by taking P (x) = 1. We infer by standard means that in the general case f (x, t) satisfies the following backward
diffusion equation:
∂f ∂f 1 ∂2f
− α(t)x + σ 2 (t) 2 − r(x, t)f = 0. (12)
∂t ∂x 2 ∂x
subject to the final condition f (x, T ) = P (x), where we define

r(x, t) := (r(t) + r∗ (t))E(xt )|xt =x . (13)

We follow Horvath et al. (2017) in rewriting (12) as
 
∂
+ L − h(x, t) f (x, t) = 0, (14)
∂t

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where
∂ 1 ∂2
L := −α(t)x + σ 2 (t) 2 − r(t)·, (15)
∂x 2 ∂x
h(x, t) := r(x, t) − r(t) (16)

and considering the formal limit solution of (14) as  → 0 with h(x, t) = O(1). Effectively we are assuming that
the deviation of the short rate from its forward curve is on average small in absolute terms. We propose as a suitable
definition of  that it lead to the following normalisation condition being satisfied:
Z Tm "Z #
Tm
1
var h(φ(t, t1 )xt , t) dt1 dt = 1, (17)
Tm 0 t

the motivation for which will subsequently become more apparent. We will on this basis look to establish a Green’s
function solution for (14) and then to obtain swaption prices as power series in , using perturbation analysis. Since
we are only using  as a marker for scaling purposes we can simply set it to unity in our final results.

3 Green’s Function
Following Horvath et al. (2017), we deduce that the Green’s function can be written asymptotically as
∞
X
G(x, t; ξ, v) = i Gi (x, t; ξ, v), (18)
i=0

with Gi (·) = O(1), and further that r∗ (t) can be expanded as1
∞
X
r∗ (t) = i ri∗ (t), (19)
i=2

with ri∗ (·) = O(1). We will in all cases be interested in ‘free-boundary’ Green’s function solutions which tend to zero
as x → ±∞. The leading order Green’s function solution subject to these conditions is straightforwardly deduced. It
is given for 0 ≤ t < v by:
!
∂ ξ − xφ(t, v)
G0 (x, t; ξ, v) = D(t, v) N p , (20)
∂ξ Ir (t, v)
with N (x) a standard Gaussian cumulative distribution function. Horvath et al. (2017) further deduce by a recursive
method that
Z v
G1 (x, t; ξ, v) = − r(t1 ) (E(x, t, t1 )Mt1 − 1) G0 (x, t; ξ, v) dt1 , (21)
t
Z v Z v
G2 (x, t; ξ, v) = r(t1 ) (E(x, t, t1 )Mt1 − 1) r(t2 ) (E(x, t, t2 )Mt2 − 1) G0,0 (x, t; ξ, v) dt2 dt1
t t1
Z v Z v
+ r(t1 )E(x, t, t1 ) r(t2 )E(x, t, t2 ) (exp (φ(t1 , t2 )Ir (t, t1 )) − 1)
t t1
Mt1 Mt2 G0,0 (x, t; ξ, v) dt2 dt1
Z v
− r2∗ (t1 )E(x, t, t1 )Mt1 G0 (x, t; ξ, v) dt1 , (22)
t
1 Thefact that there is no r1∗ (t) term is a consequence of the way we chose to define r∗ (t): consistency with (10) at O(), as we shall see below,
requires this choice, which we presage here.

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where

E(x, t, u) := E(φ(t, u)xt )|xt =x (23)

Mu G0 (x, t; ξ, v) := G0 (x, t; ξ − φ(u, v)Ir (t, u), v) . (24)

We next use our Green’s function representation to calculate the conditional price ftT of a T -maturity zero coupon
bond. In this case the payoff is given by P (x) = 1. Following Horvath et al. (2017) we note that

ftT = D(t, T ) 1 − F1T (x, t) + 2 F2T (x, t) + O(3 ),

(25)

where
Z T
F1T (x, t) := r(v) (E(x, t, v) − 1) dv, (26)
t
Z T
F2T (x, t) := 21 F0,1
2
(x, t) − r2∗ (v)E(x, t, v) dv
t
Z T Z v
+ r(v)E(x, t, v) r(u)E(x, t, u) (exp (φ(u, v)Ir (u)) − 1) du dv. (27)
t t

This clearly satisfies the required final condition f T (x, T ) = 1 up to O(2 ). It also satisfies the no arbitrage condition
that f T (0, 0) = D(0, T ) to the same level of accuracy iff F1T (0, 0) = F2T (0, 0) = 0. The automatic satisfaction of the
first order condition confirms that we were justified in starting the expansion (19) at i = 2. The second order condition
is satisfied by choosing Z v  
r2∗ (v) = r(v) r(u) eφ(u,v)Ir (u) − 1 du. (28)
0

