Calibration Methods of Hull-White Model

Sébastien Gurrieri1∗, Masaki Nakabayashi1§ and Tony Wong1¶

1 Risk Management Department, Mizuho Securities

Tokyo

Abstract
We describe several strategies for the calibration of one factor Hull-White model with con-
stant or time-dependent mean reversion and volatility parameters to the interest rate vanillas.
We propose an efficient approximation formula for the swaption implied volatility which enables
us to estimate the mean reversion independently of the volatility. We give the closed-forms for
exact pricing using explicit integrals of the model parameters and propose parametric forms for
the mean reversion and volatility. We test their performance in terms of quality of fitting and
stability w.r.t. market changes, and show that excellent fits can be obtained without suffering
from instabilities. Furthermore, our calibration methods and parameter control techniques allow
for an elegant interpretation of market moves, which we illustrate with an in-depth analysis of
Lehman crisis in the fall of 2008.

∗
email: sebastien.gurrieri@mizuho-sc.com
§
email: masaki.nakabayashi@mizuho-sc.com
¶
email: shekkeung.wong@mizuho-sc.com
Contents
1 Introduction 2

2 Model Dynamics and Closed Forms 4

2.1 Dynamics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
2.2 Closed Forms for Caplets and Swaptions . . . . . . . . . . . . . . . . . . . . . . . . . 5
2.3 An Approximation of the Swaption Implied Volatility . . . . . . . . . . . . . . . . . 5
2.4 Parameter Specifications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

3 Calibration Strategies 9
3.1 Relations Market/Model parameters . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
3.2 Optimizing on the Mean Reversion or not . . . . . . . . . . . . . . . . . . . . . . . . 11
3.3 Bootstrap vs. Overall Calibration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
3.4 Calibration to Swaptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
3.4.1 Method 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
3.4.2 Method 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
3.4.3 Method 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

4 Numerical Results 15
4.1 Performance of SMM approximation . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
4.2 Choice of Instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
4.3 Co-terminal 20Y . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
4.3.1 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
4.4 Co-terminals 10Y and 20Y . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
4.4.1 Constant a and σ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
4.4.2 Constant a and Time-Dependent σ(t) . . . . . . . . . . . . . . . . . . . . . . 21
4.4.3 Time-Dependent a(t) and σ(t) . . . . . . . . . . . . . . . . . . . . . . . . . . 24
4.4.4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
4.5 All Instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
4.5.1 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
4.6 Model and Market Evolution: analysis at Lehman Crisis . . . . . . . . . . . . . . . . 29
4.7 Bermudan Swaptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

5 Conclusion 33

A Integrals 34

B Simulated Annealing 36

C Other Numerical Results 37

C.1 SMM vs. Jamshidian Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
C.2 Other JPY calibration results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
C.3 Other currencies: USD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
C.4 Other currencies: EUR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

1
1 Introduction
Market models, pioneered by [2], [9], have recently emerged as a market standard for the pricing
of exotic interest rate products. In these models, the dynamics of observable market rates, such
as Libor and swap rates, are directly specified. They are appealing to market practitioners largely
due to the fact that they can be calibrated to market caplet and swaption volatilities as well as an
initial yield curve. In spite of their increasing popularity, market models have one serious drawback.
An accurate implementation can only be made through simulation, which is typically slow due to
the large number of state variables (i.e. the discrete–tenored market rates) needed to be evolved
through time, and the complicated drift terms associated with the underlying stochastic differential
equations (SDEs). This can be a problem for path dependent payoffs which require a large number
of simulated paths in order to obtain sufficiently accurate price and risk figures. The problem can be
even more acute for products with an early exercise provision as simulation is not naturally suited
for performing backward–in–time calculations needed to determine the optimal exercise strategy.
In contrast to market models, affine term structure models (ATSMs) attempt to model the
unobservable short rate, assumed to be an affine function of some latent factors. ATSMs have a
few appealing properties. First, they are analytically tractable. In particular, closed–form solu-
tions for caps/floors and efficient price approximation methods for European swaptions are often
available. Second, Monte Carlo implementation of ATSMs is relatively straightforward compared
to market models. In low dimensional cases, path–independent products with an early exercise
provision can also be evaluated efficiently using lattice methods. Third, under ATSMs, all kinds of
interest rates (e.g. forward Libor and swap rates with any expiry/maturity/payment dates) can be
computed readily from the short rate factors, whereas in market models interpolation and extrap-
olation are often needed when the product dates do not align with the canonical model dates. The
computational efficiency offered by ATSMs explains why many banks still use these models for risk
calculation and other risk management purposes even after the introduction of the market models.
The main objective of this paper is to analyze in details the issues of model calibration and
parameter control associated with a popular ATSM, known as one–factor Hull White (HW1F)
model ([5], see [3] for a review). The HW1F model, which is characterized by a mean reversion and
a volatility parameter, has been and is still very popular among market practitioners because of
its parsimony and analytical tractability (thanks to the normality of the short rate). In spite of its
popularity, the existing studies on the model calibration, especially in the case of time-dependent
parameters, are rather scarce. In [6] and [7], the authors have covered the basic procedures for
calibrating the HW1F model utilizing tree methods. However, there does remain several open
issues related to its practical use.
First, it is frequently claimed that adopting time-dependent parameters for the HW1F model
can introduce over–parameterization. Yet, numerical examples backing such a statement are rare
in the existing literature. As a result, it is unclear in what contexts and to what extent such
a statement can be justified. This also raises the question of how one should choose the model
parameter configuration, given a particular application at hand. Another challenging issue is related
to the calibration, especially in cases where time-dependent parameters are used. Given a certain
parameter configuration, a natural question arising is what strategy one should use in calibrating
the model. For example, one may ask what parameter constraints should be put in place during
the calibration or if the model has some separable property that can make the calibration more
efficient. Finally, from traders’ perspectives, one of the most important issues lies in control of the
model parameters. The reason is that traders often want to incorporate their particular views on
the future market moves into the pricing model through the manipulation of the model parameters.
This translates into the requirement of understanding the pricing impacts of the model parameters.

2
 In this work, we address the issues mentioned in the previous paragraph. This study provides
an explicit realization of some ideas developed in [6] and [7] and supplements them with a thorough
analysis of various issues involved such as parameter stability and relationship between model
parameters and market prices of calibrating instruments. Hence, our work can be considered as a
complement and a detailed follow-up for [6] and [7].
We introduce parametric forms for the time-dependent parameters, with additional constraints.
These give us control over the parameters while still allowing enough fitting freedom. We de-
scribe several calibration strategies, namely local and global, with constant and/or time-dependent
parameters, with separate or simultaneous optimizations. We propose an approximation of the
swaption implied volatilities, which, in the particular case of constant mean reversion and volatil-
ity, leads to a very efficient (quasi-instantaneous) calibration method. This approximation, due
to its simplicity and explicit form, provides further insights into the market/model relationships.
The case of Lehman shock in the fall of 2008 and its consequences on the parameters are analysed
in details. We emphasize the importance of the mean reversion parameter when attempting to fit
over several different tenors, possibly over the whole swaption matrix. We finally conclude that,
contrary to common beliefs, excellent fits to the whole swaption matrix can be obtained without
traces of instabilities, when both the mean reversion and volatility are time-dependent.
The remainder of this paper is organized as follows. In Section 2, we provide a brief review of
the HW1F model. Some analytical formulas relevant to our analysis are provided. In particular,
we present an analytical approximation for implied swaption volatilities. In Section 3, we propose
a few strategies for calibrating the model under various parameter configurations. In Section 4,
we present numerical results to test all the calibration strategies presented previously, and discuss
their performance. Finally, we conclude in Section 5.

3
2 Model Dynamics and Closed Forms
Hull-White model definition and properties are well-known and therefore we recall them only briefly
here. Our main purpose is instead to provide the notations used in the closed-form calculations
with the view to calibrating the model to vanilla options. More precisely, we want to display the
variance of a zero-coupon bond ratio and the expressions of the functions characterizing the affine
structure of the bond, in order to price swaptions analytically.
The closed-forms can be written thanks to various integrals of the mean reversion and volatility
that can be found in [4]. We recall them in appendix A and write them slightly more explicitly,
together with additional properties. We keep them under a symbolic form as long as possible such
that the formulae remain valid for any specific parametric form that the user may choose. Note
that they become explicit as soon as the mean reversion and volatility parametric expressions are
specified. In particular, when these are constant, the integrals reduce to their standard form, given
for instance in [3].

