The University of Reading

THE BUSINESS SCHOOL

FOR FINANCIAL MARKETS

Common Correlation Structures

for Calibrating the LIBOR Model
ISMA Discussion Papers in Finance 2002-18
First Version: 1 June 2002
This version: 20 June 2002

Carol Alexander

ISMA Centre, University of Reading, UK

Copyright 2002 Carol Alexander. All rights reserved.

The University of Reading • ISMA Centre • Whiteknights • PO Box 242 • Reading RG6 6BA • UK
Tel: +44 (0)118 931 8239 • Fax: +44 (0)118 931 4741
Email: research@ismacentre.rdg.ac.uk • Web: www.ismacentre.rdg.ac.uk

Director: Professor Brian Scott-Quinn, ISMA Chair in Investment Banking

The ISMA Centre is supported by the International Securities Market Association
 Summary
In 1997 three papers that introduced very similar lognormal diffusion processes for interest rates
appeared virtuously simultaneously. These models, now commonly called the 'LIBOR models'
are based on either lognormal diffusions of forward rates as in Brace, Gatarek & Musiela (1997)
and Miltersen, Sandermann & Sondermann (1997) or lognormal diffusions of swap rates, as in
Jamshidian (1997). The consequent research interest in the calibration of the LIBOR models has
engendered a growing empirical literature, including many papers by Brigo and Mercurio, and
Riccardo Rebonato (www.fabiomercurio.it and www.damianobrigo.it and www.rebonato.com).
The art of model calibration requires a reasonable knowledge of option pricing and a thorough
background in statistics − techniques that are quite different to those required to design no-
arbitrage pricing models. Researchers will find the book by Brigo and Mercurio (2001) and the
forthcoming book by Rebonato (2002) invaluable aids to their understanding.
I aim to provide an accessible account of some interesting problems in LIBOR model calibration,
but the ideas are complex, so notational complexities are reduced to a minimum. We take fresh
look at three important modelling decisions when calibrating the LIBOR model: the
parameterization of the correlation matrix for semi-annual forward rates; the use of principal
component analysis in the orthogonal transform of the log normal forward rate model; and the
iterations for recovering caplet volatilities from 'flat' cap volatilities.
The first section provides the briefest of introductions to the lognormal forward rate version of
the LIBOR model. Section two considers the calibration of the model to the cap market, where it
is shown that the iteration of caplet volatilities from the 'flat' cap volatilities quoted in the market,
should be performed by equating a vega weighted sum of caplet volatilities to the cap volatility.
Section 3 discusses the more difficult problem of calibration to the swaption market. Two full
rank parsimonious parameterizations of the semi-annual correlation matrix are specified, where
correlations between annual forward rates are determined by the same parameters.
Section 4 reconsiders calibration to the swaption market where the rank of forward rate
correlation matrices is reduced by setting all but the three largest eigenvalues to zero. Rebonato
(1999a), Rebonato and Joshi (2001) Hull and White (1999, 2000) and Logstaff, Santa-Clara and
Schwartz (1999) have all found that this technique is useful for performing the simulations that
are necessary for pricing path dependent options. The implication of zeroing eigenvalues is a
transformation of the lognormal forward rate model where each forward rate is driven by three
orthogonal factors that are derived from a principal component analysis. We show that, in fact, it
is the common principal components model of Flury (1988) that should be used. That is, the same
eigenvectors should be calibrated to all swaptions of the same tenor, and we advocate the use of
market data rather than historical data for the calibration of these common eigenvectors.

Contacting Author:
Prof. Carol Alexander
Chair of Risk Management and Director of Research
ISMA Centre, School of Business, University of Reading, Reading RG6 6AA
c.alexander@ismacentre.rdg.ac.uk

This discussion paper is a preliminary version designed to generate ideas and constructive comment. The
contents of the paper are presented to the reader in good faith, and neither the author, the ISMA Centre, nor
the University, will be held responsible for any losses, financial or otherwise, resulting from actions taken
on the basis of its content. Any persons reading the paper are deemed to have accepted this.
 ISMA Centre Discussion Papers in Finance 2002-18

1. The Lognormal Forward Rate Model

f1 f2 f3

Today t1 t2 t3 t4

To ease the notation we assume that day counts are constant. That is, year-fractions between
payment (or reset) dates are constant for all forward rates, and the basic forward rate is a semi-
annual rate. Denote by fi the semi-annual forward rate that is fixed at time ti but stochastic up to
that point in time. Each forward rate has its own 'natural' measure, which is the measure with
numeraire Pi+1 where P i is the value of a zero coupon bond maturing at date ti . Under it's natural
measure each forward rate is a martingale and therefore has zero drift in its dynamics. The log
normal forward rate model is therefore

dfi(t)/ fi(t) = σi (t) dWi [ i = 1, ….., m; 0 < t < ti ] (1)

where dW1, ……, dWm are Brownian motions with correlations ρij(t). That is,

E[dWi dWj ] = ρij (t) dt (2)

Calibration of the model requires using current market (and/or historical) data to estimate the
parameters σi (t) and ρij (t) [i, j = 1, ….., m]

2. Calibration to the Cap Market

Consider a T maturity cap with strike K as a set of caplets from ti to ti+1 [i = 1,….., m −1 and t m =
T]. Each caplet pay-off = max (Li – K, 0) where Li is the LIBOR rate revealed at time ti and at ti
we have Li = fi. Assume for the moment that σi (t) = σi . Then the Black-Scholes type formula for
each caplet value at time 0 is:

B-S (Caplet, ti , K, σi ) = Pi+1 [fi (0)Φ (x) - KΦ(y)] = Ci (σi ) , say

and x = ln (fi (0)/K) / σi √ti + σi √ti /2; y = x - σi √ti

The B-S cap price is the sum Σ Ci(σi ) of all prices of the caplets.

