Thursday, April 13, 2023

QuantLib-Python: Monte Carlo Valuation for Power Reverse Dual-Currency Note (PRDC)

PRDC note


Essentially, PRDC note can be thought as taking a leveraged position on FX forward curve. Floating coupon rate is a function of FX rates, usually defined as follows.

Additional FX term (at t=0) will scale FX rate used in coupon and is usually set to be equal to FX forward at inception. Mathematically, this changes the slope of coupon payoff and therefore, adding desired leverage to the product.

Model for FX stochastics


From pricing perspective, we need to get a view on FX forward curve. This can be simulated by using Garman-KohlHagen stochastic process for an exchange rate, which is available in QuantLib-Python library. In essence, this process is Geometric Brownian Motion, with an added term for foreign interest rate. We will use this model, even it does not necessarily fully reflect the statistical properties of exchange rate.

Applying Ito's rule to Geometric Brownian Motion, gives us the following solution for an exchange rate S observed at time t.


Python program


In order to implement completely new instrument and corresponding new pricing engine in QuantLib, one should first implement these in QuantLib C++ library by following carefully the designed Instrument-Engine scheme and then, interface these newly created C++ types back to Python by using swig. However in here, we will skip the previous approach completely. Instead, we just take "all the useful bits and pieces" available in QuantLib-Python library and use these to implement our own valuation code.

QuantLib-Python object building documentation by David Duarte is available in here.

The complete code is available in here.

Libraries


The following two libraries are being used.

import numpy as np
import QuantLib as ql

FX path generator


Path generator implements spot rate simulation, based on a given 1D stochastic process. Generated path is exactly in line with the dates given in coupon schedule. Note, that the exact number of paths to be generated has not been defined in this class. Whoever will be the client for this class, can request as many paths as desired. 

class PathGenerator:
    def __init__(self, valuation_date, coupon_schedule, day_counter, process):        
        self.valuation_date = valuation_date
        self.coupon_schedule = coupon_schedule
        self.day_counter = day_counter
        self.process = process
        #
        self.create_time_grids()
        
    def create_time_grids(self):
        all_coupon_dates = np.array(self.coupon_schedule)
        remaining_coupon_dates = all_coupon_dates[all_coupon_dates > self.valuation_date]
        self.time_grid = np.array([self.day_counter.yearFraction(self.valuation_date, date) 
            for date in remaining_coupon_dates])
        self.time_grid = np.concatenate((np.array([0.0]), self.time_grid))
        self.grid_steps = np.diff(self.time_grid)
        self.n_steps = self.grid_steps.shape[0]
        
    def next_path(self):
        e = np.random.normal(0.0, 1.0, self.n_steps)
        spot = self.process.x0()
        dw = e * self.grid_steps
        path = np.zeros(self.n_steps, dtype=float)
        
        for i in range(self.n_steps):
            dt = self.grid_steps[i]
            t = self.time_grid[i]
            spot = self.process.evolve(t, spot, dt, dw[i])
            path[i] = spot

        return path


Monte Carlo pricer


Monte Carlo pricer class will use path generator for simulating requested number of FX paths. A call for method npv will trigger coupon rates simulation. Simulated rates will then be corrected by taking into account of intro coupon. Finally, a series of cash flows will be created, based on calculated coupon rates and schedule dates.

class MonteCarloPricerPRDC:
    def __init__(self, valuation_date, coupon_schedule, day_counter, notional, discount_curve_handle, 
        payoff_function, fx_path_generator, n_paths, intro_coupon_schedule, intro_coupon_rate):

        self.valuation_date = valuation_date
        self.coupon_schedule = coupon_schedule
        self.day_counter = day_counter
        self.notional = notional
        self.discount_curve_handle = discount_curve_handle
        self.payoff_function = payoff_function
        self.fx_path_generator = fx_path_generator
        self.n_paths = n_paths
        self.intro_coupon_schedule = intro_coupon_schedule
        self.intro_coupon_rate = intro_coupon_rate
        #
        self.create_coupon_dates()
        
    def create_coupon_dates(self):
        self.all_coupon_dates = np.array(self.coupon_schedule)
        self.past_coupon_dates = self.all_coupon_dates[self.all_coupon_dates < self.valuation_date]
        n_past_coupon_dates = self.past_coupon_dates.shape[0] - 1
        self.past_coupon_rates = np.full(n_past_coupon_dates, 0.0, dtype=float)        
        self.remaining_coupon_dates = self.all_coupon_dates[self.all_coupon_dates > self.valuation_date]
        self.time_grid = np.array([self.day_counter.yearFraction(self.valuation_date, date) 
            for date in self.remaining_coupon_dates])
        self.grid_steps = np.concatenate((np.array([self.time_grid[0]]), np.diff(self.time_grid)))
        self.n_steps = self.grid_steps.shape[0]
        
        if(self.intro_coupon_schedule==None):
            self.has_intro_coupon = False
        else:
            self.intro_coupon_dates = np.array(self.intro_coupon_schedule)
            self.remaining_intro_coupon_dates = self.intro_coupon_dates[self.intro_coupon_dates > self.valuation_date]
            self.n_remaining_intro_coupon_dates = self.remaining_intro_coupon_dates.shape[0]
            if(self.n_remaining_intro_coupon_dates > 0):
                self.has_intro_coupon = True
            else:
                self.has_intro_coupon = False

    def simulate_coupon_rates(self):
        self.simulated_coupon_rates = np.zeros(self.n_steps, dtype=float)
        
        for i in range(self.n_paths):
            path = self.fx_path_generator.next_path()
            for j in range(self.n_steps):
                self.simulated_coupon_rates[j] += self.payoff_function(path[j])

