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Bounding Bermudans

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Thomas Roos derives model-independent bounds for amortising and accreting Bermudan swaptions in terms of portfolios
of standard Bermudan swaptions. In addition to the well-known upper bounds, the author derives new lower bounds for
both amortisers and accreters. Numerical results show the bounds to be quite tight in many situations. Applications include
model arbitrage checks, limiting valuation uncertainty, and super-replication of long and short positions in the non-standard
Bermudan

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Bermudan swaption gives the holder the right to enter into a fixed no more liquid than the ABerm itself, so their prices must themselves be

A versus floating swap at a set of future exercise dates. A standard

Bermudan swaption (SBerm), sometimes called a ‘bullet’Bermu-
dan, is characterised by the fact that it is exercisable into a swap whose
notional (and fixed rate) is the same for all coupons. In addition to the
important and relatively liquid market for SBerms, there is considerable
modelled. See Andersen & Piterbarg (2010) for an overview of ABerm
calibration methodologies.
Whatever methodology is chosen to determine the calibration targets for
ABerms, the resulting local calibrations can be significantly different from
those used for SBerms. Such differences can translate into inconsistencies

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interest in accreting and amortising Bermudan swaptions (we will refer
to these collectively as ABerms). Accreting Bermudans are exercisable
into swaps whose notionals increase coupon by coupon, while amortis-
ing Bermudans are exercisable into swaps whose notionals decrease for
each coupon. Economically, accreting Bermudans arise from the issuing
of callable zero-coupon bonds, with the notional accreting at (or close to)
cis
the fixed rate of the bond (see, for example, Andersen & Piterbarg 2010,
section 19.4.6). Amortising Bermudans can be used, for example, to hedge
the prepayment risk on a loan, with the amortising notionals representing
the loan repayment schedule.
In this article, we derive super-replication portfolios for both long and
short ABerm positions in terms of SBerms. The motivation for seeking
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and even arbitrage between these closely related products. The bounds
obtained in this article provide a useful safeguard against this kind of
model arbitrage.
Notation and preliminaries
We consider a schedule fTi gniD0 constituting the fixed leg of a swap. Let
V a .t/ be the time t < T0 value of an amortising or accreting swap with
notional schedule fNi gn1 a
i D0 , and let B .t / be the value of the corresponding
Bermudan swaption. Further, let V .tI i; j / be the value of a unit notional
vanilla swap spanning Ti to Tj , with B.t I i; j / being the value of the
corresponding standard Bermudan swaption. For example, for a receiver
swap,1 we have:2

such portfolios is threefold. First, the super-replication provides an alter- n1

X
native, static risk management strategy for ABerms. Second, the values V a .t/ D Nk k .K  Lk .t //P .t; TkC1 /
of the super-replication portfolios provide two-sided, model-independent kD0
bounds on the values of theABerms. Such bounds are useful checks against and
model arbitrage, in a way that will be explained further below. Finally, as jX
1
ABerms are more complex to model than SBerms, the bounds are useful V .tI i; j / D k .K  Lk .t //P .t; TkC1 /
gh

to quantify valuation uncertainties for internal or regulatory prudent valu- kDi

ation adjustments. For similar applications of model-independent bounds
in different contexts, see, for example, Laurence & Wang (2004) and John-
son & Nonas (2009). For an exact replication strategy of flexi-swaps using
SBerms, see Evers & Jamshidian (2005).
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where P .t; T / is the discount bond at time t with maturity T , and i
and Li .t/ are the day count fraction and forward Libor rate for period
(Ti , Ti C1 ), respectively. For future use, we note that the ASwap can be
decomposed into a portfolio of co-initial standard swaps:

In relation to model arbitrage, it is clear that, when using a globally cali- n

X
brated model (eg, a Libor market model), there is no possibility of arbitrage V a .t/ D ıNk V .tI 0; k/ (1)
between ABerm and SBerm prices. In practice, however, SBerms are often kD1
valued using low-dimensional models with local (ie, trade-dependent) cali- as well as into a portfolio of co-terminal standard swaps:
bration. For example, for performance reasons, practitioners typically use n1
X
p