If we further assume that σi = σ for every i then we can ‘back-out’ a single ‘flat volatility’ σ
from the observed market price of a cap. Note that each fixed strike caplet in the cap with strike K
has a different moneyness. For example, consider an ‘at-the-money’ (ATM) cap. Each ti+1
maturity caplet is ATM if fi (0) = K, but since each caplet has a different underlying forward rate,
each caplet would have a different ATM strike. We normally define the ATM cap strike as the
current value of the swap rate for the period of the cap, so the different caplets in an ATM cap are
only approximately ATM.

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 ISMA Centre Discussion Papers in Finance 2002-18

Volatility

Maturity
Figure 1: Typically 'humped shape' flat cap volatility term structure. The ATM flat cap
volatility is the volatility that should be substituted into the B-S Cap formula with strike
equal to the swap rate, so that the model price equals the market prices of caps.

Figure 1 shows the typical 'humped shape' term structure for flat volatilities of caps.1 This is the
curve of σ(n) plotted against maturity, n where σ(1) is the volatility of a single caplet [say for 3
months]; σ(2) is the volatility of a 6 months cap [the sum of two 3 month caplets] and so forth. In
the simple version of the LFR model, with σi (t) = σi ∀ i, the implied forward rate volatilities are
the caplet volatilities that are stripped out from the ‘flat’ volatility term structure for caps using
some iterative method. These volatilities will display a more pronounced humped shape than the
cap volatilities – and may even be negative if the hump is very pronounced.

The market quotes flat volatilities for caps of different maturities, T and strikes, K; thus an
implied volatility surface σ(K, T) is quoted at any point in time. So what are the implied
volatilities of the caplets that make up the caps with different strikes and maturities that are
consistent with the quoted cap volatility surface?

The first proposition in the paper concerns the iterative method used to back out these caplet
volatilities from the cap market implied volatility surface. In option markets where the underlying
is a single asset whose dynamics are governed by a standard lognormal Brownian motion, the
average variance of log returns over a period T = T1 + T2 is the sum of the average variance of log
returns over period T1 and the average variance of log returns over period T2 . The additivity of
variances is a consequence of the independent increments in the stochastic process for a single
underlying asset, and because variances are additive it is standard practice to 'back out' volatilities
from a term structure using the iterative method:

Set σ1 = σ (1); then solve for σ2 from [σ1 2 + σ22 ]/2 = σ (2) 2 and so forth.

However, for a cap there is no single stochastic process for the underlying. The underlying
forward rate changes for every caplet in the cap and therefore an iteration on variances is not
appropriate. In fact, the iteration should be performed on the volatilities. The following
proposition shows that the cap volatility is approximately equal to the vega weighted sum of the
caplet volatilities:

1
Note that the market prices of caps may imply inconsistent caplet volatilities; that is, caps with common
caplets may imply different volatilit ies for the same caplets.
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 ISMA Centre Discussion Papers in Finance 2002-18
Proposition 1:

Denote by σ(K, T) the market quote of a 'flat' implied volatility for a cap of strike K and maturity
T. Denote by σi(K) the implied volatility and by and v i (K) the vega of the ith caplet in the cap of
strike K and maturity T (thus v i = ∂Ci (σi )/∂σi ). Then

σ (K, T) ≈ Σ [vi(K)σi(K)]/ Σ vi (K)

That is, the flat cap volatility σ (K, T) is approximately equal to the vega weighted sum of the
caplet volatilities.

Proof:

For ease of notation we drop the explicit mention of the dependence of implied volatilities on
strike and maturity. For a fixed maturity T and strike K, the flat volatility σ is defined as the
volatility such that the B-S cap price, (denoted C(σ) and written as a function just of volatility) is
equal to the sum of the caplets priced at the caplet constant volatilities; that is C(σ) = Σ Ci (σi).
Expanding each Ci (σi ) using a first order Taylor approximation about σ gives:

C(σ) = Σ Ci (σi ) ≈ Σ [Ci (σ) + (σi − σ) ∂Ci (σi )/ ∂σi ]

Where the derivative ∂Ci (σi )/ ∂σi = vi is evaluated at σi = σ. This implies

Σ (σi − σ) ∂Ci (σi )/ ∂σi ≈ 0

and so the flat volatility is approximately a vega weighted sum of each caplet volatility:

σ ≈ Σ wi σi

where wi = vi / Σ vi so Σai = 1.
♦

The cap vega is the sum of the caplet vegas, so caplet vegas can be backed out from estimates of
the cap vegas. They will normally decrease with maturity. Note that if one assumes that all
caplets have the same vega the caplet volatilities will be found by setting σ1 = σ(1) as before and
then iterating for σ2 using [σ1 + σ2 ]/2 = σ(2) and so forth. However more generally the caplet
volatilities should be backed out using the following iteration:

Set σ1 = σ(1); then solve forσ2 from [v1 σ1 + v2 σ2 ]/[[v1 + v2 ] = σ(2) , and so forth.