2.1 Dynamics
In the risk neutral measure, denoted by Q, the Hull-White short-rate SDE reads

( )
dr(t) = θ(t) − a(t)r(t) dt + σ(t)dW Q (t), (1)

with the time-dependent functions a(t) for the mean reversion and σ(t) for the volatility. Exact
replication of the initial curve is realized by fixing the function θ(t) to the expression (39) given in
appendix A. r(t) has a normal distribution with mean and variance

[ ] E(s) E(s)
E r(t) | Fs = r(s) + α(t) − α(s) (2)
E(t) E(t)
[ ]
Var r(t) | Fs = Vr (s, t) (3)

where Fs is a σ-field capturing the information generated by the process r(t) up to time s, E(t) is
given in (30), α(t) in (36) and Vr (s, t) in (37).
The zero-coupon bond P (t, T ) has the affine structure

( )
P (t, T ) = exp A(t, T ) − B(t, T )r(t) (4)

where the functions A(t, T ) and B(t, T ) are given in (43) and (31). It is log-normal with SDE

dP (t, T )/P (t, T ) = r(t)dt − σ(t)B(t, T )dW Q (t) (5)

To calculate closed forms, we are particularly interested in the bond ratio with fixing and paying
times TF and TP (t 5 TF 5 TP ), which has the dynamics in the TP -forward measure

P (t, TF ) P (t, TF ) ( )
d = σ(t) B(t, TP ) − B(t, TF ) dW TP (t) (6)
P (t, TP ) P (t, TP )

4
with integrated variance

∫ TF ( )2
Vp (t, TF , TP ) = σ 2 (u) B(u, TP ) − B(u, TF ) du (7)
t
= Vr (t, TF )B(TF , TP )2 . (8)

Equation (8) holds due to property (34).

2.2 Closed Forms for Caplets and Swaptions

Caplets
Let us consider a caplet with strike K, fixing time TF and paying time TP . This can be rewritten
as a zero-bond put option (ZBP), priced by Black Formula with the variance of the bond ratio in
(8), i.e.

1
Caplet(K, TF , TP ) = (1 + Kδ)ZBP(TF , TP , ) (9)
1 + Kδ
ZBP(TF , TP , X) = XP (0, TF )N (d+ ) − P (0, TP )N (d− ) (10)
ln( PP(0,TF )X √
(0,TP ) ) 1
d± = √ ± Vp (0, TF , TP ) (11)
Vp (0, TF , TP ) 2

where δ = δ(TF , TP ) is the accrual between TF and TP .

Swaptions
Let us consider a (payer) swaption with strike K, maturity T0 , swap tenor TP , and swap cash-
flow times {Ti }i=1..n , with Tn = TP . This can be rewritten as a weighed sum of zero-bond (put)
options using Jamshidian’s decomposition [8]. More precisely,

∑
n
PSwaption(K, T0 , TP ) = ci ZBP(T0 , Ti , Xi ) (12)
i=1
ci = Kδ(Ti−1 , Ti ) i = 1..n − 1 (13)
cn = 1 + Kδ(Tn−1 , Tn ) (14)
( )
Xi = exp A(T0 , Ti ) − B(T0 , Ti )r∗ (15)

where r∗ satisfies the equation

∑
n ( )
ci exp A(T0 , Ti ) − B(T0 , Ti )r∗ = 1. (16)
i=1

2.3 An Approximation of the Swaption Implied Volatility

Although (12) gives us an analytical expression of the swaption price, it is not explicit in the model
parameters, and the dependence of the implied volatility derived from the price PSwaption(K, T0 , TP )
on a(t) and σ(t) is far from obvious. For calibration purposes, it may be desirable to see a more

5
direct relation between the market implied volatility and the model parameters. In this section, we
suggest an approximation satisfying this goal.
From the definition of swaptions it is clear that if we could calculate the variance of a swap
rate having a log-normal distribution (i.e. the SMM model), we would be able to calibrate simply
by equating this variance with that obtained from the market implied volatility. Unfortunately,
Hull-White model is not a swap rate model, the swap rate is not log-normal. However the bond
ratio PP (t,T
(t,TF )
P)
is. This observation directs us toward an approximation relating the swap rate to
the bond ratio above. We follow the strategy proposed in [3] for BGM model and adapt it to the
Hull-White case.
Denote by S(t, T0 , Tn ) the swap rate prevailing at time t for the swap starting at T0 and ending
on Tn , with t < T0 < Tn . It is defined by

P (t, T0 ) − P (t, Tn )
S(t, T0 , Tn ) = . (17)
∑
n
δ(Ti−1 , Ti )P (t, Ti )
i=1

The approximation consists in assuming it is log-normal under the annuity measure A and try to
calculate its variance, the quantity we need for pricing. To this end, we approximate the true swap
rate S(t, T0 , Tn ) by S̃(t, T0 , Tn ) with

[ ]
P (0, Tn ) P (t, T0 )
S̃(t, T0 , Tn ) = −1 . (18)
∑
n
P (t, Tn )
δ(Ti−1 , Ti )P (0, Ti )
i=1

Now applying Ito’s Lemma to the approximated swap rate above, we find

( )
dS̃(t, T0 , Tn ) 1 P (0, Tn ) P (t, T0 )
= d
S̃(t, T0 , Tn ) ∑
n
S̃(t, T0 , Tn ) P (t, Tn )
δ(Ti−1 , Ti )P (0, Ti )
i=1
S(0, T0 , Tn )P (0, Tn )P (t, T0 )
= σ(t)[B(t, Tn ) − B(t, T0 ]dW Tn (t)
S̃(t, T0 , Tn )[P (0, T0 ) − P (0, Tn )]P (t, Tn )
P (0, T0 )
≈ drift + σ(t) (B(t, Tn ) − B(t, T0 )) dW A (t).
P (0, T0 ) − P (0, Tn )

In reaching the final line above, we have replaced S̃(t, T0 , Tn ) and PP (t,T
(t,T0 )
n)
by their initial values
and changed measure from the Tn -forward to the annuity measure A. This introduces a drift but
for pricing purpose we are only interested in the variance, which reads

[ ]2
P (0, T0 )
Vswap (T0 , Tn ) = Vp (0, T0 , Tn ) (19)
P (0, T0 ) − P (0, Tn )

where Vp (0, T0 , Tn ) is the variance of the bond ratio as defined in formula (7).
Beware that this approximation is crude and should not be considered as a replacement of (12)
for analytical pricing. Its quality is investigated numerically in chapter 4. Let us point out that we

6
intend to use it only to estimate the mean reversion, and later correct this estimation by a fitting
to the actual analytical price.
Finally, note that due to the specific form of Vp (0, T0 , Tn ) in (8), the Hull-White implied variance
Vswap (T0 , Tn ) depends on the model volatility σ(t) only through the function Vr (0, T0 ), in other
words the dependences in the swap tenor Tn and σ(t) are decoupled. This means that the ratio
of two implied volatilities having the same maturity T0 is independent of σ(t), a feature that will
enable us to estimate the mean reversion without knowledge of the volatility.

2.4 Parameter Specifications

One way to achieve at the same time ease of implementation and ability to integrate the functions
a(t) and σ(t) analytically is to set these to piecewise constant functions. This is what we will always
do from now on, constant a and σ being just particular cases.
Let us call the parameter time grid {ti }i=0..N −1 where N is the number of points on the grid.
Since a(t) and σ(t) are piecewise constant, we only need to specify their values {ai }i=0..N −1 and
{σi }i=0..N −1 at the points {ti }i=0..N −1 , with the convention on [0, +∞)

a(t) = ai t ∈ [ti , ti+1 ), i = 0..N − 2 (20)

a(t) = aN −1 t ≥ tN −1 (21)
σ(t) = σi t ∈ [ti , ti+1 ), i = 0..N − 2 (22)
σ(t) = σN −1 t ≥ tN −1 . (23)

Let us illustrate this by assuming the time grid runs up to 30 years with 6M intervals. There
are then N = 61 points in the grid (t0 = 0, t60 = 30). A generic piecewise constant function would
thus be defined by 61 values, which means 122 parameters including the mean reversion and the
volatility. This is clearly too much, so one must constrain them in some manner.
One natural way to reduce the number of parameters is to match their number with the number
of market maturities, with the view to calibrating using a bootstrap-like method. If the first market
maturity is at t2 = 1, then one will enforce the conditions a1 = a0 and σ1 = σ0 , and so on and so
forth for the remaining maturities. Although this strategy is commonly used, probably due to its
intuitive meaning and ease of implementation, we are not interested in developing it further here.
It suffers from serious drawbacks, among which big jumps in values from one time to the other,
causing instabilities, especially visible when pricing exotics.
We choose instead to constrain the parameters ai and σi to be generated by functional forms.
The resulting number of free parameters will be that of the functional forms, while a suitable choice
of such functional form will ensure that the functions a(t) and σ(t) do not suffer from dangerously
jumping values.
Apart from the constant case, in this work we will make use of the logistic function to generate
the mean reversion, i.e. we define

A1 − A0
ai = A0 + (24)
1 + eA2 (A3 −ti )
where A0 ..A3 are 4 parameters describing (heuristically)

• A0 : the short-term value

• A1 : the mid/long term value

7
 • A2 : the slope at the transition

• A3 : the time at the transition.

We call transition the area where the function changes rapidly between its early time and late time
regimes. See fig. 1 for a visual example of the type of shapes it produces.

Figure 1: Piecewise constant mean reversion based on the logistic function

Logistic[−5%, 5%, 0.5, 10]

For the volatility we will study a functional form based on interpolating at the times {ti }i=0..N −1
a given grid of volatility vs. time {T̃k , Σk }k=0..Ñ −1 , i.e.