Gaussian or local volatility one-factor models, and price the Bermudan V a .t/ D ıNk V .tI k; n/ (2)
optionality using partial differential equation (PDE) solvers and back- kD0
ward induction. When such a low-dimensional model is used for SBerms,
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where we have defined ıNk  Nk Nk1 , with N1 D Nn  0. We will

it is often considered desirable to use the same approach for ABerms.
Given the limited calibration capabilities of the model, calibration strate-
gies are then necessarily product dependent. For SBerms, the model is
typically calibrated to the set of co-terminal European swaptions (at one
or more strikes), and the mean-reversion parameter is adjusted to match any
observable Bermudan premiums. For ABerms, the fundamental difference
refer to (1) and (2) as the ‘co-initial’ and ‘co-terminal’ decompositions,
respectively.
1 A receiver swap receives the fixed leg (pays floating). A receiver swaption
is an option to enter into a receiver swap.
2 When explicitly writing out the floating leg, we will assume it has the same

is that the corresponding calibration targets are the co-terminal amortis- frequency and day count as the fixed leg. This is done solely to simplify
ing or accreting European swaptions (ASwaptions). These are generally the notation; all results are valid for general conventions.

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Model-independent bounds on the right-hand side of (7) into Bermudan swaptions. However, the neg-
 Upper bounds: amortisers. From (1), we see that amortising swaps ative notionals present a problem in that we cannot be short options in
(where Nk1 > Nk ) can be decomposed into a sum of standard co-initial our super-replicating portfolio, as we need to have control over when the

dia
swaps with positive notionals. Explicitly, we have: options are exercised to match the ABerm. We could make the notionals
positive by simply viewing a negative notional payer swap as a positive
n1
X notional receiver swap (and vice versa). This leads to an upper bound in
V amo .t/ D jıNk jV .tI 0; k/ C Nn1 V .tI 0; n/ (3)
terms of a mixed portfolio of payers and receivers, which is not useful in
kD1
practice (and always inferior to the upper bound in (4)). If, instead, we
We now consider a Bermudan swaption to enter into this amortising swap move the negative notional swaps to the left-hand side:

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(ABerm), and the portfolio of standard Bermudans (SBerms) to enter n1
X
into the standard swaps on the right-hand side of (3). It is evident this V amo .t/ C jıNk jV .tI k; n/ D N0 V .tI 0; n/
portfolio of SBerms enables us to replicate all possible payouts of the kD1
ABerm: the strategy is simply to exercise all SBerms at the same time the and apply our previous reasoning, we conclude that if we owned a port-
ABerm is exercised. Since the SBerm portfolio must be worth at least as folio of Bermudan swaptions that could be exercised into the swaps on
much as the ABerm it can replicate, this gives us an upper bound for the the left-hand side, then this portfolio would constitute a super-replicating
value of the amortising Bermudan in terms of the portfolio of standard strategy for the Bermudan to enter into the standard swap on the right-hand

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Bermudans: side. This gives us an upper bound on the value of this standard Bermu-
n1 dan, which we write as a lower bound on the value of the amortising
X
B amo .t/ 6 jıNk jB.tI 0; k/ C Nn1 B.tI 0; n/ (4) Bermudan:
kD1 n1
X
B amo .t/ > N0 B.tI 0I n/  jıNk jB.t I k; n/ (8)
 Upper bounds: accreters. The reasoning behind accreting Bermudan
kD1
swaptions (where Nk > Nk1 ) is similar, except that we need to start from
cis
 Lower bounds: accreters. Decomposing the accreter using the co-
(2) to get a decomposition of the accreting swap into a sum of standard
initial decomposition in (1), we find:
swaps with positive notionals. These swaps are co-terminal, starting at
fTi gn1
iD0 and ending at Tn . Explicitly, we have:
n1
X
V acc .t/ D Nn1 V .tI 0I n/  jıNk jV .tI 0; k/ (9)
n1
X kD1
V acc .t/ D N0 V .tI 0I n/ C jıNk jV .tI k; n/ (5)
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kD1
As in the case of the amortiser, it is clear that if we own options that allow
us, at all possible exercise times of the ABerm, to enter into the standard
swaps on the right-hand side of (5), then we can replicate all possible
payouts of the ABerm. The same reasoning as before gives us an upper
bound on the value of the accreting Bermudan in terms of a portfolio of
gh
Again, only the longest tenor swap has positive notional in this repre-
sentation. Following the approach of the previous section, we move the
negative notional swaps to the left-hand side and deduce that the corre-
sponding portfolio of Bermudan swaptions is a super-replication of the
standard Bermudan swaption corresponding to the right-hand side. This
gives us an upper bound for this standard Bermudan, which we write as a
lower bound for the accreter:

standard Bermudans: n1

X
B acc .t/ > Nn1 B.tI 0I n/  jıNk jB.t I 0; k/ (10)
n1
X kD1
B acc .t/ 6 N0 B.tI 0I n/ C jıNk jB.tI k; n/ (6)
 Discussion. In the previous sections, we obtained two-sided bounds
kD1
for amortising and accreting Bermudan swaptions using super-replication
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One difference to the case in the previous section, where all SBerms start at
the same time as the ABerm, is that, here, some of the co-terminal SBerms
in our portfolio may not have started at the time the ABerm is exercised.
However, this presents no difficulty for the replication strategy, as we can
simply wait for the Bermudan to start and exercise it then.
p
arguments. A more formal proof can be found in appendix A. The upper
bounds in (4) and (6), and their usefulness in providing arbitrage checks
for ABerm prices, are well known to many practitioners (see, for example,
Andersen & Piterbarg 2010, section 19.4.5). From a risk management point
of view, these bounds provide a static super-replication (ie, overhedge) for

 Lower bounds: amortisers. Previously, we used the co-initial a short position in the ABerm: whenever the short ABerm is exercised by
decomposition in (1) to write the amortising swap as a sum of standard the counterparty, the portfolio of SBerms is able to reproduce the ASwap
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swaps with positive notionals. If we instead look at the co-terminal decom- payout. While the reasoning above for deriving upper and lower bounds
position in (2), we find that only the notional of the longest tenor swap is is similar, the lower bounds in (8) and (10) do not seem to be known in
positive, with all others being negative. Explicitly, we have: the literature or by many practitioners. In addition to providing arbitrage
checks from the ‘other side’, they also represent overhedge strategies for
n1
X
V amo .t/ D N0 V .tI 0I n/  jıNk jV .tI k; n/ (7) long positions in the ABerm. For example, (10) tells us that if we can buy
kD1 the accreting Bermudan at the lower bound value of:
n1
X
We would like to follow our previous reasoning and obtain a super-
Nn1 B.tI 0I n/  jıNk jB.t I 0; k/
replicating portfolio for the amortiser by turning all the standard swaps kD1