The intuition behind proposition 1 may be illustrated by considering the notion of an ATM flat
cap volatility term structure. The ATM cap is a sum of approximately ATM caplets, and ATM
options are approximately linear in volatility [but not in variance!] so it is the volatilities of the
cap and the caplets that have an approximate linear relation, not their variances.

A vega weighted iteration is less likely to give negative forward rate volatilities than a variance
iteration; also note that there will be no problem with imaginary volatilities, but that imaginary
volatilities could arise under the variance iteration when iterated variances are negative. The
following simple example will illustrate this point.

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 ISMA Centre Discussion Papers in Finance 2002-18

Suppose that a flat cap volatility term structure is parameterised as At[exp(-Bt)] + C, which is a
simple hump shaped curve, and t = 0.5, 1, 1.5, ….10 years. We consider the two cases (i) A = 0.2;
B = 0.6; C = 0.2 and (ii) A = 0.2; B = 0.6; C = 0.1. Figures 2(i) and 2(ii) illustrate the cap
volatility curve and the caplet volatilities that are obtained by three different methods: the
variance iteration, the volatility iteration (which is proposition 1 with the assumption that all
vegas are equal) and the vega iteration of proposition 1.

The cap volatilities are uniformly greater in case (i), and all three methods lead to real, non-
negative caplet volatilities; however in case (ii) - with lower cap volatilities which are perhaps
more realistic of current market conditions in the US and Europe - the variance weighted method
gives imaginary volatilities from 4 years onwards. Note that the effect of vega weighting is to
reduce the longer maturity caplet volatilities in both cases.

Figure 2(i)

Cap Vol: A = 0.2; B = 0.6; C = 0.2

Figure 2(i)
Volatility Iteration Vega Iteration Variance Iteration
35.00%
40.00%

30.00%
30.00%

20.00%

25.00%
10.00%

20.00% 0.00%

Figure 2(ii)

Cap Vol: A = 0.2; B = 0.6; C = 0.1 Volatility Iteration Vega Iteration Variance Iteration
25.00% 30.00%

20.00% 20.00%

15.00% 10.00%

10.00% 0.00%

Figure 2: Cap volatilities and iterated caplet volatilities under the three methods

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 ISMA Centre Discussion Papers in Finance 2002-18
Moving now to the LFR model (1) with time-varying but deterministic volatilities, it is standard
to assume

σi(t) = θi h(t) (3)

where the parametric form h(t) that is common to all volatilities is a simple form that can capture
the ‘hump’ in volatility: for example, the parametric form:

h(t) = [(a + b(T − t)exp(-c(T −t)) + d] (4)

was introduced by Rebonato (1999a) and has since been used by many others. The parameters a,
b, c, d define a common volatility structure, and the individual parameters θi are there so that
instantaneous volatilities can be adjusted upwards or downwards to exactly match the prices in
the cap market.

The parameters a, b, c, d and θ may be calibrated to implied caplet volatilities. We have the
average caplet volatilities implied from the market σ i imp and to these we need to calibrate the model
instantaneous volatilities σ i (t) = θi h(t). Considering the calibration objective, calibration is to
(approximately) ATM option prices and ATM options are (approximately) linear in volatility.
Thus an objective that minimizes the (weighted) sum of the squared pricing errors translates to an
objective that minimizes the (weighted) sum of the squared volatility differences – not variance
differences. A simple calibration objective is therefore:

 ti 
∑ i  σimp 
2
∫
2
min η t i − θi h(t) dt
i

i
 0 
The weights ηi are there to account for the uncertainty that surrounds different option prices (and
volatilities). Normally the weights will be a decreasing function of maturity (and tenor, in the
case of a swaption). How should these weights be chosen? The bid-offer spread is a good
indication of the uncertainty in pricing; it normally increases with maturity. Uncertainty in pricing
also translates to uncertainty in volatility through the caplet vega: high vega means that large
price errors will induce small volatility errors and low vega means that small price errors will
induce large volatility errors. Thus, to place more weight on the more certain volatilities, set the
calibration weights ηi to be directly proportional to vega and inversely proportional to the bid-
offer spread:

With so many parameters, of course the model will fit the market prices of caps perfectly. In fact
if we set
σ imp ti
θi = i
ti

∫ h(t)
2
dt
0

then the model will price caps perfectly. This may be used when calibrating to swaption
volatilities, as we shall see below.

