The SABR/LIBOR Market Model: Pricing, Calibration and Hedging for Complex Interest-Rate Derivatives

By Riccardo Rebonato, Kenneth McKay and Richard White

This book presents a major innovation in the interest rate space. It explains a financially motivated extension of the LIBOR Market model which accurately reproduces the prices for plain vanilla hedging instruments (swaptions and caplets) of all strikes and maturities produced by the SABR model. The authors show how to accurately recover the whole of the SABR smile surface using their extension of the LIBOR market model. This is not just a new model, this is a new way of option pricing that takes into account the need to calibrate as accurately as possible to the plain vanilla reference hedging instruments and the need to obtain prices and hedges in reasonable time whilst reproducing a realistic future evolution of the smile surface. It removes the hard choice between accuracy and time because the framework that the authors provide reproduces today's market prices of plain vanilla options almost exactly and simultaneously gives a reasonable future evolution for the smile surface.

The authors take the SABR model as the starting point for their extension of the LMM because it is a good model for European options. The problem, however with SABR is that it treats each European option in isolation and the processes for the various underlyings (forward and swap rates) do not talk to each other so it isn't obvious how to relate these processes into the dynamics of the whole yield curve. With this new model, the authors bring the dynamics of the various forward rates and stochastic volatilities under a single umbrella. To ensure the absence of arbitrage they derive drift adjustments to be applied to both the forward rates and their volatilities. When this is completed, complex derivatives that depend on the joint realisation of all relevant forward rates can now be priced.

Contents
THE THEORETICAL SET-UP
The Libor Market model
The SABR Model
The LMM-SABR Model

IMPLEMENTATION AND CALIBRATION
Calibrating the LMM-SABR model to Market Caplet prices
Calibrating the LMM/SABR model to Market Swaption Prices
Calibrating the Correlation Structure

EMPIRICAL EVIDENCE
The Empirical problem
Estimating the volatility of the forward rates
Estimating the correlation structure
Estimating the volatility of the volatility

HEDGING
Hedging the Volatility Structure
Hedging the Correlation Structure
Hedging in conditions of market stress

• Language: English
• Publisher: Wiley
• Release date: Mar 1, 2011
• ISBN: 9781119995630

Riccardo Rebonato

Riccardo Rebonato is Head of Group Market Risk and Head of the Quantitative Research Centre (QUARC) for the Royal Bank of Scotland Group. He is also a Visiting Lecturer at Oxford University's Mathematical Institute, where he teaches for the MSC/Diploma in Mathematical Finance. His books include Interest-Rate Option Models and Volatility and Correlation in Option Pricing.

Book preview

Chapter 1

Introduction

All models are wrong, but some models are useful

We present in this book a financially motivated extension of the LIBOR market model that reproduces for all strikes and maturities the prices of the plain-vanilla hedging instruments (swaptions and caplets) produced by the SABR model. In other words, our extension of the LIBOR market model accurately recovers in a financially motivated manner the whole of the SABR smile surface.

As the SABR model has become the ‘market standard’ for European options, just the recovery of the smile surface by a dynamic model could be regarded as a useful achievement in itself. However, we have tried to do more. As we have stressed in the opening sentences, we have tried to accomplish this task in a way that we consider financially justifiable.

Our reason for insisting on financial reasonableness is not (just) an aesthetic one. We believe that the quality of a derivatives model should be judged not just on the basis of its ability to price today’s hedging instruments, but also on the basis of the quality of the hedges it suggests. We believe that these hedges can be good only if the model is rooted in empirical financial reality. The ‘empirical financial reality’ of relevance for the pricing and hedging of complex derivatives is the dynamics of the smile surface. We explain below why we believe that this is the case.

We are therefore not just offering yet another model. We present a ‘philosophy’ of option pricing that takes into account the realities of the industry needs (e.g., the need to calibrate as accurately as possible to the plain-vanilla reference hedging instruments, the need to obtain prices and hedges in reasonable time) while reproducing a realistic future evolution of the smile surface (our ‘financial reality’).

