FORWARD-RATE VOLATILITIES AND THE SWAPTION MATRIX: WHY NEITHER TIME-HOMOGENEITY NOR TIME-DEPENDENCE ARE ENOUGH

Riccardo Rebonato ()
Additional contact information
Riccardo Rebonato: Quantitative Research Team, Royal Bank of Scotland, 135 Bishopsgate, London, EC2M 3UR, UK;

International Journal of Theoretical and Applied Finance (IJTAF), 2006, vol. 09, issue 05, 705-746

Abstract: This work presents the first systematic analysis of the whole swaption matrix by fitting a parsimonious, nonlinear, financially-inspired volatility model to market data. The study uses several years of data spanning period of major market volatility. We find that the quality of the fits is good (on average of the same magnitude as the bid-offer spread), and better when a displaced-diffusion approach is chosen, but some systematic shortcomings are observed and discussed. The analysis suggests that a two-regime Markov chain approach may be more successful and better financially motivated.More generally, the present study highlights the shortcomings of purely time-dependent or time-homogenous approaches. These findings should be applicable to other option markets as well.Finally, we find that the present (nonlinear) model vastly outperforms PCA-based approaches when in comes to predicting moves in implied volatilities.

Keywords: Swaption pricing; calibration to swaption matrix; displaced diffusion; LIBOR Market Model (search for similar items in EconPapers)
Date: 2006
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

Downloads: (external link)
http://www.worldscientific.com/doi/abs/10.1142/S0219024906003767
Access to full text is restricted to subscribers

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:wsi:ijtafx:v:09:y:2006:i:05:n:s0219024906003767

Ordering information: This journal article can be ordered from

DOI: 10.1142/S0219024906003767

Access Statistics for this article

International Journal of Theoretical and Applied Finance (IJTAF) is currently edited by L P Hughston

More articles in International Journal of Theoretical and Applied Finance (IJTAF) from World Scientific Publishing Co. Pte. Ltd.
Bibliographic data for series maintained by Tai Tone Lim ().