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Pricing Using Interest-Rate Tree Models

Introduction

For purposes of illustration, this section relies on the HJM and BDT models. The HW and BK functions that perform price and sensitivity computations are not explicitly shown here. Functions that use the HW and BK models operate similarly to the BDT model.

Computing Instrument Prices

The portfolio pricing functions hjmprice and bdtprice calculate the price of any set of supported instruments, based on an interest-rate tree. The functions are capable of pricing these instrument types:

  • Bonds

  • Bond options

  • Bond with embedded options

  • Arbitrary cash flows

  • Fixed-rate notes

  • Floating-rate notes

  • Floating-rate notes with options or embedded options

  • Caps

  • Floors

  • Range Notes

  • Swaps

  • Swaptions

For example, the syntax for calling hjmprice is:

[Price, PriceTree] = hjmprice(HJMTree, InstSet, Options)

Similarly, the calling syntax for bdtprice is:

[Price, PriceTree] = bdtprice(BDTTree, InstSet, Options)

Each function requires two input arguments: the interest-rate tree and the set of instruments, InstSet. An optional argument Options further controls the pricing and the output displayed. (See Derivatives Pricing Options for information about the Options argument.)

HJMTree is the Heath-Jarrow-Morton tree sampling of a forward-rate process, created using hjmtree. BDTTree is the Black-Derman-Toy tree sampling of an interest-rate process, created using bdttree. See Building a Tree of Forward Rates to learn how to create these structures.

InstSet is the set of instruments to be priced. This structure represents the set of instruments to be priced independently using the model.

Options is an options structure created with the function derivset. This structure defines how the tree is used to find the price of instruments in the portfolio, and how much additional information is displayed in the command window when calling the pricing function. If this input argument is not specified in the call to the pricing function, a default Options structure is used. The pricing options structure is described in Pricing Options Structure.

The portfolio pricing functions classify the instruments and call the appropriate instrument-specific pricing function for each of the instrument types. The HJM instrument-specific pricing functions are bondbyhjm, cfbyhjm, fixedbyhjm, floatbyhjm, optbndbyhjm, rangefloatbyhjm, swapbyhjm, and swaptionbyhjm. A similarly named set of functions exists for BDT models. You can also use these functions directly to calculate the price of sets of instruments of the same type.

HJM Pricing Example

Consider the following example, which uses the portfolio and interest-rate data in the MAT-file deriv.mat included in the toolbox. Load the data into the MATLAB® workspace.

load deriv.mat

Use the MATLAB whos command to display a list of the variables loaded from the MAT-file.

whos
Name              Size            Bytes  Class     Attributes

  BDTInstSet        1x1             15956  struct              
  BDTTree           1x1              5138  struct              
  BKInstSet         1x1             15946  struct              
  BKTree            1x1              5904  struct              
  CRRInstSet        1x1             12434  struct              
  CRRTree           1x1              5058  struct              
  EQPInstSet        1x1             12434  struct              
  EQPTree           1x1              5058  struct              
  HJMInstSet        1x1             15948  struct              
  HJMTree           1x1              5838  struct              
  HWInstSet         1x1             15946  struct              
  HWTree            1x1              5904  struct              
  ITTInstSet        1x1             12438  struct              
  ITTTree           1x1              8862  struct              
  ZeroInstSet       1x1             10282  struct              
  ZeroRateSpec      1x1              1580  struct         

HJMTree and HJMInstSet are the input arguments required to call the function hjmprice.