Until recently choosing between fitting today’s prices very accurately and being respectful of ‘financial reality’ (given our meaning of the term) entailed making hard choices. For instance, some approaches, such as local-volatility modelling (see, e.g., Dupire (1994), Derman and Kani (1994)), fulfilled (by construction) very well the first set of requirements (perfect fitting of today’s smile). This made local volatility models very popular with some traders. Yet, the dynamics of the smile these models implied were completely wrong. Indeed, the SABR model, which constitutes the starting point for our extension, was introduced to remedy the wrong dynamics imposed by the local-volatility framework.

On the other hand, financially much more palatable models, such as the Variance Gamma model (see, e.g., Madan and Seneta (1990)) and its ‘stochastic volatility’ extensions (see, e.g., Madan and Carr (1998)), have failed to gain acceptance in the trading rooms because of their computational cost and, above all, the difficulties in achieving a quick and stable calibration to current market prices. These prices may be ‘wrong’ and the Variance Gamma models ‘right’, but this is not a discussion the complex derivatives trader is interested in entering into - and probably wisely so.

We believe that these hard choices no longer have to be made. The framework we present recovers almost exactly today’s market prices of plain-vanilla options, and at the same time implies a reasonable future evolution for the smile surface. We say ‘reasonable’ and not ‘optimal’. The evolution our model implies is not the ‘best’ from an econometric point of view. Two of us (RR and RW), for instance, believe that a two-state Markov-chain model for the instantaneous volatility does a much better job at describing how smile surfaces evolve, especially in times of market turmoil. We have published extensively in this area (see, e.g., Rebonato and Kainth (2004) and White and Rebonato (2008)), and our ideas have been well received in academic circles. Yet we are aware that the approach, even after all the numerical tricks we have discovered, remains too awkward for daily use on the trading floor. It is destined to remain ‘another interesting model’. This is where the need for realism comes into play. We believe that the extension of the LMM that we present provides a plausible description of our financial reality while retaining tractability, computational speed and ease of calibration.

As we said, we take the SABR model (Hagan et al.) as the starting point for our extension of the LMM. This is not just because the SABR model has become the market standard to reproduce the price of European options. It is also because it is a good model for European options. Again, pragmatism certainly played a part in its specification as well. A log-normal choice for the volatility process is not ideal, both from a theoretical and (sometimes) from a computational point of view. However, the great advantages afforded by the ability to have an analytic approximation to the true prices, the ease of calibration and the stability of the fitted parameters have more than offset these drawbacks. The main strength of the SABR model, however, is that it is financially justifiable, not just a fitting exercise: the dynamics it implies for the smile evolution when the underlying changes are fundamentally correct - unlike the dynamics suggested by the even-better-fitting local-volatility model.

If the SABR model is so good, why do we need to tinker with it? The problem with the SABR model is that it treats each European option (caplet, swaption) in isolation - in its own measure. The processes for the various underlyings (the forward rates and swap rates) do not ‘talk to each other’. It is not obvious how to link these processes together in a coherent dynamics for the whole yield curve. The situation is strongly reminiscent of the pre-LMM days. In those days market practitioners were using the Black (1976) formula for different caplets and swaptions (each with its own ‘implied volatility’), but did not know how to link the processes together for the various forward rates to a coherent, arbitrage-free evolution for the whole yield curve. This is what the LMM achieved: it brought all the forward rates under a single measure, and specified dynamics that, thanks to the no-arbitrage ‘drift adjustments’, were simultaneously valid for all the underlyings. Complex instruments could then be priced (with a deterministic volatility).

We are trying to do something very similar. With our model we bring the dynamics of the various forward rates and stochastic volatilities under a single measure. To ensure absence of arbitrage we also derive ‘drift adjustments’. Not surprisingly, these have to be applied both to the forward rates and to their volatilities. When this is done, complex derivatives, which depend on the joint realization of all the relevant forward rates, can now be priced.