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then we can sell the longest tenor standard Bermudan and purchase the
set of shorter tenor standard Bermudans, and so create a statically hedged
portfolio that requires no rebalancing over time.
If the long tenor Bermudan is exercised against us, we simply exer-
cise the ABerm and all remaining SBerms, cancelling the resulting swap
position. In this context, it is important to note that, while our derivations
assume the entire super-replicating portfolio is exercised at once, this is
not what one would do when running the strategy in practice. Instead, one
would only exercise those Berms for which it was optimal (if any), and
sell the rest back to the market, producing a windfall. The difference in
value at inception between the ABerm and its super-replicating portfolio
is therefore the maximum possible cost of running the strategy. The actual
cost will usually be less.
We will explore the tightness of the bounds numerically in the next
section, but we can deduce some general patterns from our derivation in
terms of super-replication. In particular, we expect the tightness to depend
ive
on how suboptimal it is (in expectation) to exercise all Bermudans in the
portfolio at the optimal exercise time of the replicated Bermudan. The more
optionality we ‘give away’ when exercising the portfolio, the looser the
bound. Since it is always suboptimal to make an exercise decision before
a Bermudan’s start date, we expect the co-initial bounds (amortiser upper
and accreter lower) to be tighter than the co-terminal bounds (amortiser
cis
lower and accreter upper).
Following similar reasoning, we expect the bounds to be tighter for
payers in a rising curve environment, and vice versa. This is because
for increasing forward rates, the payer coupons become more positive
as maturity increases, meaning that longer-dated Bermudans are more
in-the-money than shorter ones. This means that when it is optimal to
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exercise the longest tenor Bermudan, we also expect it to be close to opti-
mal to exercise all shorter tenor co-initial and co-terminal Bermudans.
This is because one will wait to exercise the long tenor Bermudan if the
shorter dated co-initial Bermudans are not optimal, while the shorter tenor
co-terminal Bermudans will be deeper in-the-money than the long tenor
Bermudan, and therefore also close to optimal exercise.
gh
Finally, we note that so far we have assumed the notional change dates
match the exercise schedule of the Bermudan. In general, exercise oppor-
tunities may be more frequent (eg, notionals step up/down every five years,
while the trade is callable annually) or less frequent (eg, the trade is callable
every five years while notionals step up/down annually). The first case
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is already covered by our formulas, with ıNi D 0 on exercise dates for
which the notional does not change. The second case is more interesting. It
requires one option for each date on which the notional changes (regardless
of whether this is an ABerm exercise date or not), with the exercise sched-
ule of each such option matching the ABerm exercise schedule for sub-
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sequent dates. In particular, this means that for European amortising and
accreting swaptions, the formulas for the bounds are the same as derived
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above, except with all SBerms replaced by standard European swaptions.
Since the European ASwaptions must themselves be modelled, the bounds
can also be useful in this context as arbitrage checks and super-replication
strategies.
Numerical examples
For the bounds derived above to be useful, they must be tight enough to
act as meaningful checks against model arbitrage, or, ideally, to provide
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Cutting edge: Option pricing
tradable bids and offers that allow static hedging of ABerms via super-
replication. In this section, we provide numerical examples to explore this
question. The modelling setup is as follows. Both SBerms and ABerms
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are priced in a one-factor Gaussian (Hull-White) model, using standard
PDE backward propagation. For each SBerm, the model is calibrated to
the corresponding co-terminal standard European swaptions at the strike.
For each ABerm, the model is calibrated to the corresponding co-terminal
amortising or accreting European swaptions, priced using the basket model
in appendix B. We use US dollar yield curve and swaption volatility data
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from November 2016. The mean reversion is set to zero throughout to
reflect the low mean reversions typically required to match US dollar
Bermudan premiums in practice.
At first sight, the use of a one-factor model to price the Bermudans may
seem overly simplistic. We note, however, that the bounds only depend on
SBerm prices, and for these the use of locally calibrated, low-dimensional
models is both common practice and well established as being sufficient
(see, for example, Andersen & Andreasen 2001). For ABerms, especially
accreters, the adequacy of one-factor models is less clear. However, we
expect our basket calibration coupled with different correlation scenarios
to produce a representative range of ABerm prices; ultimately, the key
point is the ABerm price must lie within the bounds, independent of the
model used.
In the following examples, amortiser notionals decrease to zero in equal
annual steps over the life of the trade, while accreter notionals increase
annually by the fixed rate (strike) of the swaption. The initial notional is
set to one in both cases.
In the tables that follow, ‘Opt’ is the option type (payer or receiver), K
is the strike, and ‘UB’ and ‘LB’ are the upper bound and the lower bound,
respectively. All Bermudans are exercisable annually. For the ABerm, we
run two correlation scenarios: ij D 100% for all fi; j g, and ij D 90%
for all fi ¤ j g (see appendix B). In each scenario, B a is the value of
the amortising or accreting Bermudan swaption, and  a is its vega for a 1
basis point (104 ) parallel shift in (normal) European swaption volatilities.
Finally, ıU and ıL are the changes in ABerm volatility (in bp) required
to hit the upper bound and the lower bound, respectively (defined as ıU 
.UBB a /= a and ıL  .B a LB/= a ). This is a measure of the tightness
of the bound in terms of normal volatility, which can easily be compared
with volatility bid/offers, for example. Note that, given the definitions of
the ı , a negative value indicates a violation of the corresponding bound.
We begin by looking at a ‘10-year no-call one-year’(10-nc-1) Bermudan
swaption.3 Tables A and B show the results for the amortiser and accreter,
respectively.
As expected from the discussion in the previous section, the bounds are
tighter for the payers than the receivers for the currently upward-sloping
US dollar yield curve. The payer bounds are very tight indeed, with the
upper and lower bounds separated by a few bp in value, corresponding to
anywhere from a fraction of a vega to a few vegas difference over a range of
strikes. For the accreter, the  D 90% Bermudan value is actually through
the upper bound for K > 2%, indicating (mild) arbitrage for this model
specification (there are similar small violations for the amortising payer
3 Thatis, a Bermudan swaption starting in one year’s time on a swap
ending in 10 years’ time.
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A. 10-nc-1 amortiser C. 30-nc-1 amortiser

