The Valuation of American-style Swaptions in a Two-factor Spot-Futures Model

The Valuation of American-style Swaptions in a Two-factor Spot-Futures Model. We build a no-arbitrage model of the term structure of interest rates using two stochastic factors, the short-term interest rate and the premium of the futures rate over the shortterm interest rate. The model provides an extension of the lognormal interest rate model of Black and Karasinski (1991) to two factors, both of which can exhibit mean-reversion. The method is computationally e cient for several reasons. First, the model is based on Libor futures prices, enabling us to satisfy the no-arbitrage condition without resorting to iterative methods. Second, we modify and implement the binomial approximation methodology of Nelson and Ramaswamy (1990) and Ho, Stapleton and Subrahmanyam (1995) to compute a multiperiod tree of rates with the no-arbitrage property. The method uses a recombining two-dimensional binomial lattice of interest rates that minimizes the number of states and term structures over time. In addition to these computational advantages, a key feature of the model is that it is consistent with the observed term structure of futures rates as well as the term structure of volatilities implied by the prices of interest rate caps and oors. We use the model to price European-style, Bermudan-style, and American-style swaptions. These prices are shown to be highly sensitive to the existence of the second factor and its volatility characteristics. The Valuation of American-style Swaptions 1