Interest rate exotics are a class of tailor-made interest rate-related assets that cover a wide range of payoffs. To investigate this area exhaustively would necessitate devoting a complete volume to the subject. In this section, we shall develop three popular payoffs, which over time have become “standard” instruments: CMS swaps, cancelable swaps, and one of the many versions of Target Redemption Notes. This will give us the opportunity to put theory into practice. To price the CMS and cancelable swaps, we will use two different models and share the results obtained from them. The TARN will be valued under the HJM model, with and without the help of factor reduction techniques (PCA).
In the interbank market, reference rates are basically classified in three categories:
The CMS reference generates a new class of derivatives:
In fact, the only way to hedge a CMS swap is ...