 D 100%  D 90%  D 100%  D 90%
Opt K UB LB Ba  a ıU ıL B a  a ıU ıL Opt K UB LB Ba  a ıU ıL Ba  a ıU ıL

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Pay 100 396 382 396 2.5 0.1 5.5 388 2.4 3.1 2.5 Pay 100 1591 1502 1583 9.7 0.8 8.3 1549 9.1 4.6 5.2
Pay 200 180 172 180 2.7 0.1 2.9 172 2.5 3.3 0.0 Pay 200 918 831 906 12 1.0 6.4 866 11 4.6 3.1
Pay 300 81 75 80 2.0 0.7 2.6 74 1.8 4.1 0.4 Pay 300 503 436 491 11 1.1 4.9 455 10 4.7 1.9
Pay 400 45 37 42 1.3 1.8 4.1 38 1.2 5.5 0.9 Pay 400 288 243 278 8.6 1.2 4.1 249 8.0 4.9 0.8
Pay 500 24 19 22 0.8 1.5 3.8 20 0.8 5.0 0.3 Pay 500 177 149 170 6.6 1.1 3.2 147 5.9 5.1 0.4
Rec 100 96 77 91 2.3 2.0 6.2 84 2.2 5.2 3.4 Rec 100 331 241 308 8.6 2.7 7.9 280 8.0 6.4 4.9
Rec 200 298 233 286 2.4 5.3 22 278 2.4 8.5 19 Rec 200 718 540 673 10 4.6 13 638 9.5 8.5 10

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Rec 300 670 593 665 1.0 5.5 72 661 0.8 11 86 Rec 300 1439 1184 1401 6.7 5.7 32 1377 5.7 11 34
Rec 400 1120 1068 1119 0.2 6.5 256 1118 0.2 10 253 Rec 400 2502 2266 2490 1.9 6.3 118 2482 1.5 13 144
Rec 500 1586 1555 1586 0.0 4.2 637 1586 0.0 15 1127 Rec 500 3699 3534 3696 0.6 4.3 271 3695 0.3 14 536
All values in bp. Violations of the bounds are in bold. Source: Thompson Reuters All values in bp. Violations of the bounds are in bold. Source: Thompson Reuters

B. 10-nc-1 accreter D. 30-nc-1 accreter

 D 100%  D 90%  D 100%  D 90%
Opt K UB LB B a  a ıU ıL B a  a ıU ıL Opt K UB LB Ba  a ıU ıL B a  a ıU ıL
Pay 100 912 911 911 5.3 0.2 0.0 912 5.3 0.0 0.2

