# Tag Info

9

From an equities perspective, there are two concepts that should not be confused in my opinion and context should make the distinction self-explicit: Forward variance swap volatility (A) Forward implied volatility smile (B) I really recommend reading Bergomi's "Stochastic Volatility Modeling" which is an excellent book for equity practitioners. The topics ...

7

Currently the USD 10Y swaprate is $2.93 \%$ and the ATMF 1Yx10Y implied volatility (relative) is $22.5 \%$ which corresponds to the Black model (absolute) volatility of about $4.15$ bp/day. The 1Y swaprate is $2.60 \%$ and the ATMF 10Yx1Y implied volatility is $25.0 \%$ which corresponds to the Black model volatility of about $4.10$ bp/day. With the ...

7

The CMS represents the value of a swap rate for any point in time, i.e. we are interested in extrapolating the density of the swap rate in a similar way as the IBOR rate. Let us start with the fair value of a swaption under the annuity measure $\mathcal{A}$ with tenor at time $\tau$: $$\mathcal{A}(t)\mathbb{E}^\mathcal{A}_t[(\mathcal{S}(\tau)-k)^+]$$ Instead ...

6

I think you did something wrong in translating the input to numerics. As pointed out by dm63 normal vols are quoted in basis points. Using equation A.67a) from the Hagan paper you linked we see (setting $\beta = 0$) $$\sigma_N(K) = \alpha\frac{\xi}{x(\xi)}\left[1+\frac{2-3\rho^2}{24}\nu^2\tau_{exp}\right]$$ where $\tau_{exp} = 0.25$ in your example and ...

6

There is nothing in simple cubic spline fitting routines that would prevent arbitrage. Even with conscientious use of knot points and smoothing techniques you may end up with simple spread and local volatility arbitrage conditions. Stochastic volatility models on the other hand can explicitly constrain your solutions to prevent call/ put spread arbitrage at ...

6

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 ...

6

It is possible, yes, but it requires assumptions. But, philosophically speaking, this is the case as with all pricing, of any instrument. For example, given only the price of a 6Y and 7Y IRS can you correctly price the 6.5Y IRS rate? Well, yes you can, but it depends upon your assumptions about interpolation which is a subjective choice. Lets look ...

5

You are asking about the term structure of lognormal implied volatilities for European swaptions, which is a two dimensional function (expiration and tenor). First expiration: typically (but not always), implied volatilities are increasing in the 0 to 6 month sector, because the immediate future is often more predictable than the medium term. At some ...

5

The advantage of cash-settled swaptions is that the payoff only depends on one variable: the corresponding swap rate which is directly observable in the market: $$\mathrm{Payoff}(T) = f(S_T) = A^{\mathrm{Cash}}(S_T)\max(S_T - K,0)$$ The payoff of a physical swaption on the other hand depends on the physical annuity which is not directly observable. You ...

5

In swaptions, there is the expiration of the swaption into an underlying swap. When the dealers provide the vol surface, in the first column, they typically put the expiry of the swaption from earliest to farthest. Along the top row, they put maturity of the underlying swap from shortest to farthest. So when the dealers describe the upper left having high ...

4

As the swap rate is not tradable, the delta hedge ratio with respect to the spot swap rate is not really useful. However, note that \begin{align*} V_0 &= \sum_{i=\alpha+1}^{\beta}\tau_i P(0, T_i)\big[S_{\alpha, \beta}(0)N(d_1) - k N(d_2) \big]\\ &= \sum_{i=\alpha+1}^{\beta}\tau_i P(0, T_i) S_{\alpha, \beta}(0)N(d_1) - N(d_2) k \sum_{i=\alpha+1}^{\...

4

Market practitioners do the following: Correlation is calibrated most often by looking at historical correlations between liquid par swap rate pairs. One could look at implied correlations within options on the yield curve (eg 10 yr minus 2yr) also. Swaption calibration should be done by comparing straddle prices in the market to prices produced by the ...

4

it certainly works best at the money. Why? I think it comes from the fact that Black's formula is approximately linear at the money. The approximation $$\frac{1}{\sqrt{2\pi}} \operatorname{SR} \sigma \sqrt{T} A,$$ with $A$ the annuity is remarkably good. One way of deducing these formulas is to do an asymptotic/Taylor expansion about $\sigma=0.$

4

The market standard formula approximation for cash settled swaptions applies Black/shifted Black/Bachelier around the forward swap rate so that with this formula parity between payer and receiver swaptions occurs around the forward swap rate, and in particular the zero wide collar struck at the forward swap rate is worth zero (a zero wide collar is the ...