Use the function instdisp to examine the set of instruments contained in the variable HJMInstSet.

instdisp(HJMInstSet)
Index Type CouponRate Settle         Maturity       Period Basis EndMonthRule IssueDate FirstCouponDate LastCouponDate StartDate Face Name    Quantity
1     Bond 0.04       01-Jan-2000    01-Jan-2003    1      NaN   NaN          NaN       NaN             NaN            NaN       NaN  4% bond 100     
2     Bond 0.04       01-Jan-2000    01-Jan-2004    2      NaN   NaN          NaN       NaN             NaN            NaN       NaN  4% bond  50     
 
Index Type    UnderInd OptSpec Strike ExerciseDates  AmericanOpt Name       Quantity
3     OptBond 2        call    101    01-Jan-2003    NaN         Option 101 -50     
 
Index Type  CouponRate Settle         Maturity       FixedReset Basis Principal Name     Quantity
4     Fixed 0.04       01-Jan-2000    01-Jan-2003    1          NaN   NaN       4% Fixed 80      
 
Index Type  Spread Settle         Maturity       FloatReset Basis Principal Name       Quantity
5     Float 20     01-Jan-2000    01-Jan-2003    1          NaN   NaN       20BP Float 8       
 
Index Type Strike Settle         Maturity       CapReset Basis Principal Name   Quantity
6     Cap  0.03   01-Jan-2000    01-Jan-2004    1        NaN   NaN       3% Cap 30      
 
Index Type  Strike Settle         Maturity       FloorReset Basis Principal Name     Quantity
7     Floor 0.03   01-Jan-2000    01-Jan-2004    1          NaN   NaN       3% Floor 40      
 
Index Type LegRate    Settle         Maturity       LegReset Basis Principal LegType Name         Quantity
8     Swap [0.06  20] 01-Jan-2000    01-Jan-2003    [1  1]   NaN   NaN       [NaN]   6%/20BP Swap 10      


Index Type CouponRate Settle       Maturity     Period Basis  ...  Name      Quantity
1     Bond 0.04       01-Jan-2000  01-Jan-2003  1      NaN    ...  4% bond   100 
2     Bond 0.04       01-Jan-2000  01-Jan-2004  2      NaN    ...  4% bond    50  

Note that there are eight instruments in this portfolio set: two bonds, one bond option, one fixed-rate note, one floating-rate note, one cap, one floor, and one swap. Each instrument has a corresponding index that identifies the instrument prices in the price vector returned by hjmprice.

Now use hjmprice to calculate the price of each instrument in the instrument set.

Price = hjmprice(HJMTree, HJMInstSet)
Warning: Not all cash flows are aligned with the tree. Result will 
be approximated.

Price =

   98.7159
   97.5280
    0.0486
   98.7159
  100.5529
    6.2831
    0.0486
    3.6923

    Note   The warning shown above appears because some of the cash flows for the second bond do not fall exactly on a tree node.

BDT Pricing Example

Load the MAT-file deriv.mat into the MATLAB workspace.

load deriv.mat

Use the MATLAB whos command to display a list of the variables loaded from the MAT-file.

whos
 Name              Size            Bytes  Class     Attributes

  BDTInstSet        1x1             15956  struct              
  BDTTree           1x1              5138  struct              
  BKInstSet         1x1             15946  struct              
  BKTree            1x1              5904  struct              
  CRRInstSet        1x1             12434  struct              
  CRRTree           1x1              5058  struct              
  EQPInstSet        1x1             12434  struct              
  EQPTree           1x1              5058  struct              
  HJMInstSet        1x1             15948  struct              
  HJMTree           1x1              5838  struct              
  HWInstSet         1x1             15946  struct              
  HWTree            1x1              5904  struct              
  ITTInstSet        1x1             12438  struct              
  ITTTree           1x1              8862  struct              
  ZeroInstSet       1x1             10282  struct              
  ZeroRateSpec      1x1              1580  struct         

BDTTree and BDTInstSet are the input arguments required to call the function bdtprice.

