A Simple Approach to the Pricing of Bermudan Swaptions in the Multi-Factor Libor Market Model

26 Pages Posted: 7 Apr 1999

Date Written: March 5, 1999

Abstract

This paper considers the pricing of Bermuda-style swaptions in the Libor market model (Brace et al (1997), Jamshidian (1997), Miltersen et al (1997)) and its extensions (Andersen and Andreasen (1998)). Due to its large number of state variables, application of lattice methods to this model class is generally not feasible, and we instead focus on a simple technique to incorporate early exercise features into the Monte Carlo method. Our approach involves a direct search for an early exercise boundary parametrized in intrinsic value and the values of still-alive swaptions. We compare results of the proposed algorithm against prices obtained from Markov Chain approximations and finite difference methods. The proposed algorithm is fast and robust, and produces a lower bound on Bermuda swaption prices that appears to be very tight for many realistic structures. The paper contains several numerical results against which other methods can be tested.

JEL Classification: G12, G13, E43

Suggested Citation

Andersen, Leif B.G., A Simple Approach to the Pricing of Bermudan Swaptions in the Multi-Factor Libor Market Model (March 5, 1999). Available at SSRN: https://ssrn.com/abstract=155208 or http://dx.doi.org/10.2139/ssrn.155208

Leif B.G. Andersen (Contact Author)

Bank of America Merrill Lynch ( email )

One Bryant Park
New York, NY 10036
United States
646-855-1835 (Phone)

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