Patrick S.

Hagan
IN THE TRENCHES
Adjusters: Turning Good
Prices into Great Prices*
1 Managing Exotics market requires maintaining a volatility cube, which contains the volatili-
I’m sure we’ve all been there: We need to price and trade an exotic deriv-
ties σ as a function of the three coordinates. However, the vast majority
ative, but because of limitations in our pricing systems, we cannot cali-
of swaptions are struck at-the-money, at strikes equaling the current swap
brate on the “natural set” of hedging instruments. Instead we have to
rate of the underlying forward swap, so desks normally track this market
calibrate on some other set of vanilla instruments, which provide only a
by maintaining a volatility matrix containing the vols of at-the-money
poor representation of the exotic. Consequently, our prices are question-
swaptions, and a set of auxilliary “smile” matrices showing how much to
able, and if we are bold enough to trade on these prices, our hedges are
add/subtract to the volatility for strikes 50bps, 100bps,. . . above or below
unstable, chewing up any profit as bid-ask spread. Here we discuss how
the swap rate. Alternatively, some swap desks determine the adjustment
to get out of these jams by using “adjusters,” a technique for re-express-
by using a smile model, such as the SABR or Heston models. In any case,
ing the vega risks of an exotic derivative in terms of its “natural hedging
desks are reasonably confident that they can trade the vanilla instru-
instruments.” This helps prevent unstable hedges and exotic deal mis-
ments at the indicated prices.
management, and, as a side benefit, leads to significantly better pricing
Now consider the typical management of an exotic interest rate deriv-
of the exotic.
ative, such as a Bermudan swap or a callable range note. During the
First let us briefly discuss how we get in these jams. During the nor- nightly mark-to-market, the deal will be priced by
mal course of business, the pricing and management of fixed income
derivatives depend on two key markets. First is the swap market (delta mar- ● selecting an interest rate model, such as Hull-White or Black-
ket), which is encapsulated by the yield curve. Swap desks maintain cur- Karasinski;
rent yield curves by continually stripping and re-stripping a set of liquid ● selecting a set of vanilla swaptions and/or caplets as the cali-
swaps, futures, and deposit rates throughout the day. This curve deter- bration instruments;
mines all current swap rates, FRA rates, forward swap rates, etc. The yield ● calibrating the interest rate model so that the model repro-
curve also shows how to hedge all interest rate risks by buying and selling duces the market prices of these instruments, either exactly of
the same swaps, futures, and deposit rates used in the stripping process. in a least squares sense;
The second market is the vanilla option market (vega market) for Euro- ● using the calibrated model to find the value of the exotic via
pean swaptions, caps, and floors. Prices of these options are quoted in finite difference methods, trees, or Monte Carlo.
terms of the volatility σ , which is inserted into Black’s 1976 formula to
determine the dollar price of the option. European swaptions are The exotic’s vega risks will then be obtained by
defined by three numbers: the exercise date and the tenor (length) and
strike (fixed rate) of the swap received upon exercise. Keeping track of this ● bumping each volatility in the matrix (or cube) one at a time;

*The views presented here are soley the authors, and do not necessarily reflect the views of Bear-Stearns or any of its affiliates or subsidiaries.
Bear, Stearns & Company 383 Madison Avenue New York, NY 10179 phagan@bear.com