Use the function instdisp to examine the set of instruments contained in the variable BDTInstSet.

instdisp(BDTInstSet)
Index Type CouponRate Settle         Maturity       Period Basis EndMonthRule IssueDate FirstCouponDate LastCouponDate StartDate Face Name     Quantity
1     Bond 0.1        01-Jan-2000    01-Jan-2003    1      NaN   NaN          NaN       NaN             NaN            NaN       NaN  10% Bond 100     
2     Bond 0.1        01-Jan-2000    01-Jan-2004    2      NaN   NaN          NaN       NaN             NaN            NaN       NaN  10% Bond  50     
 
Index Type    UnderInd OptSpec Strike ExerciseDates  AmericanOpt Name      Quantity
3     OptBond 1        call    95     01-Jan-2002    NaN         Option 95 -50     
 
Index Type  CouponRate Settle         Maturity       FixedReset Basis Principal Name      Quantity
4     Fixed 0.1        01-Jan-2000    01-Jan-2003    1          NaN   NaN       10% Fixed 80      
 
Index Type  Spread Settle         Maturity       FloatReset Basis Principal Name       Quantity
5     Float 20     01-Jan-2000    01-Jan-2003    1          NaN   NaN       20BP Float 8       
 
Index Type Strike Settle         Maturity       CapReset Basis Principal Name    Quantity
6     Cap  0.15   01-Jan-2000    01-Jan-2004    1        NaN   NaN       15% Cap 30      
 
Index Type  Strike Settle         Maturity       FloorReset Basis Principal Name     Quantity
7     Floor 0.09   01-Jan-2000    01-Jan-2004    1          NaN   NaN       9% Floor 40      
 
Index Type LegRate    Settle         Maturity       LegReset Basis Principal LegType Name          Quantity
8     Swap [0.15  10] 01-Jan-2000    01-Jan-2003    [1  1]   NaN   NaN       [NaN]   15%/10BP Swap 10  

Note that there are eight instruments in this portfolio set: two bonds, one bond option, one fixed-rate note, one floating-rate note, one cap, one floor, and one swap. Each instrument has a corresponding index that identifies the instrument prices in the price vector returned by bdtprice.

Now use bdtprice to calculate the price of each instrument in the instrument set.

Price = bdtprice(BDTTree, BDTInstSet)
Warning: Not all cash flows are aligned with the tree. Result will 
be approximated.

Price =

   95.5030
   93.9079
    1.7657
   95.5030
  100.4865
    1.4863
    0.0245
    7.4222

Price Vector Output

The prices in the output vector Price correspond to the prices at observation time zero (tObs = 0), which is defined as the valuation date of the interest-rate tree. The instrument indexing within Price is the same as the indexing within InstSet.

In the HJM example, the prices in the Price vector correspond to the instruments in this order.

InstNames = instget(HJMInstSet, 'FieldName','Name')
InstNames =

4% bond     
4% bond     
Option 101  
4% Fixed    
20BP Float  
3% Cap      
3% Floor    
6%/20BP Swap

Consequently, in the Price vector, the fourth element, 98.7159, represents the price of the fourth instrument (4% fixed-rate note); the sixth element, 6.2831, represents the price of the sixth instrument (3% cap).

In the BDT example, the prices in the Price vector correspond to the instruments in this order.

InstNames = instget(BDTInstSet, 'FieldName','Name')
InstNames =

10% Bond     
10% Bond     
Option 95    
10% Fixed    
20BP Float   
15% Cap      
9% Floor     
15%/10BP Swap

Consequently, in the Price vector, the fourth element, 95.5030, represents the price of the fourth instrument (10% fixed-rate note); the sixth element, 1.4863, represents the price of the sixth instrument (15% cap).

Price Tree Structure Output

If you call a pricing function with two output arguments, for example,

[Price, PriceTree] = hjmprice(HJMTree, HJMInstSet) 

you generate a price tree along with the price information.

The optional output price tree structure PriceTree holds all the pricing information.

HJM Price Tree.  In the HJM example, the first field of this structure, FinObj, indicates that this structure represents a price tree. The second field, PBush, is the tree holding the price of the instruments in each node of the tree. The third field, AIBush, is the tree holding the accrued interest of the instruments in each node of the tree. Finally, the fourth field, tObs, represents the observation time of each level of PBush and AIBush, with units in terms of compounding periods.