σi = CubicSpline(ti , {T̃k }, {Σk }) (25)

where we interpolate with the Cubic Spline with left constraint of vanishing 2nd derivative and
right constraint of vanishing 1st derivative. The volatility σ(t) is set to constant after the last time
T̃Ñ −1 .

8
3 Calibration Strategies
In this section we describe a few possible strategies for the calibration of Hull-White model to the
market of swaptions. By calibration strategy we mean the following points:

1. The choice of constant or time-dependent mean reversion and volatility

2. The choice of products to calibrate to, and whether to calibrate locally or globally

3. Whether to optimize on the mean reversion a(t) and the volatility σ(t) together or separately,
and in the latter case, how to estimate one independently of the other.

3.1 Relations Market/Model parameters

Before diving into the calibration procedures, it is useful to investigate what types of swaption
implied volatilities can be obtained from Hull-White model. Indeed the range of accessible volatil-
ities is restricted, as it is not a market model such as LMM or SMM for which the market implied
volatilities are inputs. On the contrary Hull-White model constrains the shape of the implied
volatility matrix, and our goal in this section is to study the influence of the mean reversion and
the volatility on this matrix.
First of all, we take a fixed constant mean reversion (1%) and change the value of the constant
volatility σ. We display the result in fig. 2, for the two maturities 6M and 10Y.

Figure 2: Implied Volatilities for model swaptions with different volatilities.

Maturities 6M and 10Y, mean reversion a = 1%.

Apart from the intuitive fact that the implied volatility increases when the model volatility
increases, we can observe that, at fixed maturity, the ratios between two implied volatilities with
neighbouring tenors do not vary much with σ. This is an encouraging fact when considering the
use of SMM approximation and will be discussed in more details in section 4.1. It means that σ
influences mostly the level of the implied volatility curves, without changing their shapes much.
Next we fix σ and vary the mean reversion. We find the results in fig. 3, which suggest that the
mean reversion has a qualitatively different influence on the implied volatility. Indeed, this time
the shape is modified. Considering the wide change between a = 5% and a = −4% we can see
that even the monotonicity of the implied volatility curve can change due to the mean reversion.

9
Note also that the level of the implied volatility decreases significantly when the mean reversion a
increases.

Figure 3: Implied Volatilities for model swaptions with different mean reversions.
Maturities 6M and 10Y, volatility σ = 0.6%.

Remark that until now the implied volatility curves have been monotonic. Considering that the
market may have a hump, we would like to know whether such a shape is accessible in Hull-White
model, i.e. whether it is possible to see a change in monotonicity. A quick look at fig. 3 shows us
that for positive mean reversions, the implied volatility is decreasing with the tenor, but for negative
mean reversions, the volatility can be increasing. It is then natural to expect that a hump could
appear if a time-dependent mean reversion started in low (possibly negative) values and ended in
higher values. This is actually the main motivation for introducing the logistic parametric form in
section 2.4. In fig. 4 we show a few examples of hump and the corresponding model parameters.

10
Figure 4: Implied Volatilities for model swaptions with different time-dependent mean reversions.
Maturity 6M, model parameters
P1: σ = 0.2% a = Logistic[−30%, 5%, 1, 3], P2: σ = 0.2% a = Logistic[−30%, 5%, 1, 6]
P3: σ = 0.3% a = Logistic[−30%, 5%, 1, 3], P4: σ = 0.2% a = Logistic[−30%, 5%, 10, 3]
P5: σ = 0.2% a = Logistic[−50%, 5%, 1, 3], P6: σ = 0.1% a = Logistic[−50%, 5%, 1, 3]

All curves in fig. 4 are obtained from one another by changing the value of one of the parameters
σ and Ai , i = 0..3. Comparing curves P1 and P2 shows that we can control the position of the
hump in time with parameter A3 . Note however that since this makes the mean reversion negative
on a longer range, the overall level of curve P2 has increased. This effect may be compensated by
a decrease in σ.
Curves P1 and P3 provide an other example that increasing only the volatility gives a propor-
tional level change.
Curves P1 and P4 show that one can control, to some limited extent though, the steepness of
the hump by changing the parameter A2 .
Curves P1, P5 and P6 show how to obtain a hump with bigger amplitude by taking more
negative values for the mean reversion at early times (P5) and reduce the implied volatility level
by decreasing the volatility.
From these examples we can see that a rather wide range of humped shapes can be obtained by
suitably setting the values of the parameters of the logistic function Ai , i = 0..3, while compensating
with the volatility σ to adjust the level.
Overall this tells us that the mean reversion and volatility must be considered as a set, each
of them having a different impact on the implied volatilities. Moreover, both of them influence
the level of these volatilities, a fact that should be kept in mind when trying to build an intuition
of what values these parameters can take and how they vary in day-to-day market changes. For
instance, the same volatility σ can be considered as big or small, depending on the value of the
corresponding mean reversion.

3.2 Optimizing on the Mean Reversion or not

To our knowledge, there are two methods commonly adopted by market practitioners for calibrating
the HW1F model to the vanillas. The first one involves fixing the mean reversion using some
correlation input and then calibrating only the volatility parameter to cap/floorlets and/or swaption
prices. This strategy is mainly motivated by the theoretical observation that the mean reversion

11
has a strong influence on rate correlations, see eq. (46), and therefore on exotics such as Bermudan
swaptions. This was demonstrated in [4], and we also briefly address this last issue in section 4.7.
On the other hand, the second method attempts to calibrate both the mean reversion and the
volatility parameters to a series of cap/floorlets and/or swaptions with different maturities and
tenors. This is based on the fact that both model parameters have crucial impacts on cap/floorlets
and swaption prices, as is evident from the numerical examples given in the previous section. An
intuitive way to see this is that both the mean reversion and the model volatility parameterize the
associated Heath–Jarrow–Morton (HJM) volatility function.
In the current work, we focus mainly on the second calibration method. However, we shall
emphasize that the objective of this study is not to reach a conclusion as to which strategy is
superior to the other. Our intention is rather to lay out the methodology and gather some concrete
numerical results, which we believe is valuable from a practical point of view as such results are
scarce in the existing literature.
For the sake of completeness and in order to have a frame of reference, we have also included
in our analysis some numerical examples of the first calibration method described above1 .

3.3 Bootstrap vs. Overall Calibration

The first strategy that comes to mind is of bootstrap type, i.e. to use the model parameters ai
and σi from 0 to the first market maturity T1 to fit to the first instrument, and then the model
parameters from T1 to T2 to fit the second instrument at maturity T2 , and so on and so forth.
Although the above method may feel natural, produce perfect fit for (at least some of) the chosen
instruments, and has the advantage of requiring only low-dimension optimizations, it often results
in big jumps in the parameters and tends to exhibit a high dependency on the initial values fed to
the optimization algorithm. We consider these issues as serious drawbacks and prefer adopting the
following strategy.
We give up the intention of exact-fitting some specific instruments, and consider them instead as
a pool on which to optimize. We also choose parametric forms for the mean reversion and volatility,
as explained in the previous section, with a number of model parameters and fitted instruments
not necessarily equal. We then optimize on all model parameters to fit all the chosen market
instruments at once, with a predefined distance (here L2 ) between the model and market prices,
together with weights to focus on some instruments more than others.
The parametric forms actually put constraints on all parameters as a whole, such that if we
choose the functionals suitably, no big jumps will appear. The drawback of this is that there is no
more direct relation between parameters and instruments, and in general we need to perform multi-
dimensional optimizations, which are more difficult to handle than one-dimensional algorithms. It
is one of the purposes of this document to prove that these methods are feasible and can produce
more stable and meaningful results.

3.4 Calibration to Swaptions

Here we present three ways of proceeding, independently of whether the parameters are constant
or time-dependent. The main difference between these methods is the treatment of the mean
reversion. In the first method, we fix it. In the second method, we estimate it independently of the
volatility, and then find the volatility. In the third method, we optimize on the mean reversion and
the volatility simultaneously. All multi-dimensional optimizations are performed using a version of

1
For our purposes, it is sufficient to fix the mean reversion by hand without using correlation input.

12
the Simulated Annealing algorithm, see appendix B. Below are more detailed descriptions of these
three calibration methods.

3.4.1 Method 1
In this calibration method we do not optimize on the mean reversion, which is fixed to some
arbitrary (constant) value to be specified by the user. We therefore optimize on the volatility
only, such that the analytical price PVmod
a (Mi , Tj )(σ) approaches the market price PVmkt (Mi , Tj ).
PV mod is the price of a swaption as calculated in eq. (12), at ATM, and the subscript a indicates
that the mean reversion has been fixed previously. In other words, our calibrated volatility is the
point σ (possibly multi-dimensional) at which the function

∑ ( PVmod (M , T )(σ) )2
i j
Ga (σ) = Wi,j a
− 1 (26)
PVmkt (Mi , Tj )
1≤i≤nm ,1≤j≤nt −1

has its minimum. The initial point of the optimization must be chosen by the user. For the time-
dependent case, one can first optimize for a constant σ and use the result as a hint for the initial
point of the multi-dimensional optimization, in order to improve the speed of convergence. Wi,j
are the user-defined weights.