4 Swaption Pricing
The pricing of European swaptions can be achieved in a manner similar to that used by Horvath et al. (2017) for caps
and floors. We demonstrate here the first order calculation. Consider a European payer swaption exercisable at time
t0 > 0, the start of the first payment period of the underlying swap. The swaption payoff can be expressed as a strip of
forward contracts struck at K, paid at t = t0 conditional on the swap value at that time being positive. The conditional
value of the ith forward contract as of time t0 can be written
h i
t
Payoff = ft0i−1 − κ−1 ftt0i
xt0 >ξ ∗

where ξ ∗ is the critical value of x for which the swap comes into the money at time t0 . Summing these contributions,
we obtain a swaption payoff of
n
P (i) (x)1x>ξ∗
X
P (x) = (29)
i=1
(i)
where, using (25), the P (x) can be written to second order accuracy as
 
t t
P (i) (x) ∼ D(t0 , ti−1 ) 1 − F1 i−1 (x, t0 ) + 2 F2 i−1 (x, t0 ) − κ−1 D(t0 , ti ) 1 − F1ti (x, t0 ) + 2 F2ti (x, t0 ) .

Pn (30)
Thus ξ ∗ can be computed to second order, based on (30), as the zero of i=1 P (i) (x). Knowing ξ ∗ , we can then
compute the PV contribution of each term in (29) separately. We observe first that, for the option to have a non-trivial
price in the limit as  → 0, we require that the price of the forward contract is O(), viz. we can write it as
(i)
F1 (t) = D(t, ti−1 ) − κ−1 D(t, ti ), (31)

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 (i)
with F1 (t) = O(1). On this basis we can write
n  
(i) (i)
X
P (x) = P1 (x) + P1 (x) + 2 P2 (x) + O(3 ), (32)
i=1

for O(1) functions

n
F1 (t0 )1x>ξ∗ ,
(i)
X
P1 (x) := (33)
i=1
 
P1 (x) := κ−1 D(t0 , ti ) F1 i−1 (x, t0 ) − F1ti (x, t0 ) 1x>ξ∗ ,
(i) t
(34)
 
P2 (x) := −F1 (t0 )F1 i−1 (x, t0 )1x>ξ∗ − κ−1 D(t0 , ti ) F2 i−1 (x, t0 ) − F2ti (x, t0 ) 1x>ξ∗ ,
(i) (i) t t
(35)

(i) t
where a residual F1 (t0 )F2 i−1 (x, t0 ) term is by assumption O(3 ) so not included explicitly. Applying our Green’s
function expansion to (32) and grouping terms, we can then write the swaption price at time t subject to xt = x as
n  
(i) (i)
X
V (x, t) = V1 (x, t) + 2 V2 (x, t) + V1 (x) + 2 V2 (x) + O(3 ), (36)
i=1

Z ∞
V1 (x, t) = G0 (x, t; ξ, v)P1 (ξ)dξ (37)
ξ∗
Z ∞
V2 (x, t) = G1 (x, t; ξ, v)P1 (ξ)dξ (38)
ξ∗
Z ∞
(i) (i)
V1 (x, t) = G0 (x, t; ξ, v)P1 (ξ)dξ (39)
ξ∗
Z ∞  
(i) (i) (i)
V2 (x, t) = G1 (x, t; ξ, v)P1 (ξ) + G0 (x, t; ξ, v)P2 (ξ) dξ, (40)
ξ∗

At first order, we obtain

n
X
V1 (x, t) = (D(t, ti−1 ) − κ−1 D(t, ti ))N (−d1 (ξ ∗ − x, t, t0 )) (41)
i=1

and
Z ti
(i) −1
V1 (x, t) =κ D(t, ti ) r(u) (E(x, t, u)N (−d2 (ξ ∗ − x, t, u, t0 )) − N (−d1 (ξ ∗ − x, t, t0 ))) du, (42)
t0

where, following Horvath et al. (2017), we define, for u, w ∈ [t, v],

ξ
d1 (ξ, t, w) := p , (43)
Ir (t, w)
d2 (ξ, t, u, w) := d1 (ξ − φ(u ∧ w, u ∨ w)Ir (t, u ∧ w), t, w), (44)
d∗1 (ξ, t, u, v, w) := d1 (ξ − φ(w, v)Ir (u ∧ w, w), t, w), (45)
d∗2 (ξ, t, u, v, w) := d2 (ξ − φ(w, v)Ir (u ∧ w, w), t, u, w), (46)

The further calculations for the second order terms are detailed in Appendix A.