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 ISMA Centre Discussion Papers in Finance 2002-18
3. Calibration to the Swaption Market

Unlike caps, a swaption pay-off [max (value of swap, 0)] cannot be written as a simple sum of
options, so forward rate correlations as well as their volatilities will affect the value of a swaption.
We shall also need to work in a single measure, but forward rates are only drift-less under their
natural measure. Hull and White (1999, 2000) take as numeraire the discretely re-invested money
market account. This gives the ‘spot LIBOR measure’, where the appropriate rate for discounting
an expected cash flow at time ti+1 to time ti is the forward rate fi . This is intuitive and it leads to a
(relatively) tractable specification of the drift terms, so we shall adopt this here.2

Under the spot LIBOR measure the forward rate f i has dynamics given by

dfi(t)/ fi(t) = µi(t) dt + σi (t) dWi

where
i ρ ij (t) σ j (t)f j (t) (5)
µ i (t) = σ i (t) ∑
j=m(t)
1 + f j (t)

Here m(t) is the ‘number’ of the accrual period. The drift becomes important when using the LFR
model to price path dependent options, where the resolution method will, most likely, be Monte
Carlo simulation, and the drift will need updating every time step. We shall return to this in the
next section, but in this section we are considering the calibration of forward rate volatilities and
correlations to swaption volatilities, where the drift is not important.

We aim to derive an expression for the (instantaneous) volatility of the swap rate in terms of the
(instantaneous) volatilities and correlations of the semi-annual forward rates underlying the swap.
To do this we follow Rebonato (1998) and write SR2,3 as an approximate linear function of
annual forward rates Fi below. Before following Rebonato's derivation, it should be noted that
other relationships between swap and forward rates have been developed by several authors. Hull
and White (1999) write the log swap rate as a difference in logs of products of forward rates to
derive an exact expression for the volatility of the swap rate. Longstaff, Santa-Clara and Schwartz
(1999) use a least square regression technique to write the swap rate as an approximate linear
function of forward rates. Jäckel and Rebonato (2000) express the swap rate variance as a
weighted sum of forward rate covariances and thus derive an approximation for the volatility of
the swap rate. Andersen and Andreasen (2000) refine the relationship between forward rates and
swap rates in the presence of a volatility skew.

The forward swap rate SR2,3 for a 3-year swap starting at time t2 and ending at time t5 is
illustrated in figure 3. It is given by

SR2,3 = [P2 – P5 ]/[P 3 + P4 + P5 ]

which, after some calculations, becomes

SR2,3 = [P3 F2 + P4 F3 + P5 F4 ]/[P3 + P4 + P 5]

2
See Brigo and Mercurio (2001) for the specification of the drifts under other choices of numeraire.
Copyright 2002, Carol Alexander. 8
 ISMA Centre Discussion Papers in Finance 2002-18

SR2,3
F2 F3 F4

t0 t1 t2 t3 t4 t5

P2 P5
Figure 3: Swap rates, annual forward rates and discount bond prices

In general for an m-year swap starting at tn (that is, an "n into m year" swap) we have:

SRn,m = w 1Fn + ….. + w mFn+m-1

where the weights wi = Pn+i /[Pn+1 + …. + P n+m] are assumed constant [at their current value].
Consequently the variance of the swap rate may be written as a quadratic form in the 3 x3
covariance matrix of annual forward rates. Thus swap rate volatilities will be linked to annual
forward rate volatilities and correlations, as shown in figure 4.

SR 2,3
F2 F3 F4

t0 t1 t2 t3 t4 t5
σ2(t)
σ3(t)
σ4(t)
Figure 4: Swap rates volatilities and
ρ2,3(t)
forward rate volatilities and correlations
ρ2,4(t)
ρ3,4(t)

σSR2,3(t)

For the algebra, write w = (w 1, ….,wn )’ and let Vn,m (t) be the instantaneous covariance matrix of the
forward rates Fn ,……Fn+m-1 for 0 < t < tn . Then SRn.m has instantaneous variance given by

σ n,m(t)2 = w’Vn,m (t)w

The average volatility during the interval [0, tn ] is (6)

tn
1
σ model
n, m =
tn ∫σ
0
n, m (t) 2 dt

and this volatility may be used with the well-known B-S type swaption pricing formula.

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 ISMA Centre Discussion Papers in Finance 2002-18
If reliable (B-S) swaption prices are available in the market, from these we can immediately
imply the average swaption volatility σn,mimp . Otherwise we shall need to smooth the volatility
surface using a 2-dimensional smoothing algorithm. It is well known that calibration results will
be sensitive to the choice of smoothing algorithm (see for example Brigo and Mercurio, 2001).

We know the weights w [from current values of discount bonds] and we want to infer the
parameters of Vn,m (t) by equating the model volatilities (that are defined by equations (6)) to the
(smoothed) implied swaption volatilities σn,mimp . The covariance matrix of annual forward rates
Vn,m(t) contains (instantaneous) volatilities and correlations of annual rates. Indeed it may be
factored as

Vn,m(t) = Dn,m(t) Σ n,m(t) Dn,m(t) (7)

where Σn,m(t) is the correlation matrix and Dn,m(t) is the diagonal matrix of the (instantaneous)
volatilities of the m annual forward rates Fn , ….Fn+m -1 underlying the n into m year swap.

Now we shall:

Ø Express the annual rate volatilities (swaption volatilities) in Dn,m(t) in terms of the semi-
annual rate volatilities that we know how to calibrate from the cap market, and

Ø Derive a simple parameterization of the annual rate correlation matrix Σ n,m(t) from a
parameterization of the semi-annual rate correlation matrix .