56 Wilmott magazine
 ● re-calibrating the model and re-pricing the exotic derivative for
each bump; and TABLE 1.1 AT-THE-MONEY VOLATILITY MATRIX
● subtracting to obtain the difference in value for the bumped European swaptions are defined by the time-to-exercise (row), and length (col-
case versus the base (market) case. umn) and fixed rate (strike) of the swap received upon exercise. A volatility
matrix (as opposed to a volatility cube) contains the volatilities of at-the-money
This results in a matrix of vega risks. Each cell represents the deal’s dol- swaptions, swaptions whose fixed rates are equal to the current forward swap
lar gain or loss should the volatility of that particular swaption change. rate of the underlying swap. Linear interpolation is used for the volatilities in
These vega risks are then hedged by buying or selling enough of each between grid points. The 3m column is the caplet column.
underlying swaption so that the total vega risks are zero. Of course the
desk first adds up the vega exposure of all deals, and only hedges the net
exposure.
Calibration is the only step in this procedure which incorporates σ (in %) 3m 1y 2y 3y ··· 10y
information about market volatilities. Under the typical nightly proce-
1m 5.25 12.25 13.50 14.125 ··· 14.25
dure the exotic derivative will only have vega risks to the set of vanilla swaptions
3m 7.55 13.00 14.125 14.375 ··· 14.50
and/or caplets used in calibration. So regardless of the actual nature of the 6m 11.44 14.25 14.875 15.00 ··· 14.75
exotic derivative, the vega hedges will be trying to mimic the exotic 1y 16.20 16.75 16.375 16.125 ··· 15.50
derivative as a linear combination of the calibration instruments. If the 2y 19.25 17.75 17.125 17.00 ··· 15.75
calibration instruments are “natural hedging instruments” which are .. .. .. .. .. ..
“similar” to the exotic, then the hedges probably provide a faithful rep- . . . . . .
resentation of the exotic. If the calibration instruments are dissimilar to 10y 14.00 13.50 13.00 12.50 ··· 11.00
the exotic, having the wrong expiries, tenors, or strikes, then the vega
hedges will probably be a poor representation of the exotic. This often
causes the hedges to be unstable, which gets expensive as bid-ask spread
is continually chewed up in re-hedging the exotic. squares sense, and the calibration would only include at-the-money
For example, consider a cancellable 10 year receiver swap struck at swaptions. Alternatively, an interest rate model may be more easily cali-
7.50%, where the first call date is in 3 years (10NC3@7.50). Surely the nat- brated on some instruments than others. For example, a multi-factor
ural hedging instruments for this Bermudan are the diagonal swaptions: BGM model is much easier to calibrate to caplets than to swaptions.
the 3y into 7y struck at 7.50%, the 4y into 6y struck at 7.50%, . . ., and the Finally, one’s software may not be set up to calibrate on the “natu-
9y into 1y struck at 7.50%, since a dynamic combination of these instru- ral hedging instruments.” A callable range note provides an example.
ments should be capable of accurately replicating the exotic. Indeed, if Consider a regular (non-callable) 10 year range note which pays a
we do not calibrate on these swaptions, then our calibrated model would coupon of, say, $1 each day Libor sets between 2.50% and 6.00%. Apart
not get the correct market prices of these swaptions, and if our prices for from minor date differences, the range note is equivalent to being long
the 3y into 7y, the 4y into 6y, . . . , are incorrect, we don’t have a prayer of one digital call at 2.50% and short a digital call at 6.00% for each day in
pricing and hedging the callable swap correctly. the next 10 years. Since digital calls can be written in terms of ordinary
When feasible, best practice is to use autocalibration for managing calls, a range note is very, very close to being a vanilla instrument, and
exotic books. For each exotic derivative on the books, autocalibration can be priced exactly from the swaption volatility matrix (or cube). To
first selects the “natural hedging instruments” of the exotic, usually price a callable range note, one would like to calibrate on the underly-
based on some simple scheme of matching the expiries, tenors, and effec- ing daily range notes, for if we don’t price the underlying range notes
tive strikes of the exotic. It then re-calibrates the model to match these correctly, how could we trust our price for the callable range note? Yet
instruments to their market values, and then values the exotic. Autocali- many systems are not set up to calibrate on range notes.
bration then picks the next deal out of the book, selects a new set of nat-
ural hedging instruments, re-calibrates the model, and re-prices the exot-
ic, and so on. 2 Risk Migration
There are a variety of reasons why autocalibration may not be feasi- We now describe a method for moving the vega risk, either all of it, or as
ble. If one’s interest rate model is too complex, perhaps a several factor much as possible, to the natural hedging instruments. Suppose we have
affair, one may not have the computational resources to allow frequent an exotic derivative v which has h1 , h2 , . . . , hm as its natural hedging
calibration. Or if one’s calibration software is too “fractious,” one may instruments. For example, for the 10NC3 Bermudan struck at 7.50%, the
not have the patience to calibrate the model very often. In such cases one natural hedging instruments are just the 3y into 7y swaption struck at
^
would generally calibrate to all swaptions in the vol matrix in a least 7.50%, the 4y into 6y at 7.50%, . . . , and the 9y into 1y at 7.50%. Suppose