All of this is not without a price: when the volatilities become stochastic, there is a whole new set of functions to specify (the volatilities of the volatilities). There is also a whole correlation structure to assign: forward-rate/forward-rate correlations, as in the LMM; but also the forward-rate/volatility and volatility/volatility correlations. For, say, a 10-year, quarterly deal, this could provide a fitting junky with hundreds of parameters to play with. Since implying process parameters from market prices is an inverse problem (which also has to rely on the informational efficiency of the market),¹ we are very wary of this approach. Instead, our philosophy can instead be summarized with the sound bite:

Imply from market prices what you can (really) hedge, and estimate econometrically what you cannot.

This is for us so important that we must explain what we mean. Ultimately, it goes back to our desire to reproduce the dynamics of the smile surface as well as we (realistically) can.

One may say: ‘If the price of an option is equal to the cost of the instruments required for hedging, and if a model, like the local volatility one, reproduces the prices of all of today’s hedging options perfectly, what else should a trader worry about?’ We agree with the first part of the statement (‘the price of an option is equal to the cost of the instruments required for hedging’), but the bit about ‘the cost of the instruments required for hedging’ refers not just to today’s hedging, but to all the hedging costs incurred throughout the life of the complex deal. This, after all, is what pricing by dynamic replication is all about. Since volatility (vega) hedging is essential in complex derivatives trading, future re-hedging costs mean future prices of plain-vanilla options (future caplets and swaptions). Future prices of caplets and swaptions means future implied volatilities. Future implied volatilities means future smiles. This is why a plausible evolution of the smile is essential to complex derivatives pricing: it determines the future re-hedging costs that, according to the model, will be incurred during the life of the deal. If a model implies an implausible level or shape for the future smile (as local-volatility models do), it also implies implausible future prices for caplets and swaptions and therefore implausible re-hedging costs.

One of us (RR) has discussed all of this at some length in a recent book (see Rebonato (2004a), Chapter 1 in particular). Since we want to keep this book as concise and to-the-point as possible, we shall not repeat the argument in detail - matters, indeed, are a bit more complex because in a diffusive setting the theoretical status of vega hedging is at the very least dubious. Even here, however, we must say that our argument, despite its plausibility, does not enjoy universal acceptance. There is a school of thought that believes in what we call a ‘fully implied’ approach. In a nutshell, this approach says something like: ‘Fit all the plain-vanilla option prices today with your model, without worrying too much whether your chosen model may imply implausible dynamics for the smile; use all the plain-vanilla instruments you have fitted to for your hedging; future re-hedging costs may indeed be different from what your model believes; but you will make compensating errors in your complex instrument and in the hedges.’

Again, one of us (RR) has argued at length against this view. In brief, the objections are that for the ‘all-implied’ approach to work option markets must either be perfectly informationally efficient or complete. The first requirement is appealing because it suggests that traders can be spared the hard task of carrying out complicated and painstaking econometric analyses, because the market has already done all this work for them: the information, according to this view, is already all in the prices, and we only have to extract it. While this optimistic view about the informational efficiency of the market may hold in the aggregate about very large, liquid and heavily scrutinized markets (such as the equity or bond markets), it is not obvious that it should be true in every corner of the investment landscape. In particular, it appears to me a bit too good to be true in the complex derivatives arena, as it implies, among other things, that supply and demand cannot affect the level of option prices - and hence of implied volatilities (an ‘excess’ supply of volatility by, say, investors should have no effect on the clearing levels of implied volatilities because, if it made options too ‘cheap’, it would entice pseudo-arbitrageurs to come in and restore price to fundamentals). Again, see the discussion by Rebonato (2004a) about this point.