3.4.2 Method 2
The second method is divided into two steps:

1. Estimate the mean reversion a(t) using SMM approximation for the implied volatilities

2. Optimize on the volatility using the exact analytical price, knowing the mean reversion from
step 1).

Step 1) above is rendered possible, without knowledge of the volatility, thanks to property (8)
of SMM approximated implied volatilities. Indeed, taking the ratio of two implied variances with
the same maturity Mi but different tenors Tj and Tk , we find,

( ) 2
Vswap (Mi , Tj )  P (0, M i ) − P (0, T k ) B(M i , T j )
= ( )  (27)
Vswap (Mi , Tk ) P (0, Mi ) − P (0, Tj ) B(Mi , Tk )

which is independent of the volatility σ(t), as can be seen in the definition of B(t, T ) in (31).
This means that by optimizing such that ratios of the type (27) approach their market counter-
part, one can obtain an estimation of the mean reversion without knowing the volatility function
σ(t). More precisely, let us denote by IVi,j the market implied volatility for the swaption of ma-
turity Mi and tenor Tj , with nm maturities and nt tenors. Our calibrated mean reversion is the
point a (possibly multi-dimensional) at which the function

√
∑ Wi,j+1 ( Vswap (Mi , Tj+1 ) IVi,j+1 )2
F (a) = (a) − (28)
Wi,j Vswap (Mi , Tj ) IVi,j
1≤i≤nm ,1≤j≤nt −1

13
has its minimum. In case a weight Wi,j = 0 is met, it is simply ignored in the sum as we do not
intend to use the corresponding swaption for calibration. The index j will then be chosen as the
next one such that Wi,j 6= 0.
Step 2) is an optimization on the volatility σ(t) such that the analytical price approaches
its market counterpart. In other words, our calibrated volatility is the point σ (possibly multi-
dimensional) at which the function defined in (26) has its minimum, with the mean reversion fixed
at step 1).

3.4.3 Method 3
The third method is conceptually more simple and goes into one step only: optimize on the mean re-
version and the volatility such that the analytical price approaches the market price. In other words,
our calibrated mean reversion and volatility are the points a and σ (possibly multi-dimensional) at
which the function

∑ ( PVmod (M , T )(a, σ) )2
i j
G(a, σ) = Wi,j − 1 (29)
PVmkt (Mi , Tj )
1≤i≤nm ,1≤j≤nt −1

has its minimum. To choose the initial point of the optimization algorithm (multi-dimensional
in any case), we have two options. We can either choose it based on intuition and experiment,
similarly to the previous methods, or first estimate a mean reversion and volatility with method 2
and use the results as initial guesses. This guess usually yields a clear improvement in the speed
of convergence.

14
4 Numerical Results
In this section we display numerical results of calibrations to JPY ATM swaptions using the various
methods described in Section 3. Similar strategies can be applied to other currencies. We show
examples of calibration to USD and EUR swaption markets in Appendix C.3 and C.4.

4.1 Performance of SMM approximation

The SMM approximation formula (19) has shed some light on the roles of the mean reversion and
volatility parameters in determining implied swaption volatilities. In this section, we attempt to
verify the implication of the SMM approximation formula and its accuracy through some numerical
examples.
In the left panel of Figure 5 below, we display the ratios of the implied volatilities of swaptions
with a 5–year maturity and adjacent tenors under various mean reversion parameters. Here, we
fix the volatility parameter to 0.5%. The right panel focuses on the impacts of changing the
volatility parameters on the implied volatility ratios with the mean reversion fixed to 8%. All
implied volatilities used in Figure 5 are computed using the Jamshidian decomposition method.
It is clear that the implied volatility ratio curve moves systematically downward as the mean
reversion parameter increases. In contrast, the changes in implied volatility ratios are relatively
insignificant as the volatility parameter varies. This observation indeed agrees with what the SMM
approximation formula suggests: implied volatility ratios of swaptions with the same maturity
date depend mainly on the mean reversion parameter. It is this observation that motivates the
introduction of the second calibration strategy described in the previous section in which the mean
reversion and volatility parameters can be calibrated separately.

Figure 5: Swaption Implied Volatility Ratios, maturity 5Y.

Left: changing a at fixed σ
Right: changing σ at fixed a.

In Figures 23 in Appendix C.1, we also compare the swaption implied volatilities computed
using the Jamshidian method with those computed using the SMM approximation formula. The
top two panels correspond to two different volatility parameter values (0.5% and 1.5%), while fixing
the mean reversion at 8%. On the other hand, the bottom two panels correspond to two different
mean reversion values (-2% and 3%), while fixing the volatility at 0.5%. In all four figures, we fix

15
the maturity of the swaptions to 5 years while changing the underlying swap tenors from 1 year to
30 years. From these figures, we see that the SMM approximations appear to be able to capture the
qualitative behavior of the benchmark swaption implied volatilities obtained from the Jamshidian
method. However, under certain cases, the approximated swaption implied volatilities are quite
far from the benchmark values calculated from the Jamshidian method. For example, in the third
panel, the discrepancies between the SMM approximated volatilities and the benchmark values can
be more than 10% for swaptions with long tenors. Indeed, we have run the same comparison tests
under many other parameter values and the results agree what we have suggested before: the SMM
approximation can be crude and is not meant to be used for actual pricing purposes.
We emphasize that the SMM approximation shall be used as a means to understand the qual-
itative behavior of the implied swaption volatilities in terms of the HW model parameters, which
can be useful from model control point of view. Its accuracy can vary very much depending on the
model parameter values and the tenor and maturity of the underlying swaption. Hence, it cannot
serve as a reliable way for pricing swaptions in general. In this next section, we shall also demon-
strate numerically the effectiveness of the calibration strategy utilizing the SMM approximation
result.

4.2 Choice of Instruments

As an illustration consider the case of a calibration to JPY swaptions, for which we have 10
maturities and 12 tenors, in other words 120 swaptions. That is not to say there are 120 degrees
of freedom (d.o.f.). As it is not clear what the actual number of d.o.f. is, we do not know exactly
how many parameters in the model can be used to fit how many swaptions. This requires testing.
In the tests we present here, we will consider 3 instrument choice scenarios. The first one
represents a strategy commonly used, the local calibration, in parts for hedging reasons, which
consists in picking swaptions with fixed co-terminal (maturity + tenor). We will consider here the
20Y co-terminal calibration. In practice this means that we choose non-zero weights Wi,j only for
one swaption per maturity.
The second scenario is an extension of the previous one where we consider 2 co-terminal dates,
10Y and 20Y. The purpose of this test is to analyse the behaviour of the calibration procedure when
we increase the quantity of information and see how this translates in terms of model parameters.
This is rather a toy strategy, we are not aware of its actual use in the industry.
Finally the third scenario represents the calibration to the whole swaption matrix, i.e. global
calibration. The goal here is to take into account all the market information and analyse, on the
one hand how many model parameters are needed to describe it and on the other hand what is the
best fitting quality that we can hope for, knowing that perfect fit to the whole matrix cannot be
expected in this model.
We will consider a testing period of 2 years between Nov. 2007 and Sept. 2009 where we will
perform the calibration weekly.

4.3 Co-terminal 20Y

According to our interpretation of the mean reversion as influencing strongly the slope of the
swaption implied volatility curves, in the tenor direction, it seems risky to calibrate it in the
settings described here. Indeed, the only information we have is 1 number for each maturity, such
that we have no information at all on the slope.
Taking the simplest case of constant a and σ, we do find a typical behaviour of over-fitting on
the mean reversion side. In fig. 24 in the appendix, we show the constant mean reversion calibrated

16
over our testing period. It bears big jumps from weeks to weeks such that even its overall order
of magnitude is unclear. Although it is not obvious what this order of magnitude should be, such
jumps do not seem acceptable for pricing in practice. We will therefore conclude that it is too
unstable to optimize on the mean reversion when only 1 instrument per maturity is chosen, such
that in the remainder of this subsection, we keep the mean reversion fixed over the testing period.
Now we fix the mean reversion at the value obtained on Nov. 27th, 2007 with Method 3, i.e.
a = 0.97%, and proceed to calibrating the volatility as a constant or time-dependent function. We
are interested in 2 aspects, the stability of the parameters over the 2 year period of our tests, and
the quality of the fit to the considered market instruments. For the volatility function σ(t) we first
consider a 10pts function with no constraints on the parameters, such that, having the same number
of parameters as fitted instruments, we can hope for a perfect fit. This is indeed what happens,
as can be seen in table 1 below, which gives an example of fit quality comparison between the
constant and time-dependent calibrations. ”Mkt” refers to the market implied volatilities, ”Md”
to the model implied volatilities for constant σ, and ”Mdt ” to the model implied volatilities for
time-dependent σ(t).