Wilmott magazine 57
 PATRICK S.HAGAN

that for “operational reasons,” one could not calibrate on h1 , h2 , . . . , hm , of braces, and use the market prices to evaluate the instruments in the
but instead were forced to calibrate on the swaptions and/or caplets second set of braces. This yields the adjusted price
S1 , S2 , . . . , Sn . Let these instruments have market volatities σ1 , σ2 , . . . , σn .
Then after calibrating the model, all prices obtained from the model are  

m 
m
functions of these volatilities. So let V adj
= V mod
− bk Hkmod + bk Hkmar , (2.5a)
k =1 k =1

V mod = V mod (σ1 , σ2 , . . . , σn ) (2.1a) 

m  
= V mod + bk Hkmar − Hkmod . (2.5b)
be the value of the exotic derivative v obtained from the model. Suppose k =1

we use the model to price the natural hedging instruments

h1 , h2 , . . . , hm . Let This procedure is generally known as “applying an adjuster.” In equa-
tion 2.5a, the terms in braces are evaluated using the calibrated model,
Hkmod (σ1 , σ2 , . . . , σn ) k = 1, 2, . . . , m (2.1b) so they only have vega risk to the volatilities of the calibration instru-
ments σ1 , σ2 , . . . , σn . With the weights bk chosen to eliminate these risks
be the value of these instruments according to the calibrated model. as nearly as possible, the adjusted price V adj has little or no vega risk to
Finally, let the calibration instruments. Instead, the vega risks of the adjusted price
come from the last term,
Hkmar k = 1, 2, . . . , m (2.1c) 
m
bk Hkmar (2.6a)
be the market price of the natural hedging instruments. k =1

Let us create an imaginary portfolio consisting of the exotic deriva- which only contains the market prices of the natural hedging instru-
tive and its natural hedging instruments, ments. So, as claimed, the adjuster has moved the vega risks from the cal-

m ibration instruments to the natural hedging instruments. In fact, to
π =v− bk hk , (2.2) hedge these risks one must take the opposite position
k =1

m
where the amounts bk of the hedging instruments will be selected short- − bk hk (2.6b)
ly. Using the calibrated model to price this portfolio yields k =1

in the natural hedging instruments of the exotic. For the 10NC3 Bermu-

m dan struck at 7.50%, for example, the resulting hedge is a combination of
 = V mod (σ1 , σ2 , . . . , σn ) − bk Hkmod (σ1 , σ2 , . . . , σn ). (2.3a) the 3y into 7y, the 4y into 6y, ..., and the 9y into 1y swaptions, all struck
k =1 at 7.50%, regardless of the which set of instruments were used to origi-
nally calibrate the model.
According to the calibrated model, this portfolio has the vega risks Equation 2.5b gives a different view. It shows the adjusted price as
being the model price corrected for the difference between the market
 price and the model price of the natural hedging instruments.
∂ H mod
m
∂ ∂ V mod
= − bk k (2.3b)
∂σj ∂σj ∂σj
k =1

3 Choosing the Portfolio Weights

to the calibration instruments.
Suppose we have chosen the portfolio weights bk . (In the next sec- We wish to choose the amounts bk to minimize the model’s vega risks
tion we show how to choose the amounts bk so as to eliminate the vega in 2.3b. This is an exercise in linear algebra. Define the matrix M and
risks, either completely or as completely as possible). We add and sub- vectors U and b by
tract this portfolio of natural hedging instruments to write the exotic
∂ Hkmod ∂
derivative v as Mjk = , Uj = , (3.1a)
   m  ∂σj ∂σj
 m 
v= v− bk hk + bk hk . (2.4) and let b be the vector of positions (b1 , b2 , . . . , bm )T so that the vega risks
k =1 k =1 to the calibration instruments are

We now use the calibrated model to value the instruments in the first set U−Mb (3.1b)