The second line of defence for the ‘all-implied’ approach is somewhat less ambitious. It simply implies that ‘wrong’ prices can be ‘locked in’ by riskless trades - much as one can lock in a forward rate if one can trade in the underlying discount bonds: if one can trade in discount bonds of, say, six and nine months, one can lock in the future borrowing/lending rate without worrying whether this implied level is statistically plausible or not. This view, however, implies that the market in complex derivatives is complete, i.e., that one can notionally trade, or synthetically construct, a security with a unit payment in every single state of the world of relevance for the payoff of the complex security we want to price. But plain-vanilla instruments (caplets and European swaptions) emphatically do not span all the states of the world that affect the value of realistically complex derivatives products. The relevant question is therefore how much is left out by the completeness assumption. We believe that the answer is ‘far too much’.

Our approach therefore is to calibrate our model as accurately as possible to those instruments we are really going to use in our hedging (this is the ‘hedge what we really can’ part of our sound bite). We then try to ‘guesstimate’ as accurately as possible using econometric analysis the remaining relevant features of the future smile (remember, this ultimately means ‘of the future re-hedging costs’) and to ensure that our calibrated model reflects the gross features of these empirical findings in the whole if not in the detail. This is why we give such great importance to the econometric estimation of the dynamic variables of our models as to devote a whole part of the book (Part III) to the topic.

But, if the future smile is unknown today, what hopes can we have of calibrating our model appropriately, and therefore of guessing correctly the future re-hedging costs? Our hopes lie in the fact that the future smile surface may well be stochastic, but certain regularities are readily identifiable. We may not be able to guess exactly which shape the smile surface will assume in the future, but we should make sure that these identifiable regularities are broadly recovered. An informed guess, we believe, is way better than nothing. If the goal seems too modest, let us not forget that the local-volatility model miserably fails even this entry-level test of statistical acceptability.

So, we do not peddle the snake-oil of the ‘perfect model with the perfect hedge’. After all, if a substantial degree of uncertainty did not remain even after the best model was used, it would be difficult to explain why, in a competitive market, the margins enjoyed by complex derivatives traders are still so much wider than the wafer-thin margins available in less uncertain, or more readily hedgeable, asset classes. The name of the game therefore is not to hope that we can eliminate all uncertainty (perhaps by deluding ourselves that we can ‘lock in’ all the current market prices). A more realistic goal for a good model is to offer the ability to reduce the uncertainty to an acceptable minimum by making as judicious a use as possible of the econometric information available.

This is what we believe our modelling approach can offer. And this is why our book is different from most other books on derivatives pricing, which tend to be heavy on stochastic calculus but worryingly thin on empirical analysis.

Finally, we are well aware that there are conditions of market stress that our model ‘does not know about’. We therefore propose in the last chapter of our book a pragmatic hedging approach, inspired by the work two of us (RR and RW) have done with the two-state Markov-chain approach mentioned above. This approach can ensure a reasonable hedging strategy even in those situations when the (essentially diffusive) assumptions of our model fail miserably. This will be an unashamedly ‘outside-the-model’ hedging methodology, whose strength relies on two essential components: the empirical regularities of the dynamics of the smile surface; and the robustness of the fits we propose. As these are two cornerstones of our approach, we believe that we have a chance of succeeding.

Part I

The Theoretical Set-Up

Chapter 2

The LIBOR Market Model

... When we have contracted a habitude and intimacy with any [pricing model]; tho’ in [using it] we have not been able to discover any very valuable quality, of which [it] is posseess’d; yet we cannot forbear preferring [it] to [new models], of whose superior merit we are fully convinc’d ...

Adapted from David Hume, A Treatise on Human Nature, 1740.²

In order to make our treatment self-consistent, we review in this chapter the ‘standard’ (i.e., deterministic-volatility) LIBOR market model (LMM). The most influential original papers published in refereed journals about the LMM were by Brace, Gatarek and Musiela (1997), Jamshidian (1997) and Rutkowski (1998). For a treatment of the topic conceptually aligned with our way of looking at things, see Rebonato (2002) and Rebonato (2004a). For a discussion of the historical development of interest-rate modelling leading to the LMM and beyond, see Rebonato (2004b). In order to set the LMM in the broader modelling context of term-structure models, a very good discussion and many references can be found in Hughston (2003) and Hughston and Brody (2000).