Table 1: 20Y Fitted JPY swaptions on 2009/09/08, no parameter constraints

Inst. Mkt Md Mdt Md-Mkt Mdt -Mkt

1M20Y 29.00% 28.92% 29.25% -0.08% 0.25%
3M20Y 29.30% 28.67% 29.03% -0.63% -0.27%
6M20Y 29.40% 28.33% 29.41% -1.07% 0.01%
1Y20Y 28.80% 27.59% 28.80% -1.21% 0.00%
2Y20Y 27.10% 26.28% 27.10% -0.82% 0.00%
3Y15Y 26.20% 27.01% 26.20% 0.81% 0.00%
4Y15Y 25.00% 25.60% 25.00% 0.60% 0.00%
5Y15Y 24.00% 24.50% 24.00% 0.50% 0.00%
7Y15Y 22.70% 23.10% 22.70% 0.40% 0.00%
10Y10Y 21.90% 22.66% 21.90% 0.76% 0.00%

Apart from the earliest maturities, which are not very liquid anyway, the fit is nearly perfect in
the case of the time-dependent model volatility. However a study of the stability of the parameters
over the testing period shows in fig. 25 in the appendix that, while the constant volatility σ and the
parameter Σ0 of σ(t) are stable, the parameter Σ9 of σ(t) is very noisy. We conclude that although
we can reach a nearly perfect fit for most chosen instruments, there is again over-fitting, this time
due to σ(t).
There are two ways to remedy this problem, one is reducing the number of parameters in our
parametric form for σ(t), and the other one is putting constraints on these. Since both strategies
lead to similar behaviours, we choose to display only the latter here. We choose to constrain the
parameters Σi such that |Σi+1 − Σi | < αΣi for α = 0.1. We obtain the stability results in fig. 6

17
Figure 6: Volatility calibrated to 20Y co-terminal at fixed mean reversion. Constraint α = 0.1.
Left: constant σ, parameters Σ0 and Σ9 of σ(t)
Right: objective function for constant σ and time-dependent σ(t).

Once the constraint has been enforced, the calibration result becomes stable. As should be
expected, the time-dependence of the volatility always improves the quality of the fit, though this
improvement may be more or less significant depending on the dates. It appears to be particularly
efficient in times of unstable or quickly changing markets, for instance at and after Lehman crisis
at the fall of 2008.
In terms of quality of fitting to the chosen instruments, we display in table 2 the result of the
calibration on the dates 2009/04/14 and 2009/09/08. As can be seen in fig. 6, 2009/04/14 is typical
of the ”after-Lehman-shock” period, extending over several months, during which calibration with
constant parameters behaves relatively poorly.

Table 2: 20Y Fitted JPY swaptions in 2009, α = 0.1

Inst. Mkt 04/14 Md-Mkt Mdt -Mkt Mkt 09/08 Md-Mkt Mdt -Mkt
1M20Y 38.20% -9.21% -1.07% 29.00% -0.08% 0.25%
3M20Y 38.10% -9.35% -1.33% 29.30% -0.63% -0.27%
6M20Y 34.10% -5.67% 0.49% 29.40% -1.07% 0.04%
1Y20Y 30.20% -2.45% 0.75% 28.80% -1.21% 0.02%
2Y20Y 27.00% -0.46% -0.06% 27.10% -0.82% -0.31%
3Y15Y 26.00% 1.71% 0.45% 26.20% 0.81% 0.35%
4Y15Y 24.30% 2.09% 0.02% 25.00% 0.60% -0.12%
5Y15Y 23.00% 2.31% 0.06% 24.00% 0.50% 0.04%
7Y15Y 21.10% 2.72% 0.18% 22.70% 0.40% -0.03%
10Y10Y 19.90% 3.39% 0.22% 21.90% 0.76% 0.01%

On the 2009/04/14 the time-dependent calibration offers a clear improvement over the constant
one, although now, due to the presence of the constraint on the cubic spline, perfect fit is no longer
possible. This improvement will not always be so obvious, as can be observed on the later date
2009/09/08.

18
4.3.1 Conclusion
We conclude from these tests that the time-dependency of the volatility enables us to adapt in a
more flexible way to different types of swaption matrices that may appear in times of large market
moves. Some quality of fitting has been lost compared to the unconstrained volatility case, but
stability has greatly improved.
Although we have chosen a specific set of instruments and analysed the fitting quality for these
instruments, it is interesting to have a look at how the other swaptions were fit. In fig. 7, we display
the market and model swaptions at the 1Y and 10Y maturities, for the time-dependent volatility
with constraint calibration scheme. We can see that away from the chosen instruments, the model
swaptions can be off by a very large amount, especially for early maturities and in the presence of
a hump.

Figure 7: Market and Model Implied Volatilities on 2009/09/08, constant a, time-dependent σ(t)
Left: maturity 1Y, calibrated instrument at tenor 20Y
Right: maturity 10Y, calibrated instrument at tenor 10Y

4.4 Co-terminals 10Y and 20Y

4.4.1 Constant a and σ
Here we compare the results of the 3 methods described in section 3.4. We briefly summarize them
below.

• Method 1 The mean reversion is fixed and the volatility is calibrated by using the analytical
prices. This means we perform one 1-dimensional minimization.
• Method 2 The mean reversion is calibrated separately by using the approximated implied
volatility ratios, while the volatility is calibrated by using the analytical prices. This means
we perform two 1-dimensional minimizations successively.
• Method 3 The mean reversion and volatility are calibrated simultaneously by using the
analytical prices. This means we perform one 2-dimensional minimization.

First we display the 3 different mean reversions and model volatilities obtained with these
methods in fig. 8

19
 Figure 8: Constant a and σ are calibrated to the co-terminals 10Y and 20Y.

We observe that all these methods have a similar satisfactory stability. On top of this, we see
a clear regime change in the mean reversion at the time of Lehman crisis. After this, the mean
reversion is clearly lower than before. This echoes a structural change in the swaption matrix that
will be discussed in more details in section 4.6.
As to the quality of the fit to the chosen swaptions, we find the target values in fig. 9 for all
dates and the detailed fitting errors in table 3 for the particular date 2009/09/08.

Figure 9: Constant a and σ are calibrated to the co-terminals 10Y and 20Y.

20
 Table 3: 10Y and 20Y co-terminal fitted JPY swaptions on 2009/09/08

Inst. Mkt Md(1)-Mkt Md(2)-Mkt Md(3)-Mkt

1M10Y 33.40% 6.52% 4.89% 2.48%
1M20Y 29.00% -3.97% -2.31% -0.28%
3M10Y 34.00% 5.04% 3.52% 1.23%
3M20Y 29.30% -4.52% -2.82% -0.75%
6M10Y 33.60% 4.28% 2.92% 0.80%
6M20Y 29.40% -4.96% -3.21% -1.05%
1Y9Y 33.60% 4.53% 2.95% 0.58%
1Y20Y 28.80% -5.10% -3.25% -0.95%
2Y8Y 31.90% 3.58% 2.13% -0.09%
2Y20Y 27.10% -4.72% -2.67% -0.10%
3Y7Y 29.60% 3.41% 2.07% 0.00%
3Y15Y 26.20% -2.64% -1.44% -0.27%
4Y6Y 28.10% 2.82% 1.56% -0.37%
4Y15Y 25.00% -2.86% -1.45% 0.04%
5Y5Y 26.70% 2.37% 1.19% -0.62%
5Y15Y 24.00% -2.98% -1.37% 0.42%
7Y3Y 24.80% 1.25% 0.18% -1.40%
7Y15Y 22.70% -3.21% -1.20% 1.24%
10Y1Y 23.40% -0.08% -0.79% -1.83%
10Y10Y 21.90% -2.58% -0.96% 0.91%

Several conclusions can be drawn from these numbers. Up to the Lehman crisis time, Method 1
and Method 3 behave quite similarly. This is natural as the fixed mean reversion is the calibrated
one on the first day, and the mean reversion with Method 3 does not vary much during this period,
such that its original value on 2007/11/27 remains a good estimation. However from the time the
crisis is triggered, we have seen that the mean reversion enters a new regime. Method 1 is then no
longer able to adapt to the new market conditions. Method 2 on the other hand, while fitting not
as well as Method 3 since it is not a true 2-dimensional optimization, is nevertheless able to take
into account the new situation after the shock.
We conclude that the mean reversion can be estimated safely when two co-terminal swaption
information is included, and that it should be optimized on if one wants to adapt to changing
market conditions. While method 3 is a true 2-dimensional optimization and therefore offers the
best fitting quality in these parameter settings, it is clearly slower at runtime. Method 2 represents
an alternative for which we can both adapt to market changes and have a very short runtime
(quasi-instantaneous), if one is ready to sacrifice a little fitting quality.

4.4.2 Constant a and Time-Dependent σ(t)

Similarly to the constant σ case, we can distinguish the 3 methods

• Method 1: the mean reversion is fixed, and we perform one multi-dimensional optimization
on the parameters Σk of σ(t)

• Method 2: the mean reversion is calibrated separately by a 1-dimensional optimization, and

we perform one multi-dimensional optimization on the parameters Σk of σ(t)

21
 • Method 3: the mean reversion and the volatility are calibrated simultaneously in one multi-
dimensional optimization on a and the parameters Σk of σ(t).