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Pay 100 3570 3541 3548 25 0.9 0.3 3566 25 0.1 1.0
Pay 200 504 502 502 6.4 0.2 0.0 505 6.4 0.1 0.4 Pay 200 2541 2473 2497 36 1.2 0.7 2544 36 0.1 2.0
Pay 300 265 263 264 5.7 0.2 0.1 266 5.7 0.2 0.5 Pay 300 1748 1657 1698 41 1.2 1.0 1771 42 0.5 2.7
Pay 400 156 152 154 4.4 0.3 0.4 156 4.4 0.2 0.9 Pay 400 1296 1201 1250 41 1.1 1.2 1342 43 1.1 3.3
Pay 500 96 94 95 3.2 0.3 0.4 97 3.3 0.3 1.0 Pay 500 1040 957 1006 40 0.9 1.2 1115 43 1.7 3.7
Rec 100 201 199 200 5.0 0.2 0.2 201 5.0 0.0 0.3 Rec 100 752 722 738 22 0.7 0.7 750 22 0.1 1.3
Rec 200 529 516 522 6.1 1.1 1.0 524 6.1 0.7 1.3 Rec 200 1770 1638 1706 30 2.2 2.3 1748 30 0.7 3.6
cis
Rec 300 1192 1169 1175 3.6 4.8 1.5 1177 3.9 3.7 2.1 Rec 300 3825 3513 3646 31 5.8 4.4 3728 31 3.1 6.9
Rec 400 2125 2104 2106 1.2 16 1.9 2108 1.3 14 3.1 Rec 400 7433 6991 7105 18 18 6.3 7205 22 10 9.6
Rec 500 3186 3169 3170 0.3 53 2.3 3171 0.4 38 3.5 Rec 500 12610 12158 12217 9.2 43 6.3 12303 13 23 11
All values in bp. Violations of the bounds are in bold. Source: Thompson Reuters All values in bp. Violations of the bounds are in bold. Source: Thompson Reuters

at K D 1% (upper bound) and K D 3% (lower bound)). The receiver dynamic hedge for the ABerm, which requires expensive vega rebalancing
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bounds are somewhat wider, but they are still only a few vegas for most for duration-extending or contracting curve moves.
strikes for the accreter. For the amortiser, the upper bound is significantly More generally, we found the bounds are tight enough to provide mean-
better than the lower; this is expected for the co-initial versus co-terminal
ingful tests of model arbitrage for locally calibrated ABerm models. For
portfolio.
example, our Hull-White pricer with basket calibration violates the amor-
Tables C and D show the results for 30-nc-1 amortisers and accreters,
tiser lower and accreter upper bounds already at  D 90%, with these
respectively. While the bounds are wider in absolute terms for these long-
violations growing larger for lower correlations. In this context, it is
gh

dated trades, the difference is not significant when measured in terms

important to remember that the tightness of the bounds depends both
of vega (ıU and ıL ). As before, the payer bounds are tighter than the
on the shape of the volatility surface and, sensitively, on the shape of
receiver bounds due to the upward-sloping curve.
the yield curve. Since any local ABerm calibration methodology must
work in a wide range of market environments, such schemes should
Conclusion be checked for arbitrage against a diverse set of historical and scenario
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The numerical results show that, in our model, the upper and lower bounds
are often within a few normal vegas of the ABerm price across a range of
strikes for both amortisers and accreters. From a market participant’s point
of view, the most interesting cases are the amortising payer upper bound
and the accreting receiver lower bound. This is because the owner of a loan
p
market data.
Finally, the tightness of the bounds makes them useful to set prudent
valuation limits for ABerms in terms of more readily observable SBerms.
For example, the uncertainty related to the correlation parameters ij of
the ABerm model can define a significantly wider range of ABerm prices

subject to prepayment risk is short an amortising payer, while the issuer than the upper and lower SBerm portfolios, which are not sensitive to this
of a callable zero-coupon bond is long an accreting receiver. Moreover,
correlation.
as discussed in appendix B, both of these positions are short correlation,
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which we expect to be significantly bid/offered. Looking, therefore, at the

 D 100% model, we see that even for the long-dated (30Y) trades, ıU is
around 1bp for the amortiser (table C), while ıL is 1–6bp for the accreter
(table D). These values are of the same order as typical volatility bid/
offers for liquid SBerms. Bid/offers for ABerms are usually substantially
wider. Assuming that our model produces realistic SBerm prices, setting
up a super-replicating portfolio for an ABerm is therefore not necessar-
ily impractical. Ultimately, this approach may be cheaper than running a
Appendix A: proof of bounds
Here, we sketch a more formal derivation of the bounds that were obtained
using super-replication arguments. The proofs are straightforward, if
somewhat tedious.
 Co-initial decomposition. We start from the co-initial decomposition
of the non-standard swap in (1), which will give us the upper bound for the
amortising Bermudan and the lower bound for the accreting Bermudan.