In this example, the price tree looks like

PriceTree = 
FinObj: 'HJMPriceTree'
 PBush: {[8x1 double]  [8x1x2 double]  ...[8x8 double]}
AIBush: {[8x1 double]  [8x1x2 double] ... [8x8 double]}
  tObs: [0 1 2 3 4]

Both PBush and AIBush are 1-by-5 cell arrays, consistent with the five observation times of tObs. The data display has been shortened here to fit on a single line.

Using the command line interface, you can directly examine PriceTree.PBush, the field within the PriceTree structure that contains the price tree with the price vectors at every state. The first node represents tObs = 0, corresponding to the valuation date.

PriceTree.PBush{1}
ans =

   98.7159
   97.5280
    0.0486
   98.7159
  100.5529
    6.2831
    0.0486
    3.6923

With this interface, you can observe the prices for all instruments in the portfolio at a specific time.

BDT Price Tree.  The BDT output price tree structure PriceTree holds all the pricing information. The first field of this structure, FinObj, indicates that this structure represents a price tree. The second field, PTree, is the tree holding the price of the instruments in each node of the tree. The third field, AITree, is the tree holding the accrued interest of the instruments in each node of the tree. The fourth field, tObs, represents the observation time of each level of PTree and AITree, with units in terms of compounding periods.

You can directly examine the field within the PriceTree structure, which contains the price tree with the price vectors at every state. The first node represents tObs = 0, corresponding to the valuation date.

[Price, PriceTree] = bdtprice(BDTTree, BDTInstSet)

PriceTree.PTree{1}
ans =

   95.5030
   93.9079
    1.7657
   95.5030
  100.4865
    1.4863
    0.0245
    7.4222

Computing Instrument Sensitivities

Sensitivities can be reported either as dollar price changes or percentage price changes. The delta, gamma, and vega sensitivities that the toolbox computes are dollar sensitivities.

The functions hjmsens and bdtsens compute the delta, gamma, and vega sensitivities of instruments using an interest-rate tree. They also optionally return the calculated price for each instrument. The sensitivity functions require the same two input arguments used by the pricing functions (HJMTree and HJMInstSet for HJM; BDTTree and BDTInstSet for BDT).

Sensitivity functions calculate the dollar value of delta and gamma by shifting the observed forward yield curve by 100 basis points in each direction, and the dollar value of vega by shifting the volatility process by 1%. To obtain the per-dollar value of the sensitivities, divide the dollar sensitivity by the price of the corresponding instrument.

HJM Sensitivities Example

The calling syntax for the function is:

[Delta, Gamma, Vega, Price] = hjmsens(HJMTree, HJMInstSet)

Use the previous example data to calculate the price of instruments.

load deriv.mat
[Delta, Gamma, Vega, Price] = hjmsens(HJMTree, HJMInstSet);
Warning: Not all cash flows are aligned with the tree. Result will
be approximated.

    Note   The warning appears because some of the cash flows for the second bond do not fall exactly on a tree node.

You can conveniently examine the sensitivities and the prices by arranging them into a single matrix.

All = [Delta, Gamma, Vega, Price]
All =

       -272.65       1029.90          0.00         98.72
       -347.43       1622.69         -0.04         97.53
         -8.08        643.40         34.07          0.05
       -272.65       1029.90          0.00         98.72
         -1.04          3.31             0        100.55
        294.97       6852.56         93.69          6.28
        -47.16       8459.99         93.69          0.05
       -282.05       1059.68          0.00          3.69

As with the prices, each row of the sensitivity vectors corresponds to the similarly indexed instrument in HJMInstSet. To view the per-dollar sensitivities, divide each dollar sensitivity by the corresponding instrument price.

BDT Sensitivities Example

The calling syntax for the function is:

[Delta, Gamma, Vega, Price] = bdtsens(BDTTree, BDTInstSet);

Arrange the sensitivities and prices into a single matrix.