First of all, let us compare the constant and time-dependent volatility calibrations. In fig. 10
we display the targets over the test period. In order not to burden the text with too many graphics,
we show only the result for Method 3, similar conclusions holding for the other methods.

Figure 10: Calibration to co-terminals 10Y and 20Y, constant a, Method 3.

As can be expected, time-dependence represents a clear improvement in general, though for

some special dates it might be less significant. Indeed, it may happen that the global minimum of
the target function is obtained for an almost constant σ(t). Such situations occur in the summer
of 2009, as can be seen in the figure above. Outside of these periods, the improvement due to
time-dependence is obvious. We display the detailed fitting results for such a case in table 4.

Table 4: 10Y and 20Y fitted JPY swaptions on 2009/04/14, α = 0.1

Inst. Mkt Md-Mkt Mdt -Mkt

1M10Y 42.20% -3.65% 3.34%
1M20Y 38.20% -9.40% -3.03%
3M10Y 43.20% -5.23% 1.62%
3M20Y 38.10% -9.51% -3.22%
6M10Y 40.40% -3.18% 1.43%
6M20Y 34.10% -5.78% -1.19%
1Y9Y 36.80% 0.34% 1.48%
1Y20Y 30.20% -2.46% -0.54%
2Y8Y 33.80% 1.34% 0.06%
2Y20Y 27.00% -0.29% -0.19%
3Y7Y 31.80% 1.64% -0.28%
3Y15Y 26.00% 1.23% 0.40%
4Y6Y 30.40% 1.60% -0.91%
4Y15Y 24.30% 1.81% 0.55%
5Y5Y 29.20% 1.52% -1.20%

22
 Inst. Mkt Md-Mkt Mdt -Mkt
5Y15Y 23.00% 2.22% 0.84%
7Y3Y 27.20% 1.22% -1.90%
7Y15Y 21.10% 2.97% 1.29%
10Y1Y 25.10% 0.74% -2.17%
10Y10Y 19.90% 3.39% 1.47%

Note also that now that we fit to a larger number of swaptions, a near-perfect fit can no longer
be hoped for, considering the number of model parameters available here.
In fig. 11 we compare the fit to the co-terminals 10Y and 20Y for the 3 calibration methods
described in this subsection, all with a time-dependent model volatility.

Figure 11: Calibration to co-terminals 10Y and 20Y, constant a and time-dependent σ(t)

We find that these targets reproduce a similar pattern as for the constant volatility case. Conse-
quently the same conclusions hold, i.e. that calibrating the mean reversion is preferable, especially
in case a wildly changing markets, and that simultaneous calibration performs better in terms of
fitting quality than separate calibration of the mean reversion and volatility. For the particular
date 2009/09/08, the detailed errors for each method are given in table 5 below.

Table 5: 10Y and 20Y co-terminal fitted JPY swaptions on 2009/09/08

Inst. Mkt Md(1)-Mkt Md(2)-Mkt Md(3)-Mkt

1M10Y 33.40% 5.14% 3.75% 1.76%
1M20Y 29.00% -5.11% -3.11% -0.89%
3M10Y 34.00% 3.73% 2.44% 0.55%
3M20Y 29.30% -5.62% -3.58% -1.33%
6M10Y 33.60% 4.38% 3.00% 1.02%
6M20Y 29.40% -5.18% -3.15% -0.91%
1Y9Y 33.60% 4.55% 3.05% 0.85%
1Y20Y 28.80% -5.40% -3.18% -0.77%
2Y8Y 31.90% 4.04% 2.45% 0.03%
2Y20Y 27.10% -4.76% -2.44% -0.03%

23
 Inst. Mkt Md(1)-Mkt Md(2)-Mkt Md(3)-Mkt
3Y7Y 29.60% 3.03% 1.72% 0.17%
3Y15Y 26.20% -3.14% -1.71% -0.15%
4Y6Y 28.10% 2.77% 1.51% -0.19%
4Y15Y 25.00% -3.14% -1.49% 0.17%
5Y5Y 26.70% 2.74% 1.30% -0.54%
5Y15Y 24.00% -3.00% -1.28% 0.46%
7Y3Y 24.80% 2.40% 0.74% -1.42%
7Y15Y 22.70% -2.69% -0.72% 1.18%
10Y1Y 23.40% 1.49% 0.13% -1.49%
10Y10Y 21.90% -1.57% -0.12% 1.25%

In terms of runtime, these 3 methods differ only by their treatment of the mean reversion.
Since the volatility is time-dependent, in any case we must run a multi-dimensional constrained
optimization, the question is whether to run it on 10 parameters (volatility only) or 11 (volatility and
mean reversion). The runtime difference is not such that one can consider Method 2 as significantly
faster than Method 3.

4.4.3 Time-Dependent a(t) and σ(t)

For both available methods (separate or simultaneous optimization), we find an unstable behaviour
of the calibrated mean reversion parameters. We are now fitting to 2 co-terminals, that is, 20
swaptions, however not all the swaptions are independent d.o.f. Considering that we are using
10 + 4 model parameters, though constrained, it appears that we do not have enough information
to fix their values in a stable way suitable for practical use. Furthermore even if we allow the
calibration to run in this manner, we do not observe a drastic improvement due to the introduction
of the time-dependent mean reversion. We conclude that the new d.o.f. coming from the mean
reversion are superfluous when only 2 co-terminals are fitted and that it is safer to use a constant
mean reversion.

4.4.4 Conclusion
A significant improvement in the fitting quality can be observed when including the mean reversion
in the calibration procedure. Tests show that a constant mean reversion together with a time-
dependent volatility can be obtained in a stable way while preserving a good quality of fit. It
appears difficult and not particularly profitable to optimize on a time-dependent mean reversion.
Simultaneous calibration of the constant mean reversion together with the volatility also brings a
clear improvement of the fit while retaining stability.
While the 2 chosen co-terminals are approached with a reasonable accuracy by the model
implied volatilities, we do not have any control on the rest of the swaption matrix. By focusing
on 2 instruments per maturity, we may miss the other ones by quite a large amount, especially for
early maturities, in a similar fashion to fig. 7. The hump in particular, is not captured at all.

4.5 All Instruments

Finally we consider the fit to all instruments in the swaption matrix.
It is often stated that Hull-White model, even with time-dependent volatility, is not able to fit
the whole swaption matrix. What happens concretely is that, by trying to fit to all instruments,
we lose control on which instruments will be fit correctly and which will not, see a typical example

24
of this in fig. 26 in the appendix. It may occur that only one instrument is fitted correctly, and
the user would not be able to know in advance which one, which is quite a risky bet.
However, depending on the trade details and the purpose of the practitioner, it may be desirable
to obtain a reasonable fit on the overall matrix. We have observed in the previous section that
focusing on (a) particular co-terminal(s), even by optimizing on the mean reversion, has the disad-
vantage that other instruments may be seriously mis-priced. On the other hand, trying to optimize
on a time-dependent mean reversion resulted in an unstable behaviour, which we attributed to the
lack of information to constrain the mean reversion parameters.
It is therefore natural to wonder whether the information contained in the whole swaption
matrix is suitable to stabilize a time-dependent mean reversion, and if so, how good the resulting
fit would be. In this section we attempt to answer these questions. As method 2 did not seem
to yield a significant runtime or stability improvement in the case of the calibration to 10Y and
20Y co-terminals, we will consider here only method 3, i.e. simultaneous calibration of the mean
reversion and volatility in one multi-dimensional optimization.
First of all, in fig. 12 we compare the calibration targets over 2 years for the 3 strategies constant
a and σ, constant a and time-dependent σ(t), and finally both time-dependent a(t) and σ(t).

Figure 12: All instruments are fitted.

We can see that the time-dependence of the mean reversion gives us a spectacular improvement
in the fitting quality.
It also appears that by calibrating to the whole swaption matrix we are less sensitive to Lehman
crisis as can be seen from the shapes of the curves in the figure above, where we can no longer
see the target spikes observed when calibrating to the co-terminals only. Whether this is a good
feature or not is a matter of opinion. Being able to fit in a satisfactory way even in times of crisis
may seem desirable as it avoids the danger of mis-pricing (or mis-hedging). On the other hand,
a trader may hope that the model will be able to signal unusual market conditions by producing
unexpected numbers, such as a bad fit quality.
As to the stability of the parameters over the test period, we find the evolutions in fig. 13 and
14 for the short-term and mid/long-term mean reversion and volatilities.

