3
$\begingroup$

In most Banks, the Traders are provided with ATM Implied vols across different Swaption Expiry's and different Underlying Swap Maturities.(The ATM Implied Vol Cube)

If the trader wants to trade an OTM or ITM Swaption, how would he actually go about pricing the Trade with the ATM Vol Surface he has been provided along with the different analytical tools he will have at his disposal?

$\endgroup$
  • 1
    $\begingroup$ Random googling yielded the following: " there are two methods to determine non-ATM swaption vols. The method advocated by [us] is to apply the same smile shape as seen in the caplet data to the swaption vols. Numerically, this means that one calculates the difference between the furthest out-of-the-money OTM) and in-the-money (ITM) caplet vols and applies this difference to the swaption ATM vol to produce the corresponding non-ATM vols. For instance ..." $\endgroup$ – noob2 Sep 19 '16 at 14:22
  • $\begingroup$ @noob2 - Can you please give the link to this? $\endgroup$ – Deb Sep 20 '16 at 7:23
  • 1
    $\begingroup$ See under Volatility Cube here fincad.com/resources/resource-library/article/… Keep in mind I don't know the reliability of this information. $\endgroup$ – noob2 Sep 20 '16 at 13:45
6
$\begingroup$

At most banks, swaption traders have models that allow non atm volatilities to be controlled by two parameters. Specifically , a parameter to control the smile (richness of out of the money options) and the skew (whether implied vol is upward or downward sloping as a function of strike ). Look up papers on the SABR model.

In practice, one would calibrate such s model using market prices that are liquid (such as 100bp high payer swaption for example. ). Other strikes could then be inferred from the model.

Just FYI cap prices are less liquid than swaption prices , so they are not specifically used to calibrate swaption vols.

$\endgroup$

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.