All = [Delta, Gamma, Vega, Price]
All =

     -232.67       803.71      -0.00       95.50
     -281.05      1181.93      -0.01       93.91
      -50.54       246.02       5.31        1.77
     -232.67       803.71          0       95.50
        0.84         2.45          0      100.49
       78.38       748.98      13.54        1.49
       -4.36       382.06       2.50        0.02
     -253.23       863.81          0        7.42

To view the per-dollar sensitivities, divide each dollar sensitivity by the corresponding instrument price.

All = [Delta ./ Price, Gamma ./ Price, Vega ./ Price, Price]
All =

       -2.44         8.42      -0.00       95.50
       -2.99        12.59      -0.00       93.91
      -28.63       139.34       3.01        1.77
       -2.44         8.42          0       95.50
        0.01         0.02          0      100.49
       52.73       503.92       9.11        1.49
     -177.89     15577.42     101.87        0.02
      -34.12       116.38          0        7.42

Calibrating Hull-White Model Using Market Data

The pricing of interest rate derivative securities relies on models that describe the underlying process. These interest rate models depend on one or more parameters that you must determine by matching the model predictions to the existing data available in the market. In the Hull-White model, there are two parameters related to the short rate process: mean reversion and volatility. Calibration is used to determine these parameters, such that the model can reproduce, as close as possible, the prices of caps or floors observed in the market. The calibration routines find the parameters that minimize the difference between the model price predictions and the market prices for caps and floors.

For a Hull-White model, the minimization is two dimensional, with respect to mean reversion (α) and volatility (σ). That is, calibrating the Hull-White model minimizes the difference between the model's predicted prices and the observed market prices of the corresponding caplets or floorlets.

Hull-White Model Calibration Example

Use market data to identify the implied volatility (σ) and mean reversion (α) coefficients needed to build a Hull-White tree to price an instrument. The ideal case is to use the volatilities of the caps or floors used to calculate Alpha (α) and Sigma (σ). This will most likely not be the case, so market data must be interpolated to obtain the required values.

Consider a cap with these parameters:

Settle = ' Jan-21-2008';
Maturity = 'Mar-21-2011';
Strike = 0.0690;
Reset = 4;
Principal = 1000;
Basis = 0;

The caplets for this example would fall in:

capletDates = cfdates(Settle, Maturity, Reset, Basis);
datestr(capletDates')
ans =

21-Mar-2008
21-Jun-2008
21-Sep-2008
21-Dec-2008
21-Mar-2009
21-Jun-2009
21-Sep-2009
21-Dec-2009
21-Mar-2010
21-Jun-2010
21-Sep-2010
21-Dec-2010
21-Mar-2011

In the best case, look up the market volatilities for caplets with a Strike = 0.0690, and maturities in each reset date listed, but the likelihood of finding these exact instruments is low. As a consequence, use data that is available in the market and interpolate to find appropriate values for the caplets.

Based on the market data, you have the cap information for different dates and strikes. Assume that instead of having the data for Strike = 0.0690, you have the data for Strike1 = 0.0590 and Strike2 = 0.0790

MaturityStrike1 = 0.0590Strike2 = 0.0790
21-Mar-20080.15330. 1526
21-Jun-20080.17310. 1730
21-Sep-20080. 17270. 1726
21-Dec-20080. 17520. 1747
21-Mar-20090. 18090. 1808
21-Jun-20090. 18090. 1792
21-Sep-20090. 18050. 1797
21-Dec-20090. 18020. 1794
21-Mar-20100. 18020. 1733
21-Jun-20100. 17570. 1751
21-Sep-20100. 17550. 1750
21-Dec-20100. 17550. 1745
21-Mar-20110. 17260. 1719

The nature of this data lends itself to matrix nomenclature, which is perfect for MATLAB. hwcalbycap requires that the dates, the strikes, and the actual volatility be separated into three variables: MarketStrike, MarketMat, and MarketVol.