        self.simulated_coupon_rates = self.simulated_coupon_rates / self.n_paths        
        if(self.has_intro_coupon): self.append_intro_coupon_rates()
        self.coupon_rates = np.concatenate((self.past_coupon_rates, self.simulated_coupon_rates))
        self.n_coupon_cash_flows = self.coupon_rates.shape[0]

    def append_intro_coupon_rates(self):
        for i in range(self.n_remaining_intro_coupon_dates):
            self.simulated_coupon_rates[i] = self.intro_coupon_rate
    
    def create_cash_flows(self):        
        self.coupon_cash_flows = np.empty(self.n_coupon_cash_flows, dtype=ql.FixedRateCoupon)
        
        for i in range(self.n_coupon_cash_flows):
            self.coupon_cash_flows[i] = ql.FixedRateCoupon(self.all_coupon_dates[i+1], self.notional, 
                self.coupon_rates[i], self.day_counter, self.all_coupon_dates[i], self.all_coupon_dates[i+1])
        
        self.coupon_leg = ql.Leg(self.coupon_cash_flows)
        redemption = ql.Redemption(self.notional, self.all_coupon_dates[-1])
        self.redemption_leg = ql.Leg(np.array([redemption]))

    def npv(self):
        self.simulate_coupon_rates()
        self.create_cash_flows()
        
        self.redemption_leg_npv = ql.CashFlows.npv(self.redemption_leg, self.discount_curve_handle, False)
        self.coupon_leg_npv = ql.CashFlows.npv(self.coupon_leg, self.discount_curve_handle, False)
        
        date = [payment.date() for payment in self.coupon_leg]
        amount = [payment.amount() for payment in self.coupon_leg]
        amount[-1] += self.notional
        pv = [ql.CashFlows.npv(np.array([payment]), self.discount_curve_handle, False) for payment in self.coupon_leg]        
        pv[-1] += self.redemption_leg_npv
        
        self.cash_flow_table = np.array([date, amount, pv])
        return self.coupon_leg_npv + self.redemption_leg_npv    


Hard-coded factory


The creation of Garman-Kohlhagen process is isolated into hard-coded factory method. In here, we just use flat forward curves and non-calibrated short rate models for the sake of simplicity. For more realistic creation of the curves and model calibrations, check out this and this.

def process_factory():
    today = ql.Settings.instance().evaluationDate
    
    domestic_curve = ql.FlatForward(today, ql.QuoteHandle(ql.SimpleQuote(0.01)), ql.Actual360())
    domestic_curve = ql.YieldTermStructureHandle(domestic_curve)
    foreign_curve = ql.FlatForward(today, ql.QuoteHandle(ql.SimpleQuote(0.03)), ql.Actual360())
    foreign_curve = ql.YieldTermStructureHandle(foreign_curve)
    
    fx_vol = ql.QuoteHandle(ql.SimpleQuote(0.1))
    fx_vol_curve = ql.BlackVolTermStructureHandle(ql.BlackConstantVol(today, ql.NullCalendar(), fx_vol, ql.Actual360()))    
    fx_spot = ql.QuoteHandle(ql.SimpleQuote(133.2681))
    
    return ql.GarmanKohlagenProcess(fx_spot, foreign_curve, domestic_curve, fx_vol_curve)


Main program


Main program creates all required components (JPY discount curve, process, schedules, generator and pricer) and then requests npv and cash flow table as Numpy ndarray (indexing: [0] = coupon dates, [1] = cash flows, [2] = present values of cash flows).

today = ql.Date(11, 4, 2023)
ql.Settings.instance().evaluationDate = today

# create JPY discount curve
discount_curve = ql.FlatForward(today, ql.QuoteHandle(ql.SimpleQuote(0.005)), ql.Actual360())
discount_curve_handle = ql.YieldTermStructureHandle(discount_curve)

# create FX process
process = process_factory()

# create schedules for coupon- and intro coupon payments
effectiveDate = ql.Date(3, ql.September, 2015)
terminationDate = ql.Date(3, ql.September, 2041)
coupon_schedule = ql.MakeSchedule(effectiveDate, terminationDate, ql.Period(6, ql.Months), 
    backwards=True, calendar=ql.TARGET(), convention=ql.ModifiedFollowing)

intro_coupon_termination_date = ql.Date(3, ql.September, 2016)
intro_coupon_schedule = ql.MakeSchedule(effectiveDate, intro_coupon_termination_date, ql.Period(6, ql.Months), 
    backwards=True, calendar=ql.TARGET(), convention=ql.ModifiedFollowing)

# create FX path generator
fx_path_generator = PathGenerator(today, coupon_schedule, ql.Actual360(), process)

# create PRDC pricer
notional = 300000000.0
intro_coupon_rate = 0.022
n_paths = 10000
prdc_payoff_function = lambda fx_rate : min(max(0.122 * (fx_rate / 120.0) - 0.1, 0.0), 0.022)
prdc_pricer = MonteCarloPricerPRDC(ql.Settings.instance().evaluationDate, coupon_schedule, ql.Actual360(),notional, 
    discount_curve_handle, prdc_payoff_function, fx_path_generator, n_paths, intro_coupon_schedule, intro_coupon_rate)

# request results
npv_ccy = prdc_pricer.npv()
print('PV in CCY: {}'.format(npv_ccy))
jpy_eur = 145.3275
npv_eur = npv_ccy / jpy_eur
print('PV in EUR: {}'.format(npv_eur))
print()
print('Cash flow dates: {}'.format(prdc_pricer.cash_flow_table[0]))
print()
print('Cash flows: {}'.format(prdc_pricer.cash_flow_table[1]))
print()
print('Present values of cash flows: {}'.format(prdc_pricer.cash_flow_table[2]))

Thanks for reading this blog.
-Mike

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