Issue 4, March 2009

M ANAGE S MILE R ISK W ITH T HE SABR M ODEL O F

S TOCHASTIC VOLATILITY
FINCAD Analytics Suite 2009 for Excel and FINCAD Analytics Suite 2009 for Developers
expand FINCAD’s coverage to price and hedge interest rate derivatives consistent with the
market smile dynamics by adding pricing functions using the SABR model of stochastic
volatility.

Overview

The seemingly simple task of pricing and hedging a swaption can become challenging if a volatility
smile/skew is present in the market data – defined as a non-constant Black volatility as a function of
the exercise rate of the swaption. This is due to the fact that one needs a model consistent with the
entire volatility surface.

One of the first successful models to address this need is Dupire’s local volatility model [3] which can
be self-consistently calibrated to the entire volatility surface. However, as discussed in [4], the dynamic
behavior predicted by Dupire’s local volatility model is opposite to the behavior empirically observed in
interest rate markets. Specifically, Dupire’s local volatility model predicts that when the underlying
forward rate decreases, the smile shifts to higher prices and when the underlying forward rate
increases, that the smile shifts to lower prices.

The Stochastic Alpha Beta Rho (SABR) model is a model of stochastic volatility introduced by Hagan
et. al. [4] as an attempt to model the volatility surface and to capture the empirically observed dynamic
behavior of the smile.

Besides pricing and hedging the derivatives, another appealing application is to construct the “volatility
cube” (vol cube)[1], which is a representation of swaption market data characterized by three
parameters: option maturity, swap tenor and exercise rate (or strike). Some parts of the vol cube can
be populated by data easily obtained from the market, such as at-the-money (ATM) swaption vols and
the Black volatilities for caplets (floorlets) (which can be thought of as one-period swaptions). The rest
of the vol cube can be determined by interpolation with the help of the SABR model [1].

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The SABR model has gained widespread use due to its tractable pricing, ability to capture both the
correct shape of the smile, as well as the correct dynamics of the volatility smile. It also gives
practitioners the flexibility to use their intuition regarding market dynamics. For an in depth introduction
to the SABR model, consult [4], [5].

FINCAD Analytics Suite 2009 provides functions to value swaptions and interest rate caplets/floorlets
along with the functionality to calibrate the SABR model with swaption or caplet/floorlet volatilities.

Pricing Interest Rate Derivatives

Caplets and swaptions are essentially options on the underlying interest rate and forward swap rate,
respectively. The SABR model assumes that the underlying rate f follows the stochastic differential
equations

(1) dft = σt ftβ dW1 ,

(2) dσt = νσt dW2 ,

where

dWi = Brownian motion (i = 1 corresponds to the forward rate process and i = 2 to the
volatility process),

ρ = correlation, defined by the relation d hW1 , W2 i = ρdt,

σ0 = α = the initial volatility.

Hagan et. al derived the celebrated asymptotic formula for the effective Black volatility in the SABR
model [4],
 
α z
σB (f, k) = 1−β
n o· ×
(1−β)2 (1−β)4 x(z)
(f k) 2 1+ 24 log2 (f /k) + 1920 log4 (f /k) + · · ·
(3) ( " # )
(1 − β)2 α2 1 αβρν 2 − 3ρ2 2
1+ + + ν T + ··· ,
24 (f k)1−β 4 (f k) 1−β
2 24

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 where

f = relevant rate of the instrument (forward rate or forward swap rate),

k = exercise (strike) rate of the instrument,

T = time until maturity of the option,

1−β
z = αν (f k) 2log(f /k),
√ 
1−2zρ+z 2 +z−ρ
x(z) = log 1−ρ .

The beauty of the SABR model is that the prices of caplets or swaptions are given by the Black
formula with a modified volatility given in Equation (3) as long as the model parameters are in hand.

FINCAD Analytics Suite 2009 provides functions to value caplets/floorlets and swaptions in the SABR
model:

aaCaplet_SABR calculates the price and risk statistics of a caplet/floorlet.

aaSwaption_SABR calculates the fair strike and risk statistics of a swaption.

aaSwaption_SABR_fs calculates the fair strike and risk statistics of a swaption and allows free-style
user inputs.

Calibration

With a suitable set of SABR parameters in hand, pricing simply reduces to a calculation of the effective
Black volatility, via Equation (3), to use in the Black formula. The bulk of the effort, therefore, comes
down to choosing the “best” set of SABR parameters. The SABR parameters in Equation (1) can be
determined by calibration to caplet/floorlet or swaption market data. The procedure will be slightly
different for swaption calibration since ATM vol is more important than non-ATM vols.

It is empirically seen that the two parameters ρ and β have similar effects on the vol smile in that they
both control the amount of skewness. Mathematically, β (sometimes referred to as the “skewness”
parameter) is a constant elasticity of variance (CEV) exponent (see [2]). β = 1 corresponds to a
stochastic lognormal model and β = 0 corresponds to a stochastic normal model.

There are two methods used for determining β , both of which stem from the analytical form of the ATM
vols in the SABR model, calculated by setting the strike rate k in Equation (3) to equal the forward
rate f

(1 − β)2 α2 2 − 3ρ2 2
   
α 1 ρβαν
(4) σATM ≡ σB (f, f ) = 1+ + + ν T + ··· .
f (1−β) 24 f (2−2β) 4 f (1−β) 24

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The skewness parameter β can be determined by performing linear regression on the log-log plot of
historical par swap rates versus ATM vols [4] given by Equation (4).

