Control Variates for Callable LIBOR Exotics - A Preliminary Study

Abstract

Monte Carlo simulation is currently the method of choice for the pricing of callable derivatives in LIBOR market models. Lately more and more papers are surfacing in which variance reduction methods are applied to the pricing of derivatives with early exercise features. We focus on one of the conceptually easiest variance reduction methods, control variates. The basis of our method is an upper bound of the callable contract in terms of plain vanilla contracts, which is found to be a highly effective control variate. Several examples of callable LIBOR exotics demonstrate the effectiveness and wide applicability of the method.

Keywords: LIBOR market model, variance reduction, control variates, Monte Carlo, Bermudans, callable derivatives, Longstaff-Schwartz

JEL Classification: C15, C63, G13