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The proof proceeds by backward induction. For compactness, we define: Bermudan. At Tn1 , the value of the ABerm is given by (11). At Tn2 ,
we have:
j;k
Vi  V .Ti I j; k/ and X C  max.X; 0/ 

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amo n2;n n1;n
B acc .Tn2 / D max Nn2 Vn2  jıNn1 jVn2 ;
At time Tn1 , the ABerm value is simply the payout of a European option  n1;n C ˇ 
Nn1 .Vn1 / ˇ
on the remaining swap, paid on the final notional: An2 E ˇ Tn2 (15)
An1 ˇ
amo n1;n C
B acc .Tn1 / D Nn1 .Vn1 / (11) Using:

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Nn1 D Nn2  jıNn1 j
Let A.t/ be a numeraire, and define:
inside the expectation, and splitting the max operator as before to match
Ai  A.Ti / terms with the same notional, we get the inequalities:
amo
At Tn2 , we have the choice between the ASwap at this time or continuing B acc .Tn2 /
without exercising:   n1;n C ˇ 
n2;n .Vn1 / ˇ
> Nn2 max Vn2 ;E ˇ Tn2
6
An1 ˇ
amo

ive
B acc .Tn2 /   n1;n C ˇ 
 n1;n .Vn1 / ˇ
 jıNn1 j max Vn2 ; An2 E ˇ Tn2
n2;n1 An1 ˇ
D max ˙ jıNn1 jVn2
(16)
n1;n C ˇ
 
n2;n Nn1 .Vn1 / ˇ
C Nn1 Vn2 ; An2 E ˇ Tn2
An1 ˇ The second ‘max’ can be replaced with its second argument because:
(12) n1;n C ˇ
cis
 
n1;n n1;n .Vn1 / ˇ
Vn2 6 Bn2 D An2 E ˇ Tn2
An1 ˇ
where the upper sign applies to the amortiser, and the lower sign applies
to the accreter. Using: n2;n
Since the first ‘max’ is simply Bn2 , we can write the inequalities as:
max.a C b; c/ 6 max.a; 0/ C max.b; c/ amo n2;n n1;n
B acc .Tn2 / >
6 Nn2 Bn2  jıNn1 jBn2 (17)
t In

for the amortiser and:

To complete the inductive proof, one shows these inequalities hold at Ti 1 ,
assuming they hold at Ti . As above, this is done by repeatedly splitting
max.a C b; c/ >  max.a; 0/ C max.b; c/
the max operator and collecting terms with the same notional.

for the accreter, we obtain:

Appendix B: basket model
gh

  n1;n ˇ 
amo n2;n V ˇ
B acc .Tn2 / 6 Nn1 max Vn2 ; An2 E n1 ˇ Tn2 Here, we derive a simple model for amortising and accreting European
>
An1 ˇ
swaptions. Prices obtained from this model are used as calibration targets
n2;n1 C
˙ jıNn1 j.Vn2 / (13) for the Hull-White based ABerm PDE pricer discussed in the text. The
payout at expiry T0 is:
Recognising the term proportional to Nn1 as the standard Bermudan:
yri

V .T0 / D ..S a .T0 /  K//C Aa .T0 / (18)

n2;n
B.Tn2 I n  2; n/  Bn2
where:
n2;n1 Pn1
and the term proportional to ıNn1 as the standard Bermudan Bn2 ,
kD0 Nk Lk .t /k P .t; TkC1 /
S a .t/ D
p

we can write this as:

Aa .t /
amo n2;n n2;n1
B acc .Tn2 / 6 and:
> Nn1 Bn2 ˙ jıNn1 jBn2 (14)
Co

n1
X
To complete the proof, one assumes that the inequalities in (14) hold at Ti Aa .t/ D Nk k P .t; TkC1 /
and shows they hold at Ti1 . This is done by repeatedly splitting the max kD0

operator, collecting terms proportional to the same notional and identifying
them as standard Bermudans, as in the previous step.
 Co-terminal decomposition. We now look at the co-terminal rep-
resentation of the non-standard swap in (2), which will give us the lower
bound for the amortising Bermudan and the upper bound for the accreting
are the amortising/accreting swap rate and fixed leg annuity, respectively,
and  D C1 for a payer and 1 for a receiver (see footnote 2). Choosing
Aa .t/ as the numeraire, the value today is:
V .0/ D Aa .0/EAa Œ..S a .T0 /  K//C  (19)

risk.net 5

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Cutting edge: Option pricing

We also know that EAa ŒS a .T0 / D S a .0/, since S a .t/ is a martingale and N.z/ and n.z/ being the normal cumulative and probability distribu-
in the measure induced by Aa .t/. In order to evaluate (19), it therefore tion functions, respectively. To complete the specification of the model,
remains to determine the volatility of S a .T0 /. To this end, we use (1) to it remains to specify the volatilities j and the correlations ij . We set

dia
write: j equal to the market-implied swaption volatility of rate S.T0 I T0 ; Tj /
Xn for strike K. The correlation specification is more difficult. Ideally, one
S a .T0 / D wk S.T0 I T0 ; Tk / (20)
would use market-implied correlations obtained, for example, from spread
kD1
option prices. However, these trade only for a limited number of pairs; they
where: are also often illiquid, and their correlations are strike dependent. Given
wk D ıNk A.T0 I T0 ; Tk /=Aa .T0 / the absence of suitable hedge instruments and market-implied values, one

Me
can expect the correlation parameters to be marked conservatively for
and S.T0 I T0 ; Tk / and A.T0 I T0 ; Tk / are the standard swap rate and annu- risk management and to incur substantial bid/offer spreads when quot-
ity spanning .T0 ; Tk /, respectively. If we now freeze the relatively slow- ing. In this context, we note the correlation dependence of amortisers and
moving weights wk at today’s values and assume that S.T0 I T0 ; Tk / is accreters is generally opposite: for amortisers, all weights wk are positive,
normally distributed with volatility k , then the volatility of S a .T0 / is: so the volatility  a in (21), and therefore the amortising swaption price, are
v long correlation; for accreters, only the final weight wn is positive (recall
uX
u n X
n
Nn  0), with all other weights being negative. The accreter is therefore a
 Dt
a
wj wk ij j k (21)

ive
weighted spread option between a rate and a basket, and one can show that
j D1 kD1
for reasonable volatility and correlation structures, the accreter swaption
where ij is the correlation between rates S.T0 I T0 ; Ti / and S.T0 I T0 ; Tj /. price is short correlation. 
By (19), today’s value of the swaption is then given by Bachelier’s formula:
p Thomas Roos is an independent consultant specialising in
a a derivatives, located in London. He was previously global head
V .0/ D A .0/ T0 ŒzN.z/ C n.z/ (22)
cis
of interest rate quantitative analytics at Barclays. The author
with: would like to thank Vladimir Piterbarg for stimulating discus-
.S a .0/  K/ sions.
zD p
 a T0 Email: thomas.roos@rosabrunetconsulting.co.uk.
t In

REFERENCES
Andersen LBG and Andersen LBG and Evers I and F Jamshidian, Johnson S and B Nonas, 2009
J Andreasen, 2001 VV Piterbarg, 2010 2005 Arbitrage-free construction of
Factor dependence of Interest Rate Modeling Replication of flexi-swaps the swaption cube
Bermudan swaptions: fact or Atlantic Financial Press Risk March, pages 67–70 Working Paper, SSRN
fiction?
gh

Journal of Financial Economics Laurence P and T-H Wang,

62(1), pages 3–37 2004
What’s a basket worth?
Risk February, pages 73–77
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