25
 Figure 13: Parameters A0 and A1 for constraint α = 0.1

Figure 14: Parameters Σ0 and Σ9 for constraint α = 0.1

There does not seem to be any obvious instabilities. The behaviour of the parameters is similar
to that observed for the constant calibrations, the mid/long-term mean reversion (A1 ) also showing
the regime change after Lehman crisis.
To see in more details how the swaption implied volatility curves are fit, we will take two dates,
roughly one year before Lehman crisis on the 2007/11/27 (fig. 15) and one year after the shock on
2009/09/08 (fig. 16)

26
 Figure 15: Market and Model Swaptions on the 2007/11/27 for α = 0.1

Figure 16: Market and Model Swaptions on the 2009/09/08 for α = 0.1

The quality of fit is greatly improved compared to the constant mean reversion case, and we no
longer wildly mis-price any of the instruments, while retaining the stability of the parameters.
Finally, for the reference, we provide a similar result with a relaxed constraint for the time-
dependent volatility: we take α = 0.5 now, and show the result for the calibration on the 2007/11/27
in fig. 17 below, while the result of the 2009/09/08 is left to the appendix in fig. 28.

27
 Figure 17: Market and Model Swaptions on the 2007/11/27 for α = 0.5

We can see that thanks to the new freedom we could fit the swaption even more accurately. We
obtain now an excellent fit to the whole matrix, including the hump, while the parameters have
the following evolution over the two year testing period

Figure 18: Parameters A0 and A1 for constraint α = 0.5

28
 Figure 19: Parameters Σ0 and Σ9 for constraint α = 0.5

Unsurprisingly, they seem to bear wider moves than for the stronger constraint α = 0.1, although
how much stability has been lost remains ambiguous, as it is not clear how to measure it objectively.
We do not see here evidence of over-fitting as can be observed in other calibration scenarios such
as the unconstrained cubic spline or the calibration of a mean reversion to only one co-terminal,
see fig. 24 and fig. 25.

4.5.1 Conclusion
There seems to be enough information in the swaption matrix to obtain a stable estimation of a
time-dependent mean reversion together with a time-dependent volatility. The resulting fit can be
excellent over the whole swaption matrix without evidence of over-fitting.

4.6 Model and Market Evolution: analysis at Lehman Crisis

Although a perfect mirroring of the market evolution in terms of model parameters cannot be hoped
for, due to limitations of Hull-White model as mentioned in the introduction, we have observed
during this 2 year testing period a clear change in the mean reversion, visible across all types of
calibration and parameter control strategies. As this behaviour is unambiguously exhibited by
the model and its calibration methods, we can be confident that it is more than just a numerical
coincidence and bears instead a deep meaning.
Recall that at the time of Lehman crisis, at the fall of 2008, the mean reversion suddenly drops
to lower values, and does not return to its pre-shock values (at least until the end of the testing
period in fall 2009). This can be observed for example in fig. 8 for constant mean reversions, or
on the mid/long-term parameter A1 of the time-dependent mean reversion in fig. 13. At the same
time, the model volatility does not seem to react in a significant way, such that one can say that
Lehman crisis has been essentially absorbed in a mean reversion regime change.
As this change is obvious on the model side, we would like to know what is its market counter-
part. In other words, we are trying to figure out what is or what are the features of the swaption
matrix and the yield curve that have drastically changed at and after Lehman shock, and why they
affected the model parameters in such a way.
It is a rather difficult question, as there are multiple degrees of freedom involved on both parts
(market and model) and as the modelled variable, the short-rate, is not observable directly. However

29
we believe it is possible to draw a few conclusions.
First of all, we would like to separate, if possible, the influence of the swaption matrix from
that of the yield curve. To this end, we go back to the 10Y and 20Y co-terminals calibration, with
constant mean reversion and volatility for simplicity. We again calibrate over the 2 year testing
period, except that this time, we fix the swaption matrix to its value on the first day, and only
change the yield curve. We obtain the calibration result in fig. 20, with the legend ”VC – FS”.
Then we can fix the yield curve on the first day, and change only the swaption matrix. This result
is displayed in fig. 20 under the legend ”FC – VS”. And finally, we can perform a ”real” calibration
where both the curve and the swaptions vary. This has already been done and is represented in
fig. 20 by the legend ”VC – VS”.

Figure 20: Difference in influence of the yieldcurve and the swaptions on the model parameters.

To sum up,

• VC – FS: the curve varies but the swaptions are fixed. Although there is a reaction of the
parameters when Lehman crisis is triggered, this effect is not propagated afterwards and the
parameters go back to similar values as before the shock.

• FC – VS: the curve is fixed but the swaptions varies. In this case we observe a behavior very
similar to that of the real calibration, VC – VS, in that the mean reversion falls at the crisis
and stays low afterwards.

• VC – VS: both the curve and the swaptions vary. This is the real calibration.

From all this we conclude that the regime change in the mean reversion has been caused mostly
by the evolution of the swaption matrix2 .
We display then the evolution of 4 different swaption implied volatilities (market) in fig. 21.

2
Assuming that the ”swaption × yield curve” cross influence is negligible.

30
 Figure 21: Evolution of JPY swaption implied volatilities

We observe two basic effects here. First of all, a level change appearing at the shock time and
continuing afterwards. Second, a change in the relative values of the implied volatilities for the
same maturity. This change is larger and most obvious for the 10Y swaptions, but is also visible
at the 1Y maturity.
As we have discussed in section 4.1, fig. 5, a strong change in the ratios of implied volatilities at
fixed maturity cannot be accounted for by a change in the model volatility, but rather in the mean
reversion. Furthermore, since we observe in fig. 21 that the market implied volatilities have become
flatter in the tenor direction, we deduce that this effect should be accounted for by a reduction of
the value of the mean reversion, going possibly to negative values. This is indeed what is observed
and what we have called a ”regime change”. It constitutes one more argument in favor of the
consistency of the calibration methods proposed in this work.

4.7 Bermudan Swaptions

Finally we address an issue that we have not dealt with until now, i.e. the fixing of the mean
reversion in the case of a local calibration to one co-terminal. As we have shown in section 4.3, it
is not safe to optimize on it in this case. This means that the mean reversion has to be fixed by
the user, leading to an ambiguity on its value. Moreover, the subsequently calibrated volatility will
depend on the chosen mean reversion value, so one may wonder what can be the influence of this
a priori ad hoc choice on products other than simple vanilla options.
Here we fix 3 different (constant) mean reversions and calibrate the time-dependent model
volatility to the 10Y co-terminal over the 2 year testing period. As the volatility is time-dependent,
we obtain very close fits to the European swaptions whatever the mean reversion is. For the 10Y
Bermudan swaptions, we find the results in fig. 22.
As was also documented in [4], we observe a strong influence of the mean reversion on the
Bermudan swaption prices, even though the relevant European swaptions are almost perfectly fit.
This means that a trader can use this extra freedom to impose a view on the Bermudan swaptions.
Alternatively, this can be viewed as an extension of the calibration process, in which Bermudan
swaption information is also included.
This freedom may be considered as desirable and may motivate the choice of the local calibration
method instead of the global one. Indeed, we have seen in this case that calibrating the mean

31
Figure 22: 10Y Bermudan Swaption Prices (non-call 3Y) for mean reversions 6%, 0.5% and −3%.

reversion is preferable and therefore there is no more freedom in the model to impose a view on
other products.
Note that this is true for the particular parametric form that we have chosen for the mean
reversion, with its corresponding number of degrees of freedom (4). One may think that allowing
more degrees of freedom in the mean reversion and optimizing only on some of them using the
European swaption information may lead to both a stable calibration procedure with good fit to
the European swaptions while still allowing to impose a view on the Bermudan swaptions.

32
5 Conclusion
The achievements of this work are two-fold. On the one hand, we provided a detailed documentation
and numerical examples about the calibration methods of Hull-White model with time-dependent
parameters, as we believe this was missing from the literature. We hope that the readers will find
it useful as a starting point to implement their own calibration and that it will spare them the
trouble of tedious trials and errors.
On the other hand, we showed that some common negative opinions and fears about the model
are not necessarily justified. It is widely stated, for instance, that Hull-White model cannot fit
the swaption matrix well, and that introducing time-dependent parameters to improve the fitting
quality results in unstable behaviours. We believe this work has proved this is not the case, provided
a suitable calibration strategy is adopted. In particular, we showed that the fully time-dependent
model can achieve excellent fit in a stable manner. Furthermore, we provided some means, such as
the ”SMM” approximation of the implied volatilities, to interpret the behaviour of these parameters
w.r.t. market moves. In particular, we showed that the model can provide interesting insights in
the analysis of Lehman crisis in the fall of 2008.
It is not our purpose here to single out one best method. Instead we show that several calibration
methods, such as local or global, with constant or time-dependent parameters, are acceptable,
and that the choice depends on the user preferences as to fitting quality, runtime and ease of
implementation. More specifically, it is clear that time-dependent parameters offer a better fitting
quality, which comes at the cost of a slightly more complicated implementation of nested analytical
integrals. We showed how to avoid the dangers of over-fitting, by using parametric forms with
further constraints. However this method requires, in most cases, multi-dimensional constrained
optimizations, representing an extra implementation and manipulation difficulty. In these tests we
have used a customized version of the simulated annealing algorithm, which, while easily dealing
with constraints, converges quickly enough for most practical purposes. In the particular case of a
calibration with constant mean reversion and volatility though, the 2-dimensional optimization can
be broken down to two 1-dimensional optimizations due to a property (approximate) of the model
implied volatilities, captured by SMM approximation. For a user favoring ease of implementation
and speed over fitting accuracy, a quasi-instantaneous method is thus available in which the mean
reversion can be estimated. Note that this approximation may be made more accurate using the
ideas of [1]. The generalization to time-dependent parameters, and its application to the calibration
procedure, are currently under investigation in [10].
We believe that a number of open questions deserve further investigation in the future. First
of all, the notion of instability of the parameters is quite ambiguous. In order to be able to run
calibration in an automated way and discard the unstable methods, it would be useful to have an
objective criterion as to what constitutes an unstable set of parameters.
Furthermore, the parametric forms proposed here are only suggestions and by no means the
only possibilities. It may prove valuable to investigate the behaviour of other parametric forms,
with different degrees of freedom. As we have briefly mentioned in the case of the local calibration,
leaving the constant mean reversion undetermined by the calibration to European instruments may
be desirable. The parametric forms and constrained multi-dimensional optimizations proposed here
provide a suitable starting point to generalize this idea to more flexible calibration schemes in which
the information of other products, such as Bermudan swaptions, may be incorporated.
Finally, the methods described in this document have been tested in details in the case of JPY
currency (and briefly for USD and EUR) for the two year period Nov. 2007 to Dec. 2009. Although
this includes the stress case of Lehman crisis, we would find it interesting to perform similar studies
over different periods including other shocks, and for different currencies, in order to gain a deeper