MarketStrike = [0.0590; 0.0790];
MarketMat = {'21-Mar-2008';   
'21-Jun-2008'; 
'21-Sep-2008';  
'21-Dec-2008';  
'21-Mar-2009';  
'21-Jun-2009';  
'21-Sep-2009';  
'21-Dec-2009';  
'21-Mar-2010';  
'21-Jun-2010';  
'21-Sep-2010';  
'21-Dec-2010'; 
'21-Mar-2011'};


MarketVol = [0.1533 0.1731 0.1727 0.1752 0.1809 0.1800 0.1805 0.1802 0.1735 0.1757 ...
            0.1755 0.1755 0.1726;   % First column in table corresponding to Strike1
            0.1526 0.1730 0.1726 0.1747 0.1808 0.1792 0.1797 0.1794 0.1733 0.1751 ...
            0.1750 0.1745 0.1719];  % Second column in table corresponding to Strike2

Complete the input arguments using this data for RateSpec:

Rates= [0.0627;
0.0657;
0.0691;
0.0717;
0.0739;
0.0755;
0.0765;
0.0772;
0.0779;
0.0783;
0.0786;
0.0789;
0.0792;
0.0793];

ValuationDate = '21-Jan-2008';
EndDates = {'21-Mar-2008';'21-Jun-2008';'21-Sep-2008';'21-Dec-2008';...
            '21-Mar-2009';'21-Jun-2009';'21-Sep-2009';'21-Dec-2009';....
            '21-Mar-2010';'21-Jun-2010';'21-Sep-2010';'21-Dec-2010';....
            '21-Mar-2011';'21-Jun-2011'};
Compounding = 4;
Basis = 0;

RateSpec = intenvset('ValuationDate', ValuationDate, ...
'StartDates', ValuationDate, 'EndDates', EndDates, ...
'Rates', Rates, 'Compounding', Compounding, 'Basis', Basis);
RateSpec = 

           FinObj: 'RateSpec'
      Compounding: 4
             Disc: [14x1 double]
            Rates: [14x1 double]
         EndTimes: [14x1 double]
       StartTimes: [14x1 double]
         EndDates: [14x1 double]
       StartDates: 733428
    ValuationDate: 733428
            Basis: 0
     EndMonthRule: 1

Call the calibration routine to find values for volatility parameters Alpha and Sigma.  Use hwcalbycap to calculate the values of Alpha and Sigma based on market data. Internally, hwcalbycap calls the Optimization Toolbox™ function lsqnonlin. You can customize lsqnonlin by passing an optimization options structure created by optimoptions and then this can be passed to hwcalbycap using the name-value pair argument for OptimOptions. For example, optimoptions defines the target objective function tolerance as 100*eps and then calls hwcalbycap:

o=optimoptions('lsqnonlin','TolFun',100*eps);

[Alpha, Sigma] = hwcalbycap(RateSpec, MarketStrike, MarketMat, MarketVol,...
Strike, Settle, Maturity, 'Reset', Reset, 'Principal', Principal, 'Basis',... 
Basis, 'OptimOptions', o)
Local minimum possible.

lsqnonlin stopped because the size of the current step is less than
the default value of the step size tolerance.

Warning: LSQNONLIN did not converge to an optimal solution. It exited with exitflag = 2.
 
> In hwcalbycapfloor at 93
  In hwcalbycap at 75 

Alpha =

   1.0000e-06


Sigma =

    0.0127

The previous warning indicates that the conversion was not optimal. The search algorithm used by the Optimization Toolbox™ function lsqnonlin did not find a solution that conforms to all the constraints. To discern whether the solution is acceptable, look at the results of the optimization by specifying a third output (OptimOut) for hwcalbycap:

[Alpha, Sigma, OptimOut] = hwcalbycap(RateSpec, MarketStrike, MarketMat,...
MarketVol, Strike, Settle, Maturity, 'Reset', Reset, 'Principal', Principal,...
'Basis', Basis, 'OptimOptions', o);

The OptimOut.residual field of the OptimOut structure is the optimization residual. This value contains the difference between the Black caplets and those calculated during the optimization. You can use the OptimOut.residual value to calculate the percentual difference (error) compared to Black caplet prices and then decide whether the residual is acceptable. There is almost always some residual, so decide if parametrizing the market with a single value of Alpha and Sigma is acceptable.