It is simple to express an annual forward rate F in terms of the two underlying semi-annual rates
f1 and f2 :

(1 + F) = (1 + f1 /2)(1 + f2 /2) so F = f 1 /2 + f2 /2 + f1f2 /4 (8)

Differentiating:
dF = df 1 /2 + df 2 /2 + f 2 df1 /4 + f1 df2 /4 = x1 (df 1 /f1 ) + x2 (df 2 /f2 )

where x1 = f1 /2 + f1f2 /4 and x2 = f 2 /2 + f1 f2/4 . Now m1 = x1 /F and m2 = x2 /F are assumed constant [at a
value given by the current estimates of forward rates]. Then the volatility of the annual rate is
expressed in terms of volatilities of semi-annual rates and their correlation ρ12 as:

σ 2 ≈ m1 2 σ 1 2 + m2 2 σ2 2 + 2ρ 12 m1 m2 σ1 σ2

More generally, if (1 + F i ) = (1 + f2i −1 /2)(1 + f2i /2) then the annual rate volatility is

σ i 2 ≈ m2i −12 σ2i −12 + m2i 2 σ2i 2 + 2ρ 2i −1, 2i m2i −1 m2i σ 2i −1σ 2i (9)?

We have expressed annual rate volatilities in terms of the semi-annual volatilities that may be
calibrated to the cap market. But since the expression involves the correlation of adjacent semi-annual
forward rates, these parameters will also enter Dn,m (t).

Now to our second objective, which is to derive a simple parameterization of the annual rate
correlation matrix Σ n,m(t) from a parameterization of the semi-annual rate correlation matrix . Some
researchers [e.g. Brigo and Mercurio (2001), Rebonato and Joshi (2001), Jäckel (2002)] assume
that the annual rate correlation matrix is Σ n,m= {ρ i,j} where

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 ISMA Centre Discussion Papers in Finance 2002-18
ρ i,j = exp(− ϕi − j) (10)

Variants of this, such as ρ i,j = exp(− ϕiγ − jγ) are discussed in Brigo (2001) but these
parameterizations do not lend themselves to a straightforward relationship between the semi-
annual rate correlations and the annual correlations. The following proposition shows that if we
use the parameterization (10) for semi-annual forward rates then there is a simple relationship
between semi-annual correlations and annual correlations.

Write ρ = exp(− ϕ), so that (10) may be written ρ i,j = ρ i − j and we observe that the correlation
matrix is a 'circulant' matrix (written out in full below). Then we have:

Proposition 2:

Suppose the 2m x2m correlation matrix of semi-annual forward rates underlying an n into m year
swaption, denoted Σ n, m _semi , is given by the circulant correlation matrix:

 1
 ρ ρ2 ....... ρ 2 m −1 
 ρ 1 ρ ρ 2 ..... ρ 2 m − 2 
 2 
 ρ ρ 1 ρ ..... ρ 2 m − 3 
. . 
. 
 . 
. . 
 2 m − 1 
ρ ...... 1 

Then the mxm correlation matrix of the annual forward rates underlying the same swaption,
denoted Σ n, m is approximated by the correlation matrix:

 1 φ ρ2 φ ....... ρ2 ( m −2 )φ 
 
 φ 1 φ ρ2 φ..... ρ2( m −3 ) φ 
 ρ 2φ φ 1 φ ..... ρ2 ( m −4 )φ 

. . 
. . 
 
. . 
 ρ2( m −2 )φ ......1 
 

where φ = ρ(1+ρ)/2.

Proof:

Let ρ be the correlation between any two adjacent semi-annual forward rates, and we assume that the
correlation between the two semi-annual rates fi and fj is ρi−j . With this 'circulant' structure for
semi-annual rates the correlation between two adjacent annual forward rates is approximately
ρ(1+ ρ)/2 and more generally, the correlation between two annual forward rates F i and Fj is
approximately ρ2|i-j|-1 (1+ ρ) / 2. The approximation is based on the assumptions that (i) annual rates
are simply the average of two semi-annual rates and (ii) semi-annual volatilities are equal.

Under these assumptions

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 ISMA Centre Discussion Papers in Finance 2002-18
Fi = (f2i − 1 + f2i )/2,

V(Fi ) = σ2 [1 + ρ] / 2
and
Cov(Fi , Fj ) = σ2 ρ2|i-j|-1 [1 + ρ] 2 / 4

so the result follows.

♦

An interesting parameterization of Schoenmakers and Coffey (2000) allows for the empirical
observation that the correlation of adjacent forward rates tends to increase with maturity.3
Schoenmakers and Coffey's semi-parametric form for a correlation matrix of M forward rates is based
on and increasing sequence of M real numbers. The next proposition shows that the increasing
correlation of adjacent forward rates with maturity may be captured by a two parameter matrix for
semi-annual rates, where again there is a simple extension from the semi-annual correlation matrix to
a correlation matrix for annual rates that has the same two parameters:

Proposition 3:

Suppose the 2m x2m correlation matrix of semi-annual forward rates underlying an n into m year
swaption, denoted Σ n, m _semi , is given by the two parameter correlation matrix (ρij ) where:

ρ ij = (ψ j-1 ρ)i−j

i < j, 0 < ρ < 1 and ρ < ψ 2m−1ρ < 1.