For the purposes of the following discussion, the most important thing to remember is that, despite the name, the LMM is not a model; rather, it is a set of no-arbitrage conditions among forward rates (or discount bonds). The precise form of these no-arbitrage conditions depends on the chosen ‘unit of account’ (the numeraire). As it turns out, these no-arbitrage conditions are purely a function of the volatilities of, and the correlations among, the state variables (in our case, the forward rates). This is because ‘physically’ the origin of the no-arbitrage condition is the covariance between the payoff and the discounting. In a nutshell the reasoning goes as follows. We can discount cashflows in several different ways (i.e., we can use several different stochastic numeraires to relate a future payoff to its values today). These different stochastic numeraires will in general co-vary (positively or negatively) with the same payoff in different ways. For instance, the stochastic discounting might be high just when the payoff is high, thereby reducing its value today, or vice versa. However, the value today of a payoff must be independent of the arbitrary way we have chosen to discount it. It should therefore be intuitive that, in order to obtain a numeraire-independent price, we must somehow adjust the dynamics of the state variable in order to account and compensate for this co-variation. What is needed to go from this intuition to a specific form for the no-arbitrage conditions is just a moderate amount of stochastic-calculus plumbing. This is what we turn to in the following.

2.1 Definitions

We assume that in the economy a discrete set of default-free discount bonds, 002 , are traded. We denote the generic instantaneous forward rate at time t, resetting at time T and paying at time T + τ by f (t, T, T + τ). The N reset times are indexed and numbered from 1 to N: T1, T2,..., TN. If we work with spanning forward rates, the payment time for the i th forward rate coincides with the reset time for the (i + 1)th forward rate. The forward rates are then denoted by

(2.1)

003

The instantaneous volatilities of the forward rates are denoted by

(2.2)

004

The instantaneous correlation between forward rate i and forward rate j is denoted by

(2.3)

005

For discounting a numeraire must be chosen. A valid numeraire must be strictly positive in all states of the world. To make life easier, it is much better if it does not pay dividends or coupons. A possible choice can be a discount bond, 006 .

The link between the forward rates and the discount bonds introduced above is via the definition:

(2.4)

007

with

(2.5)

008

We call τi the tenor of the forward rate, but note that this definition is not universal.

The description of the (discrete) yield curve is completed by providing the value of the spot rate, i.e., the rate for lending/borrowing from spot time to T1, given by

(2.6)

009

We stress that this set-up provides a description of a discrete set of forward rates indexed by a continuous time index.

In the deterministic-volatility LMM the evolution of these forward rates is described by equations of the form

(2.7)

010

with

(2.8)

011

Here ft is the vector of spanning forward rates that constitute the yield curve, σt the vector of the associated volatilities, and ρ the matrix of the associated correlations. Note that, in principle, the functions σi (t, Ti) need not be the same for different forward rates; we have therefore used a superscript to identify the possibly different volatility functions. If these functions are the same for all the forward rates, and if the dependence on t and Ti of this common function (say, σ (·)) is of the form

(2.9)

012

then the LMM is said to be time homogeneous. This is important, because, as explained at length in Rebonato (2002), in this case the future smile surface will exactly ‘look like’ today’s smile surface. If this can be achieved, it is (most of the time) a very desirable feature, for the reasons explained in the Introduction.³

Finally, note that, with a slight abuse of notation, we will often denote these time-homogeneous functions as

(2.10)

013

In this equation the superscript i or Ti now denotes the dependence on the expiry of the forward rate, Ti, of the same volatility function for all the forward rates. So, in the time-homogenous formulation, at a given time t, the volatilities of two forward rates differ only because they have different times to expiry - i.e., they are at different times of their otherwise identical ‘life’. This is what makes the smile surface time invariant.