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 Setting x = t = 0, combining terms and setting  = 1 to revert to unscaled variables, we conclude that a second-
order expression for the payer swaption PV is given by:
n
X
VPayer = (D(0, ti−1 ) − κ−1 D(0, ti ))N (−d1 (ξ ∗ , 0, t0 ))
i=1
Xn Z ti
−1
+ κ D(0, ti ) r(u) (N (−d2 (ξ ∗ , 0, u, t0 )) − N (−d1 (ξ ∗ , 0, t0 ))) du
i=1 t0
n
X Z t0
− (D(0, ti−1 ) − κ−1 D(0, ti )) r(u) (N (−d2 (ξ ∗ , 0, u, t0 )) − N (−d1 (ξ ∗ , 0, t0 ))) du
i=1 0
n
X Z ti Z v
− κ−1 D(0, ti ) r(v) r(u)eφ(u,v)Ir (u) (N (−d∗2 (ξ ∗ , 0, u, v, t0 )) − N (−d2 (ξ ∗ , 0, v, t0 ))) dudv
i=1 t0 0
n
X Z ti Z v
+ κ−1 D(0, ti ) r(v) r(u)(N (−d∗1 (ξ ∗ , 0, u, v, t0 )) − N (−d2 (ξ ∗ , 0, v, t0 ))
i=1 t0 0

+ N (−d2 (ξ ∗ , 0, u, t0 )) − N (−d1 (ξ ∗ , 0, t0 ))) dudv + O(3 ) (47)

An appeal to put-call parity yields for the receiver swaption:

n
X
VReceiver = (κ−1 D(0, ti ) − D(0, ti−1 ))N (d1 (ξ ∗ , 0, t0 ))
i=1
Xn Z ti
− κ−1 D(0, ti ) r(u) (N (d2 (ξ ∗ , 0, u, t0 )) − N (d1 (ξ ∗ , 0, t0 ))) du
i=1 t0
n
X Z t0
− (κ−1 D(0, ti ) − D(0, ti−1 )) r(u) (N (d2 (ξ ∗ , 0, u, t0 )) − N (d1 (ξ ∗ , 0, t0 ))) du
i=1 0
n
X Z ti Z v
+ κ−1 D(0, ti ) r(v) r(u)eφ(u,v)Ir (u) (N (d∗2 (ξ ∗ , 0, u, v, t0 )) − N (d2 (ξ ∗ , 0, v, t0 ))) dudv
i=1 t0 0
n
X Z ti Z v
− κ−1 D(0, ti ) r(v) r(u)(N (d∗1 (ξ ∗ , 0, u, v, t0 )) − N (d2 (ξ ∗ , 0, v, t0 ))
i=1 t0 0

+ N (d2 (ξ ∗ , 0, u, t0 )) − N (d1 (ξ ∗ , 0, t0 ))) dudv + O(3 ) (48)

The first two lines of each of (47) and (48) constitute the first order solution; to calculate ξ ∗ in a first order context, the
F2 (·) terms should be ignored in (30)

A Derivation of Second Order Terms

We compute the second order terms for V (x, t) in the same manner as the first order terms. From (38) we have
n
X Z t0 Z ∞
D(t0 , ti−1 ) − κ−1 D(t0 , ti )


V2 (x, t) = − r(u) (E(x, t, u)Mt,u − 1) G0 (x, t; ξ, t0 ) dξdu
i=1 t ξ∗
n
X Z t0
−1


=− D(t0 , ti−1 ) − κ D(t0 , ti ) r(u)
i=1 t

(E(x, t, u)N (−d2 (ξ ∗ − x, t, u, t0 )) − N (−d1 (ξ ∗ − x, t, t0 ))) du (49)

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From (40) we have
Z t0 Z ∞  
(i) −1 t
V2 (x, t) = −κ D(t0 , ti ) r(u) (E(x, t, u)Mt,u − 1) G0 (x, t; ξ, t0 ) F1 i−1 (ξ, t0 ) − F1ti (ξ, t0 ) dξdu
t ξ∗
Z ∞  
t
− (D(t0 , ti−1 ) − κ−1 D(t0 , ti )) G0 (x, t; ξ, t0 ) F1 i−1 (ξ, t0 ) − F1ti (ξ, t0 ) dξ
ξ∗
Z ∞  
t
− κ−1 D(t0 , ti ) G0 (x, t; ξ, t0 ) F2 i−1 (ξ, t0 ) − F2ti (ξ, t0 ) dξ
ξ∗
Z t0
−1
= (D(t, ti−1 ) − κ D(t, ti )) r(u)
t
(E(x, t, u)N (−d2 (ξ ∗ − x, t, u, t0 )) − N (−d1 (ξ ∗ − x, t, t0 ))) du
ti Z Z v
−1
− κ D(t, ti ) r(v)E(x, t, v) r(u)
t0 t
 
eφ(u,v)Ir (t,u) E(x, t, u)N (−d∗2 (ξ ∗ − x, t, u, v, t0 )) − N (−d∗1 (ξ ∗ − x, t, u, v, t0 )) dudv
Z ti Z v
+ κ−1 D(t, ti ) r(v)E(x, t, v) r(u)
t0 t
(E(x, t, u)N (−d2 (ξ ∗ − x, t, u, t0 )) − N (−d1 (ξ ∗ − x, t, t0 ))) dudv
Z ti
−1
+κ D(t, ti ) r2∗ (v)E(x, t, v)N (−d2 (ξ ∗ − x, t, v, t0 ))dv
t0
(50)

Setting x = t = 0 in (37), (39), (49) and (50) and substituting into (36), using also (28) and setting  = 1, we obtain
(47).

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