58 Wilmott magazine
There are three cases to consider. First suppose that there are fewer hedg- price the Bermudan. This leads to a price of
ing instruments than model calibration instruments. One cannot expect
to eliminate n risks with m < n hedging instruments, so one cannot V = 200.18 bps. (4.1)
eliminate all the vega risks in 2.3b in this case. Instead one can minimize
the sum of squares of the vega risks: This represents the best price available within the one factor, Hull-White
framework.
min (U U − M b) .
U − M b)T (U (3.2a) Suppose we calibrate to the same “diagonal” swaptions as before, but
instead of calibrating to swaptions struck at 7.50%, we calibrate to swap-
Solving this problem yields tions struck at-the-money, at 5.00%. This yields a much lower price,
 −1
b = M TM MU (if m < n). (3.2b) V mod = 163.31 bps. (4.2a)
 −1
The matrix MT M M is known as the pseudo-inverse of M. Of course one If we add in the adjustor, we obtain the price
can use some criterion other than least squares, such as choosing the 
m
 
portfolio b to eliminate the least liquid calibration instruments first. V mod + bk Hkmar − Hkmod = 163.31 bps + 39.18 bps = 202.49 bps,
If there are exactly as many hedging instruments as calibration k =1 (4.2b)
instruments, then we can expect to completely eliminate the risk entire-
ly by choosing a great improvement.
Alternatively, suppose we calibrate the Hull-White model to the
b = M −1 U (if m = n). (3.3) caplets starting at 3 years, at 3.25 years, at 3.5 years, ..., and at 9.75 years,
with all caplets struck at 7.50%. Now we have the correct strike, but the
Finally, if there are as more hedging instruments than model calibra- wrong tenors. The calibrated model yields the price
tion instruments, then we can select the smallest hedge which com-
pletely eliminates the vega risks to the calibration instruments: V mod = 196.82 bps. (4.3a)

min bT b subject to M b = U. (3.4a) If we add in the adjustor, we obtain a price of

This yields
 −1
b = M T MM T U (if m > n), (3.4b)
 −1
where the matrix M T MM T is also known as the psuedo-inverse of M.
As before, one may use a criterion other than least squares for choosing b.
4 Examples
Consider once more the cancellable 10 year receiver swap struck at
7.50%, where the first call date is in 3 years. This derivative is normally
booked as a straight 10 year swap, with a Bermudan option to enter into
the opposite swap. Here we just price the Bermudan option, the option
to enter a payer swaption at 7.50% on any coupon date starting on the
third anniversary of the deal. For the purposes of this example, we
assume a flat 5% yield curve, and use the Hull-White model with the USD
volatility matrix from March 1999.
Clearly the natural hedging instruments are the 3y into 7y swaption
struck at 7.50%, the 4y into 6y swaption at 7.50%, . . . , and the 9y into 1y
swaption at 7.50%. Suppose we calibrate the Hull-White model to these
“natural hedging instruments” and then use the calibrated model to

m
 
V mod + bk Hkmar − Hkmod = 196.82 bps + 3.12 bps = 199.94 bps,
k =1 (4.3b)
again a distinct improvement.
5 Nothing is Free
At first glance, it appears that using an adjuster greatly increases the
computational load. After all, to determine the adjustment requires
computing the exotic derivative’s vega risk ∂ V mod /∂ σj to all calibration
instruments. These risks are usually found via finite differences, so eval-
uating these risks would seem to require model calibrations in n + 1
seperate scenarios (base case, and each σj bumped seperately). However,
these vega risks are needed for hedging purposes, and are nearly always
computed as part of the nightly batch, even if one is not applying an
adjustor. So computing the vega matrix is usually free. The computation-
al load does increase modestly, because for each natural hedging instru-
ment, one has to calculate the model price Hkmod and its vega derivatives
∂ Hkmod /∂ σj . This requires calculating the model price of m vanilla instru-
ments n + 1 times. This is the same load as calculating the calibration
error in each of the n + 1 scenarios, clearly much much faster than actu-
W
ally calibrating the model in each of the n + 1 scenarios.

Wilmott magazine 59