4

Using Taylor polynomials of 2nd order:$$V(r+h)\approx V(r) + \frac{\partial{V}}{\partial{r}}h +\frac{1}{2}\frac{\partial^2{V}}{\partial{r}^2}h^2$$ $$V(r-h)\approx V(r) - \frac{\partial{V}}{\partial{r}}h +\frac{1}{2}\frac{\partial^2{V}}{\partial{r}^2}h^2$$ The sum of the previous 2 equation will give us gamma as: Gamma = \frac{\partial^2{V}}{\partial{r}^2} ... 3 Consider a payer swaption with maturity T_0 and strike K. Here the strike K is the fixed rate paid on the fixed leg of the underlying fixed-for-floating swap with reset dates T_0, \ldots, T_{n-1} and payment dates T_1, \ldots, T_n, where 0<T_0 < \cdots < T_n. We assume that the swap exchanges the payments L(T_{i-1}; T_{i-1}, T_i)\Delta ... 3 I'm giving no assurance that this model is rigorous/functional. It also appears that time steps are severely limited. In general, though, the only way to ensure that something is created well is to create it yourself. I have been burned by canned functions/models in the past, so I avoid them whenever able or if I'm doing anything that is actually important.... 3 Typically, strategists run a regression of changes in implied vols against changes in rates. If rates are highly directional with implied vols (regression coefficient is positive and statistically significant), then it would imply a more lognormal relationship. If the two series are not correlated or very weakly correlated, then the relationship is ... 3 You can only infer forward vol by pairing a mid-curve option with a spot option. It's easier to go through an example (I'll use 5y x 5y vol since I have the sketch below handy...) One decomposition of the 5y5y spot vol is as follows: 1y forward 4y x 5y vol: this is the implied vol of an option starting in 1 year, expiring 4 years thereafter, and eventually ... 3 The procedure outlined by @attack68 is correct for estimating forward vol assuming you are in a world where volatility is deterministic and uncorrelated with the underlying. If these assumptions are not valid, the situation is more complicated. Taking his (or her) example, suppose you sell a usd100mm forward Vol contract on a 5yr 5yr swaption straddle, ... 3 Forget for a moment that your option is delivering the immediate entrance in a swap (if the swaption is physically settled) or the cash amount of the swap (if the swaption is cash-settled), as your question doesn't depend on this fact, and take a "general" 1Y option. Your today's (date t_0) cube loses the "swap tenor dimension" and becomes a today's ... 2 One of the most used interpolation techniques is the cubic spline interpolation. Here you can find an overview of that, while, on Mathworks.com, you can find the tutorial to implement that in Matlab directly simply by using the spline(x,Y,xx) command function. It is not difficult to implement and, moreover, it gives pretty reliable results. I never tried ... 2 American options pricing (swaption is just a kind of option) is a bit tricky due to the early exercise. Here is a page listing possible approaches, including some numeric methods, and some close form approximation formula. As I understand, lattice methods (tree, PDE discretization such as forward shooting) are fine to price American options. There're ... 2 You will need to recal alpha beta and rho: \begin{align*} dF_{t}&=\sigma _{t}F_{t}^{\beta }\,dW_{t}\\ d\sigma _{t}&=\alpha \sigma _{t}^{{}}\,dZ_{t}\\ \end{align*} WheredW_{t}dZ_{t}=\rho dt$$alpha, volvol, lognormal vol of vol param sigma, alpha >= 0. beta, skew, closed form soln only if in set {0,1} rho, correlation coefficient between two ... 2 These are relatively common, especially in convertible bonds. You are correct that the effective maturity of the bond becomes the call/put date. The reason for issuing them is fairly prosaic: a 10 year bond with a 3 year call/put date counts as a 10 year liability for accounting purposes, and of course a 3 year instrument for trading purposes. The latter ... 2 Pricing via characteristic functions arises naturally in models that involve Levy processes. Therefore I can see how Black's formula for swaptions can be generalized for Levy dynamics: As in Black's model take the annuity as numeraire, and define the relevant measure Q Black assumes that under this measure the swap rate is martingale GBM, that is to say$$...

2

One can write for the payoff of an swaption $$\sum_i\tau_i P_{i+1}(S_{\alpha,\beta}(T_\alpha)-K)^+$$ and therefore the pricing equation follows Joshi's explainations. To derive the above equation use that the swap rate is given by $$S_{\alpha,\beta} = \sum_i \frac{\tau_iP_{i+1}}{\sum_i\tau_iP_{i+1}}F^i,$$ where $F^i$ are the corresponding forward rates. ...

2

well just take the Bachelier formula with $r=d=0$ $S_0 = S_{\alpha,\beta}$ and then multiply by the annuity. The annuity will be $$\sum \limits_i \tau_i P_{i+1}.$$ where $P_{i+1}$ is the df for $t_{i+1}.$

2

Given that you have swap rates and Cap prices (ATM, I assume), you can back out the IVs for the time periods using by bootstrapping. Strictly speaking, you would need Caplet prices for the given strikes. In such a case, You would look at the shortest dated cap and (assume) it is made up of only one caplet. You can then use black's formula and back out ...

2

Thanks to my research leader, I found what I missed. $V_{0,1}$ is vol of swaption that matures at $T_0$ which is not 0 (as I thought), rather it is maturity of the first libor. So $V_{0,1}$ is the closest available point on market. And now this is all clear with table on page 323 in section 7.4. $V_{0,2}$ is realy vol of swaption that matures at $T_0$=1y ...

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