Alternatively, β can be chosen by the practitioner by appealing to their market intuition. This may seem
like an ad-hoc method to choose β , however by investigating Equation (4), specifically the behavior of
the ATM vol as a function of β

α
(5) σATM ≈ .
f (1−β)

This approximate equation describes the so-called “backbone”, defined as the curve followed by the
ATM vol as a function of the par swap rate. As the par swap rate changes, this curve represents how
these changes affect the ATM vol. Notice that in the stochastic lognormal model, where β = 1 the
backbone is flat. Financially this corresponds to a constant level of overall forward swap rates as the
par swap rate changes. Some practitioners use this model since it represents a common model used
throughout finance and they believe that the flat backbone “best represents their market” [4].
Nevertheless, the parameter β is usually chosen exogenously, and not via calibration.

Calibration of SABR parameters to swaption data proceed differently than the two other instrument
classes (options and caplets/floorlets) in that when calibrating to swaptions, the parameter α is not
determined by calibration, instead it is determined by the Equation (4). Given σATM , β , ρ and ν ,
Equation (4) can be inverted to give a cubic equation whose roots yield the value of α, meaning that
the parameter α is chosen so that the ATM vols seen in the market are reproduced exactly. This is not
done for caplets because caplets ATM data is not a widely quoted number – it may or may not exist in
the marketplace. Swaption market data, on the other hand, is typically only quoted as ATM vols, so
this must be taken into account during calibration.

FINCAD Analytics Suite 2009 provides functions to calibrate the SABR model to caplets/floorlets or
swaptions data:

aaCalibrateCaplets_SABR calibrates the SABR model to caplet/floorlets.

aaCalibrateSwaptions_SABR calibrates the SABR model to swaptions.

Volatility Cube

As mentioned before, vol cube is a representation of swaption market data characterized by three
parameters: option maturity, swap tenor and exercise rate (or strike). Market data can be used to
directly populate two of the “faces” of the vol cube as follows.

First, the at-the-money (ATM) swaption vols can populate the ATM slice (defined by the condition that
the exercise rate is the par swap rate).

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Second, rate caps and floors can be used to populate the slice containing the smallest swap tenor. To
achieve this, the caps (floors) must first be stripped to produce the Black volatility of the constituent
caplets (floorlets) (this step can be achieved by using the FINCAD function aaVol_Crv2_Rcap_BL).
The resulting series of caplets/floorlets can be thought of as one-period swaptions with a swap tenor
equal to the frequency of the cap/floor.

With one more piece of information, we can construct the entire vol cube. In order to be able to use the

function aaCalibrateSwaptions_SABR, we need more than just the ATM swaption market quotes.

According to [1] there are two methods to determine non-ATM swaption vols. The method advocated

by FINCAD 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, suppose the par swap rate is 6%, and we see

the following market caplet vols.

Strike Black Vol

2% 25.1%

4% 16.7%

6% 14.4%

8% 16.1%

10% 15.0%

The skew can be characterized by two numbers δ2% ≡ σ2% − σATM = 10.7% and
δ10% ≡ σ10% − σATM = 0.6%. To produce the swaption data, simply apply these skewness shifts to
the swaption data. A non-ATM swaption vol is approximated as σi = σATM + δi . In the above scenario,
with a 10Yx10Y swaption with an ATM vol of 11%, the two data points to use in the calibration are
σ2% = 11% + δ2% = 21.7% and σ10% = 11% + δ10% = 11.6%. According to [1] this procedure is “not
just ‘parallel shifting’ the caplet smile to longer swap tenors, but we are, on the contrary, calculating the
implied cap smile in the surface instead”. The FINCAD function aaCalibrateSwaptions_SABR will fix
α by requiring the calibration to reproduce the ATM volatility exactly, and the other parameters by the
usual minimization procedure. This method can therefore be used to interpolate in all the dimensions
of the vol cube.

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Figure 1: Screen shot of the inputs to aaCaplet_SABR for the calculations

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Example: Pricing a Caplet

In this example, we calculate the fair value and all risk statistics for a caplet using the SABR model.

We use the FINCAD function aaCaplet_SABR for our calculations. Figure 1 shows the inputs for this
function.

Given the inputs in Figure 1, we find the fair value of the caplet is 0.361, which was calculated with the
function aaCaplet_SABR. The other risk statistics are shown in Figure 2.

Figure 2: Screen shot of the outputs from aaCaplet_SABR

Summary

FINCAD Analytics Suite 2009 provides functions to compute prices and all risk statistics for
caplets/floorlets and swaptions using the SABR model. It also provides a function to calibrate the
SABR model to market caplets/floorlets or swaptions data, which enable users to construct the
volatility cube.

References

[1] Banking, SEB Merchant (2008), SEB’s VolCube, Research Paper.

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[2] Cox, J. (1975), Notes on Option Pricing 1: Constant Elasticity of Variance Diffusions, Working
Paper, Stanford University.

[3] Dupire, B. (1994), Pricing with a Smile, Risk, 7(1): pp. 18–20.

[4] Hagan, Patrick S., Kumar, D., Lesniewski, A. S., and Woodward, D. E. (September 2002),
Managing smile risk, Wilmott, pp. 84–108.

[5] Option Pricing with the SABR Model of Stochastic Volatility (2008), Math Reference Document,
FINCAD, ../SABROptionPricing/SABROptionPricing.htm.

Disclaimer

Your use of the information in this article is at your own risk. The information in this article is provided on an “as
is” basis and without any representation, obligation, or warranty from FINCAD of any kind, whether express or
implied. We hope that such information will assist you, but it should not be used or relied upon as a substitute for
your own independent research.

This document is for informational purposes only. FinancialCAD Corporation MAKES NO WARRANTIES,
EXPRESSED OR IMPLIED, IN THIS SUMMARY.

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