33
understanding of the model implications and possibly discover other regime changes in the market.

Acknowledgments
We would like to thank T. Hayashi for providing us with convenient and efficient tools to access
market data, and O. Lenoble for his remarks which helped improve the manuscript.

Appendix

A Integrals
The basic integral that appears in most intermediate equations and final closed forms is based on
integrating only the mean reversion. We denote it by E(t), and it has the expression

Rt
a(u)du
E(t) = e 0 . (30)

From it we obtain the B(t, T ) function involved in the affine structure of the discount bond

∫ T
du
B(t, T ) = E(t) (31)
t E(u)

for which the following properties hold

∂
B(t, T ) = a(t)B(t, T ) − 1 (32)
∂t
∂ E(t)
B(t, T ) = (33)
∂T E(T )
E(t)
B(t, S) − B(t, T ) = B(T, S). (34)
E(T )

The short-rate is integrated explicitly as

∫ t
E(u)σ(u)dW Q (u)
E(s) E(s) 1
r(t) = r(s) + α(t) − α(s) + (35)
E(t) E(t) E(t) s
∫ t
1
α(t) = f (0, t) + E(u)σ 2 (u)B(u, t)du. (36)
E(t) 0

where 0 5 s 5 t and f (0, t) is the initial instantaneous forward rate. The variance of the short-rate
is given by

∫ t
1
Vr (s, t) = 2 E 2 (u)σ 2 (u)du. (37)
E (t) s

r(t) can be negative with non-zero probability

34
 α(t)
P (r(t) < 0) = N (− √ ) (38)
Vr (0, t)
where N (x) is the normal cumulative distribution function.
For the function θ(t) involved in the SDE (1) and ensuring exact replication of the initial curve,
we find

∂ 1 ( ∂2 ∂ )
θ(t) = f (0, t) + a(t)f (0, t) + V (0, t) + a(t) V (0, t) (39)
∂t 2 ∂t2 ∂t
∫ T
V (t, T ) = σ 2 (u, T )du (40)
t
σ(u, T ) = σ(u)B(u, T ). (41)
where σ(u, T ) is the volatility at time u of the discount bond with maturity T .
In the discount bond affine structure

( )
P (t, T ) = exp A(t, T ) − B(t, T )r(t) (42)

the A(t, T ) function is

P (0, T ) 1
A(t, T ) = ln + B(t, T )f (0, t) − B(t, T )2 Vr (0, t). (43)
P (0, t) 2
The variance of the bond ratio

∫ TF ( )2
Vp (t, TF , TP ) = σ(u, TP ) − σ(u, TF ) du (44)
t

factorizes as

Vp (t, TF , TP ) = Vr (t, TF )B(TF , TP )2 . (45)

The correlation between two short-rates r1 = r(t1 ) and r2 = r(t2 ), with t1 < t2 , is

√
E(t1 ) Vr (0, t1 )
ρ(r1 , r2 ) = . (46)
E(t2 ) Vr (0, t2 )
Finally, other useful formulae include the expression of the instantaneous forward rate at t

E(t) ( Vp (t, T ) )
f (t, T ) = f (0, T ) + r(t) − f (0, t) + (47)
E(T ) B(t, T )
and the relation between the discount bound and the short-rate

∫ T ∫ T
σ(u, T )dW Q (u).
1
r(u)du = − ln P (t, T ) + V (t, T ) + (48)
t 2 t

35
B Simulated Annealing
There are many different ways of running a simulated annealing algorithm, all centered on the same
idea of drawing the next point randomly. Our version is based on the following steps

1. Choose an initial point x0 and set running variable xr = x0

2. Evaluate the function and record its value under variable fr = f (x0 )

3. Draw a random point x under a normal distribution of mean xr and standard deviation σj

4. Check if x satisfies the constraints. If it does, go to step 5. If it does not, go back to step 3.

5. Evaluate f (x)

6. i) If f (x) < fr then the new point is closer to the minimum. It is thus recorded : fr = f (x)
and xr = x.
ii) If f (x) = fr then the new point does not represent an improvement. We can forget about
it.3

7. Go to step 3 until stop condition is met. Minimum is at xr with function value fr .

If we have some intuition of where the minimum is, we should take a small standard deviation
σj . The algorithm will then focus on the region around our initial estimate and thus converge
faster. If however we have little information about where this minimum could be (and its unicity,
and the existence of a global minimum and local minima, etc...), we should take a large σj , such
that the algorithm will explore a large portion of the parameter space.
For the stop condition, we advise to perform a number of convergence tests to observe how
many function evaluations are necessary to reach a satisfying degree of convergence and runtime.
In pratice, for a 10-dimensional optimization, a few thousands of evaluations may be necessary, but
runtime on a single 3.0GHz CPU typically does not exceed 10s.
Finally, we introduce a ”cooling down” mechanism realized by a decrease of the standard devi-
ation σj with each iteration j, according to

j
σj = σ0 ∗ exp(−γ × ) (49)
N −1
where N is the total number of simulations, σ0 is the initial standard deviation and γ > 0 describes
the speed of cooling down.
Note that near the end of the algorithm, the standard deviation is σN −1 ≈ σ0 ∗ exp(−γ). If γ
is chosen such that σN −1 ≈ 0, all remaining draws will be extremely close to the mean. In other
words, the algorithm has been ”frozen”. This is analogous to the idea of cooling down for which a
temperature parameter T (that may be chosen as T = 1 − N j−1 here) is decreasing little by little
until reaching 0 and is used in Metropolis algorithm to allow or not uphill moves, T = 0 signifying
that no more moves are allowed and thus the algorithm has reached its end.
It is difficult to say what the values of the algorithm parameters x0 , N, σ0 and γ should be in
general. A few tests are required to find a compromise between a satisfactory convergence speed
and the ability to find the global minimum as well as the independence of the result on the initial
point x0 .
3
Metropolis algorithm can be used to allow ”uphill” moves and increase the ability to escape from a local minimum.

36
C Other Numerical Results
C.1 SMM vs. Jamshidian Method

Figure 23: Swaption Implied Volatilities for various parameter values: Jamshidian Decomposition
vs. SMM approximation.

37
C.2 Other JPY calibration results

Figure 24: Instabilities in the mean reversion calibrated to 20Y co-terminal with Method 3.

Figure 25: Model volatility calibrated to 20Y co-terminal at fixed mean reversion
Displayed: constant σ, parameters Σ0 and Σ9 of σ(t).

38
Figure 26: Market and Model Implied Volatilities on 2009/09/08.
All Instruments are calibrated, with constant a and time-dependent σ(t)

Figure 27: All instruments are calibrated. Mean reversion is time-dependent.

39
 Figure 28: Market and Model Swaptions on the 2009/09/08 for α = 0.5.

C.3 Other currencies: USD

Figure 29: Market and Model USD Swaptions on the 2007/11/27 for α = 0.1
A0 = −1.2%, A1 = 7.6%, Σ0 = 1.27%, Σ13 = 1.42%

40
Figure 30: Market and Model USD Swaptions on the 2009/09/08 for α = 0.1
A0 = −41%, A1 = 5%, Σ0 = 0.52%, Σ13 = 1.44%

C.4 Other currencies: EUR

Figure 31: Market and Model EUR Swaptions on the 2007/11/27 for α = 0.1
A0 = −2.8%, A1 = 6.1%, Σ0 = 0.73%, Σ16 = 0.65%

41
Figure 32: Market and Model EUR Swaptions on the 2009/09/08 for α = 0.1
A0 = −16.2%, A1 = 3.2%, Σ0 = 0.70%, Σ16 = 0.81%.

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