As for the drifts, μi ({ft}, {σt}, ρ, t), which appear in Equation (2.7), these will be derived in a unified manner when dealing with the LMM-SABR model.

2.2 The Volatility Functions

There are, of course, many financially plausible functions that satisfy Equation (2.10) above. One of us (RR) has explained at length in Rebonato (2002) and Rebonato (2004a) why the following specification provides a good choice:

(2.11)

014

A selction of possible shapes of this functional form is shown in Figure 2.1. Summarizing briefly, this functional form has the following properties.

• It allows for a monotonically decaying or for a humped volatility function. This is desirable because Rebonato (2002) and Rebonato (2004a) explain that a humped volatility should be appropriate for normal trading periods and a monotonically decaying one for excited periods. In a nutshell, the argument points to the fact that, in normal market times, the actions of the monetary authorities are such that the maximum uncertainty in the value of rates is found neither in immediately resetting forward rates, nor in forward rates with very long expiries. It is in the intermediate-maturity range that the uncertainty should be greatest. In Part III we present empirical evidence to buttress the claims made in the references above.

• It is, of course, square-integrable and allows for closed-form solutions of the integrals of its square. As we shall see, this is important because these integrals are linked to the pricing of plain-vanilla and complex instruments.

• Its parameters lend themselves to an easy interpretation. For instance, a + d is the value of the instantaneous volatility of any forward rate as its expiry approaches zero; d is the value of the instantaneous volatility for very long maturities; the maximum of the hump, if the choice of parameters allows for one, is given by 015 . If we believe in the ‘financial story’ presented in the references above, we can check whether our market-fitted parameters are consistent with it. Also, we can compare the position of the maximum obtained from these market fits with the econometric evidence presented in Part III of this book.

• When market fits are carried out for at-the-money swaptions or caplets, ‘natural’ fits are obtained, with parameters that lend themselves to the financial interpretation above.

• When coupled with a simple correlation function, the functional form (2.11) describes well and in a parsimonious manner the whole at-the-money swaption surface. See, for instance, the studies by Rebonato (2006) and White and Rebonato (2008).

For these reasons, this is the particular functional form that we shall use, and expand upon, in this book. However, there is no loss of generality in doing so, and all of our treatment would still hold if any other form for the time-homogeneous function g(·) were used.

2.3 Separating the Correlation from the Volatility Term

Let us go back to Equation (2.7) and rewrite it as

(2.12)

016

Figure 2.1 Possible shapes of the volatility function in Equation (2.11). Note how both ‘excited’ (series 5) and ‘normal’ states (series 1 to 4) can be obtained.

017

where we now assume that we are dealing with m (m ≤ N) factors and that the Brownian increments are independent:

(2.13)

018

where δij is the Kronecker delta (δij = 1 for i = j and 0 otherwise). The quantities σik can be interpreted as the loadings of the ith forward rate onto the kth factor. Clearly, because of this independence, the relationship between the volatility σi and the loadings σik is given by

(2.14)

019

If we have chosen the function in such a way that the relationship

(2.15)

020

holds true, then the market caplets will be correctly priced. (In the equation above, and everywhere in the book, the quantity 021 represents the Black implied volatility - recall that, for the moment, we are dealing with a world without smiles.) For this reason we call Equation (2.14) the caplet-pricing condition.

Let us now multiply and divide each loading σik by the volatility, σi, of the

Reviews for The SABR/LIBOR Market Model

[mistero_1 · Rating: 4 out of 5 stars]

Having to deal with Exotic Interest Rates product professionally, I had to get the latest Rebonato's opum. I've found in the past that there is much to be annoyed with this author, but also very frequently insights you would not get anywhere else: in the case of this book, the couple of pages where he explains what makes a good model should be mandatory reading for any aspiring "quant" thinking about applying the tools of his trade to the dirty world of finance. Recommended as such.