Then the mxm correlation matrix of the annual forward rates underlying the same swaption,
denoted Σ n, m is approximated by the correlation matrix (ρ ij ) where:

2 i − j −1
(ψ 2(j −1) ρ) (1 + (1 + ψ)ψ 2( j−1) ρ + (ψ 2 ( j−1) ρ) 2 )
ρ ij =
2 (1 + ψ 2(i −1) ρ)(1 + ψ 2(j −1) ρ)

Note also that an alternative parameterization of semi-annual rate correlations as ρ ij = ψ j-1ρ i−j
leads to the approximated annual correlation matrix (ρij ) where:

2 i − j −1
ρ ψ 2j−1 (1 + ρ)(1 + ρ/ψ )
ρ ij =
2 (1 + ψ 2(i −1) ρ) (1 + ψ 2(j −1) ρ)

Proof:
The results follow after some algebra using similar assumptions and methods as in proposition 2. For
example
V(Fi ) = σ2 [1 + ψ2(i -1)ρ] / 2
and with the first parameterization:

Cov(Fi , Fj ) = σ2 (ψ2(j -1) ρ) 2|i-j|-1[1 + (1+ ψ)ψ2(j -1) ρ + (ψ2(j -1) ρ)2 ] / 4

3
Note that any empirical observation on forward rates must necessarily be based on an assumed historical
data period and an assumed method of yield curve interpolation. See Alexander and Lvov (2002) for more
information about the empirical behaviour of correlations in forward rates.
Copyright 2002, Carol Alexander. 12
 ISMA Centre Discussion Papers in Finance 2002-18
Turning now to the calibration objective corresponding to the parsimonious parameterizations of
propositions 2 or 3, note that in the covariance matrix of annual forward rates given by (7), the
correlation matrix Σ n,m(t) is defined in terms of a single parameter ρ [proposition 2] or it is
defined in terms of two parameters ρ and ψ [proposition 3]. Also, by (9), the diagonal matrix of
the annual forward rate volatilities Dn,m(t) is defined in terms of the semi-annual forward rate
volatilities and the same parameters of the semi-annual correlation matrix (i.e. ρ or, under
proposition 3, ρ and ψ).4

Therefore Vn,m(t) is determined by the parameters: a, b, c, d, θ, ρ and ψ. Note that we may

suppose that θ is itself parameterized in terms of a, b, c, and d, serving only to equate model and
market prices for caps as described above. Note also that we could assume time-varying
parametric forms for ρ and ψ. Now we can state that the objective for the calibration is to choose
parameters a, b, c, d, and ρ and ψ (or parameters of ρ(t) and ψ(t)) to:

( )
2
min ∑ ωn, m σ imp
n, m − σ n, m
model

n, m

where the model volatilities are given by (6) and the implied volatilities are from the market.
Again, the weights should be directly proportional to the swaption vega and inversely
proportional to the bid-ask spread.

4. Calibration for Pricing Interest Rate Options

The LFR model may be used to price path dependent options such as Bermudan swaptions. No
analytic pricing formulae exist and resolution methods are used. Some preferred methods based on
Monte Carlo simulation are described in Jäckel (2002). Whichever method is chosen the drifts that are
induced by the change of numeraire will be important, and they will need updating with the current
value of the instantaneous volatilities and correlations at every time step.

For example, consider the drift term for f 3. By (5), and dropping the time variable temporarily, to
shorten notation: when t0 < t < t1:

ρ3 j σ j f j
µ 3 = σ3 ∑
3

j =1 1 + f j
[
ρ σ f ρ σ f σ f
= σ3 31 1 1 + 32 2 2 + 3 3
1 + f1 1 + f2 1 + f3
]
When t1 < t < t2:

ρ3j σ j f j
µ 3 = σ3 ∑
3

j= 2 1 + f j
= σ3 [
ρ32 σ2 f 2 σ 3 f 3
1 + f2
+
1 + f3
]
When t2 < t < t3:

µ 3 = σ3 [ ]
σ3 f 3
1 + f3

4
Note that ρ2i −1, 2i −2 = ρ under proposition 2 and ρ2i −1, 2i −2 = ψ2(i −1) ρ under proposition 3.

Copyright 2002, Carol Alexander. 13

 ISMA Centre Discussion Papers in Finance 2002-18
Thus the instantaneous drift term in the ith forward rate fi depends on the forward rates of lower
maturity fi-1 , fi-2 , etc., but only if these are still random variables at the time that the drift is
estimated. For example, see figure 5. In the accrual period t1 to t2 , f1 is known. Thus only the
volatilities and the correlation of f2 and f3 will affect the drift of f3 in that period.

f3
m(t) = 1 m(t) = 2 m(t) = 3

t0 t1 t2 t3

Figure 5: Correlations of forward rates and the drift

The correlation matrix that one needs to consider for the calibration of the drift term thus
decreases in dimension (by 1) as every payment /reset date passes. This is not the only
complication for the simulation. If m is large the dimension of the simulation will be large and
computationally burdensome. However it is possible to reduce dimensions by reducing the rank
of the correlation matrix. A review of rank reduction methods is given in Brigo (2001).