Price caplets using market data and Black's formula to obtain reference caplet values.  To determine the effectiveness of the optimization, calculate reference caplet values using Black's formula and the market data. Note, you must first interpolate the market data to obtain the caplets for calculation:

MarketMatNum = datenum(MarketMat);
[Mats, Strikes] = meshgrid(MarketMatNum, MarketStrike);
FlatVol = interp2(Mats, Strikes, MarketVol, datenum(Maturity), Strike, 'spline');

Compute the price of the cap using the Black model:

[CapPrice, Caplets] = capbyblk(RateSpec, Strike, Settle, Maturity, FlatVol,...
'Reset', Reset, 'Basis', Basis, 'Principal', Principal); 
Caplets = Caplets(2:end)';
Caplets =

    0.3210
    1.6355
    2.4863
    3.1903
    3.4110
    3.2685
    3.2385
    3.4803
    3.2419
    3.1949
    3.2991
    3.3750

Compare optimized values and Black values and display graphically.  After calculating the reference values for the caplets, compare the values, analytically and graphically, to determine whether the calculated single values of Alpha and Sigma provide an adequate approximation:

OptimCaplets = Caplets+OptimOut.residual;

disp('   ');
disp('    Black76   Calibrated Caplets');
disp([Caplets                   OptimCaplets])

plot(MarketMatNum(2:end), Caplets, 'or', MarketMatNum(2:end), OptimCaplets, '*b');
datetick('x', 2)
xlabel('Caplet Maturity');
ylabel('Caplet Price');
title('Black and Calibrated Caplets');
h = legend('Black Caplets', 'Calibrated Caplets');
set(h, 'color', [0.9 0.9 0.9]);
set(h, 'Location', 'SouthEast');
set(gcf, 'NumberTitle', 'off')
grid on
 Black76   Calibrated Caplets
    0.3210    0.3636
    1.6355    1.6603
    2.4863    2.4974
    3.1903    3.1874
    3.4110    3.4040
    3.2685    3.2639
    3.2385    3.2364
    3.4803    3.4683
    3.2419    3.2408
    3.1949    3.1957
    3.2991    3.2960
    3.3750    3.3663

Compare cap prices using the Black, HW analytical, and HW tree models.  Using the calculated caplet values, compare the prices of the corresponding cap using the Black model, Hull-White analytical, and Hull-White tree models. To calculate a Hull-White tree based on Alpha and Sigma, use these calibration routines:

  • Black model:

    CapPriceBLK = CapPrice;
  • HW analytical model:

    CapPriceHWAnalytical = sum(OptimCaplets);
  • HW tree model to price the cap derived from the calibration process:

    1. Create VolSpec from the calibration parameters Alpha and Sigma:

      VolDates    = EndDates;
      VolCurve    = Sigma*ones(14,1);
      AlphaDates  = EndDates;
      AlphaCurve  = Alpha*ones(14,1);
      HWVolSpec = hwvolspec(ValuationDate, VolDates, VolCurve,AlphaDates, AlphaCurve);
    2. Create the TimeSpec:

      HWTimeSpec  = hwtimespec(ValuationDate, EndDates, Compounding);
    3. Build the HW tree using the HW2000 method:

      HWTree = hwtree(HWVolSpec, RateSpec, HWTimeSpec, 'Method', 'HW2000');
    4. Price the cap:

      Price = capbyhw(HWTree, Strike, Settle, Maturity, Reset, Basis, Principal); 
      
      disp('   ');
      disp(['  CapPrice Black76 ..................:  ', num2str(CapPriceBLK,'%15.5f')]);
      disp(['  CapPrice HW analytical..........:  ', num2str(CapPriceHWAnalytical,'%15.5f')]);
      disp(['  CapPrice HW from capbyhw ..:  ', num2str(Price,'%15.5f')]);
      disp('   ');
      CapPrice Black76 ..........: 34.14220
      CapPrice HW analytical.....: 34.18008
      CapPrice HW from capbyhw ..: 34.14192

Price a portfolio of instruments using the calibrated HW tree.  After building a Hull-White tree, based on parameters calibrated from market data, use HWTree to price a portfolio of these instruments:

  • Two bonds

    CouponRate = [0.07; 0.09];
    Settle= ' Jan-21-2008';
    Maturity = {'Mar-21-2010';'Mar-21-2011'};
    Period = 1;
    Face = 1000;
    Basis = 0;
    
  • Bond with an embedded American call option

    CouponRateOEB = 0.08;
    SettleOEB = ' Jan-21-2008';
    MaturityOEB = 'Mar-21-2011';
    OptSpec = 'call';
    StrikeOEB = 950;
    ExerciseDatesOEB = 'Mar-21-2011';
    AmericanOpt= 1;
    Period =1;
    Face = 1000;
    Basis =0;
    

To price this portfolio of instruments using the calibrated HWTree:

  1. Use instadd to create the portfolio InstSet:

    InstSet = instadd('Bond', CouponRate, Settle,  Maturity, Period, Basis, [], [], [], [], [], Face);
    InstSet = instadd(InstSet,'OptEmBond',  CouponRateOEB, SettleOEB, MaturityOEB, OptSpec,...
    StrikeOEB,   ExerciseDatesOEB, 'AmericanOpt', AmericanOpt, 'Period', Period,...
    'Face',Face,  'Basis', Basis);
    
  2. Add the cap instrument used in the calibration:

    SettleCap = ' Jan-21-2008';
    MaturityCap = 'Mar-21-2011';
    StrikeCap = 0.0690;
    Reset = 4;
    Principal = 1000;
    
    InstSet = instadd(InstSet,'Cap', StrikeCap, SettleCap, MaturityCap, Reset, Basis, Principal);
  3. Assign names to the portfolio instruments:

    Names = {'7% Bond'; '8% Bond'; 'BondEmbCall'; '6.9% Cap'};
    InstSet = instsetfield(InstSet, 'Index',1:4, 'FieldName', {'Name'}, 'Data', Names );
  4. Examine the set of instruments contained in InstSet:

    instdisp(InstSet)
    
    IdxType CoupRate Settle Mature Period Basis EOMRule IssueDate 1stCoupDate LastCoupDate StartDate Face Name
    
    1 Bond 0.07       21-Jan-2008    21-Mar-2010    1  0  NaN  NaN     NaN   NaN  NaN  1000    7% Bond
    2 Bond 0.09       21-Jan-2008    21-Mar-2011    1  0  NaN  NaN     NaN   NaN  NaN  1000    8% Bond
    
    IdxType CoupRate Settle Mature OptSpec Stke ExDate Per Basis EOMRule IssDate 1stCoupDate LstCoupDate StrtDate Face AmerOpt Name
    3 OptEmBond 0.08 21-Jan-2008 21-Mar-2011 call 950  21-Jan-2008  21-Mar-2011  1  0  1  NaN  NaN NaN  NaN  1000 1 BondEmbCall
     
    Index Type Strike Settle     Maturity   CapReset Basis Principal Name 
    4 Cap  0.069  21-Jan-2008    21-Mar-2011    4      0     1000    6.9% Cap   
  5. Use hwprice to price the portfolio using the calibrated HWTree:

    format bank
    PricePortfolio = hwprice(HWTree, InstSet)
    PricePortfolio =
            980.45
           1023.05
            945.73
             34.14
    
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