Following Rebonato (1999c) and Hull and White (1999, 2000), we now consider a natural
method for rank reduction, that is to use an orthogonal transformation of the correlated Brownian
motions in (5). The forward rate dynamics are express in terms of three uncorrelated stochastic
processes that are common to all forward rates:

dfi (t)/ fi (t) = µi (t) dt + λi,1(t) dZ1 + λi,2 (t) dZ2 + λi,3 (t) dZ3

where dZ1 , dZ2 , dZ3 are uncorrelated Brownian motions and

σ i (t) dWi = λi,1(t) dZ1 + λι,2 (t) dZ2 + λi,3 (t) dZ3

From this it follows that:

σi (t) = √ [λi,1 (t) 2 + λi,2(t)2 + λi,3(t)2]

and

ρij (t) = [λi,1(t) λj,1(t)+ λi,2(t) λj,2(t)+ λi,3(t) λj,3(t)] / σ i(t) σ j(t)

Thus the forward rate volatilities and correlations are completely determined by three volatility
‘components’ for each forward rate, λi,1(t), λi,2(t) and λi,3(t).

Suppose (for the moment) that the implied forward rate volatilities σi(t) have been calibrated
from cap prices. The volatility ‘components’ λ1 , λ2 and λ3 could then be determined from the
spectral decomposition of the correlation matrix of the m forward rates5 underlying the derivative,
that is

Σ n,m(t) = W Λ (t) W’

5
Or more precisely, the correlation matrix of the first differences in the logarithms of the forward rates fn , ….fn+m-1
(as is standard for lognormal diffusions).

Copyright 2002, Carol Alexander. 14

 ISMA Centre Discussion Papers in Finance 2002-18
where Λ(t) is the (time-varying) diagonal matrix of eigenvalues and W is the m x m matrix of
eigenvectors (assumed constant).

To see how this spectral decomposition does indeed determine the volatility components, denote
by Λ1 (t), Λ2 (t), Λ3 (t), the three largest eigenvalues of Σ n,m(t) and denote their eigenvectors by
α 1 , α 2 , α 3. Set

M(t)2 = σi (t) 2 /Vi (t)

where

Vi (t) = α i12 Λ1 (t) + α i22 Λ2 (t) + α i32 Λ3 (t) ≈ V(∆ ln fi )

Then set
λi,1 (t) = M(t) α i1 √ Λ1 (t)
λi,2 (t) = M(t) α i2 √ Λ2 (t)
λi,3 (t) = M(t) α i3 √ Λ3 (t)
So that
σ i(t)2 = λi,1(t)2+ λi,2(t)2 + λi,3(t)2
as required.

A number of researchers, notably Rebonato (1999a), Rebonato and Joshi (2001) Hull and White
(1999, 2000) and Logstaff, Santa-Clara and Schwartz (1999) have advocated the use of historical
data for the calibration of the volatility components. The calibration is then based on a principal
component analysis (PCA) of historical data on forward rates.6 The general finding that the first
eigenvector is relatively flat, the second eigenvector is monotonically decreasing (or increasing)
and the third eigenvector is convex - all as a function of the maturity of the forward rate - comes
as no surprise. Forward rates are a highly correlated term structure and the interpretation of
eigenvectors as trend, tilt and curvature components is one of the stylised facts of all term
structures, particularly when they are highly correlated (see Alexander, 2001).

Unfortunately, a LFR model calibration that is based on any historical data will depend very
much on which forward rates are used and the historical period chosen. Should one use the
forward rates obtained from and ordinary cubic spline interpolation (as in Longstaff, Santa-Clara
and Schwartz, 1999), a B-spline interpolation for the yield curve, or those obtained from the
Nelson-Siegal or Svensson parametric forms for the yield curve? And should one use daily data
over the past year, weekly data over the past three years, or what ……? It must be stressed that
when historical data on forward rates are used, the calibration results will be critically dependent
on both the choice of yield curve model and the historical period chosen. See Alexander and
Lvov (2002) for further details and empirical results.

An alternative approach is to parameterize the eigenvectors and then calibrate these and the
eigenvalues using current market implied swaption volatilities.7 The eigenvalues are simply the
dot product of the forward rate volatility vector with the corresponding eigenvector:

6
Note that Hull and White (2000) use the first difference in forward rates (not the first difference in their
logarithms) for the PCA.
7
Rebonato (2002) does not advise one to attempt simultaneous calibration to both swaption and caplet
volatilities. Forcing the model to fit market prices of caps and swaptions is not necessary, since apparent
arbitrages arising from the model mis -pricing of either instrument would be too risky to trade upon, and
the simultaneous calibration constraint is too restrictive.
Copyright 2002, Carol Alexander. 15
 ISMA Centre Discussion Papers in Finance 2002-18
Λ1 (t) = α 11 σ n(t)2 + …. + α m1 σ n+m-1(t)2 = α 1 • σ(t)2

and similarly Λ2 (t) = α 2 • σ(t)2 ; Λ 3 (t) = α 3 • σ(t)2

Thus when the (instantaneous) forward rate volatilities are parameterized by the 'hump' (4), the
time dependence in the eigenvalues is a function of this 'hump' and the parameters of the
eigenvectors. We assume the standard form for the eigenvectors of a term structure correlation
matrix, that is:

α 1 = (α1 , α1 , ….. , α1 )’

the first eigenvector in W is constant, and

α 2 = (α2 + β2 , α2 + 2β2 , α2 + 3β2 ,….. , α2 + mβ2 )’

the second eigenvector in W is linear: α i2 = α 2 + iβ2 and

α 3 = (α3 + β3 + γ 3 , α3 + 2β3 + 4γ 3 ,….. , α2 + mβ3 + m2γ 3 )’

the third eigenvector in W is quadratic: α i3 = α 3 + i β3 + i2 γ3

For reasons mentioned above we do not employ historical values for the eigenvectors. However
the historical analysis in Alexander and Lvov (2002) demonstrates that a common
parameterization of the eigenvectors for all swaptions with underlying swaps of the same tenor
should be taken. The implementation of the common principal component model of Flury (1988)
yields results that are robust to the various yield curve models used to compute the forward rates
and to the choice of historic data period. They indicate that we should define a family of m x m
forward rate correlation matrices

Σ n,m(t) = Am Λ n(t) Am ’

where Λ n(t) is the 3 x 3 matrix of the three largest eigenvalues of Σ n,m(t) and Am is the (constant)
m x 3 matrix of eigenvectors with columns α 1, α 2 α 3 .

To summarize and formulate the calibration objective, under the orthogonal transformation of the
LFR model, the calibration for the parameters (α1 , α 2 , β 2, α 3 , β3 , γ3) of the eigenvectors
α 1, α 2 and α 3 should be performed using market prices of all swaptions of tenor m. The common
principal component model of Flury (1988) should be employed to calibrate common
eigenvectors to all swaps of the same tenor. That is, A m is the same for all n. Writing

w*(t) = Dn,m(t)w

for short, the model volatility (6) has instantaneous variance given by

σ n,m (t) 2 = w* (t)' A m Λ n (t) A m ' w* (t)

and the average volatility in the calibration objective is

Copyright 2002, Carol Alexander. 16

 ISMA Centre Discussion Papers in Finance 2002-18

tn
1
σ = ∫σ
model
n, m n, m (t) 2 dt
tn
0

As before, the calibration objective will be a vega/(bid-ask spread) weighted sum of squared
volatility differences, and the calibration problem is:

( )
2
min ∑ ωn, m σ imp
n, m − σ n, m
model

n, m

5. Conclusion

In the lognormal forward rate LIBOR model for interest rate option pricing, forward rate
volatilities and correlations may be calibrated to a (smoothed) swaption volatility surface.
Following Rebonato (1998) we write swap rates as a linear sum of annual forward rates and link
annual forward rates with semi-annual forward rates. We consider two simple parametric forms
for the semi-annual forward rate correlations: a single parameter 'circulant' form, which is based
on the parametric form for annual rate correla tions that has been advocated by Brigo and
Mercurio (2001), Rebonato and Joshi (2001), Jäckel (2002) and others, and a two parameter form
that allows the adjacent semi-annual forward rate correlations to increase with maturity, as in
Schoenmakers and Coffey (2000).

We have shown that both these parametric forms imply a simple form for the annual forward rate
correlations that depend on the same parameter(s). This construction allows one to define
calibration objectives that are used with swaption volatilities, but whose parameters are those of
the semi-annual rate volatilities and correlations. We have also proposed a vega weighted
iteration for computing the semi-annual rate volatilities from the cap market volatility surface
which mitigates the problem of negative (or even imaginary) volatilities that may be encountered
when calibrating to the swaption market.

We often need to use numerical resolution (e.g. simulation) for the forward rate dynamics, where
the drift terms that are induced by the change to a single measure will become important. Since
these change at every time step, the computations are burdensome and it may be desirable to
reduce dimensions in the numerical method. For this, an orthogonal transformation is described
that is based on a common principal component analysis (PCA) of the forward rates. Several
researchers have advocated the use of PCA in conjunction with historic data, for example, for
calibrating the eigenvectors of the forward rate correlation matrix. However the parsimonious
parametric form for common eigenvectors that is proposed here can be calibrated to the current
market data without resorting to (potentially very unreliable) historical data on the unobservable
forward rates. This form, which is based on the common PCA model of Flury (1988), should be
used to calibrate common eigenvectors to all swaptions of the same tenor.

Acknowledgements
I would like to thank Damiano Brigo and Fabio Mercurio of Banca IMI, Milan, Riccardo Rebonato of the
Royal Bank of Scotland, London, Peter Jäckel of Commerz Bank, London and my husband Jacques Pezier,
all of whom provided very helpful comments and suggestions on preliminary drafts of this paper.

Copyright 2002, Carol Alexander. 17

 ISMA Centre Discussion Papers in Finance 2002-18
References
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Alexander, C and D. Lvov (2002) Statistical Properties of Forward Rates: Model Risk and its Implications
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Copyright 2002, Carol Alexander. 18