Volatility transformation in a multi-curve setting applied to caps and swaptions

Master Thesis


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University of Cape Town

The effects of the 2007-08 financial crisis have resulted in a sharp change in the way interest rate markets are viewed as well as modelled. As a result of the crisis, the general market framework has transitioned from a single curve framework to what is commonly known as the 'multiple-curve' framework. In addition to this, there is debate as to which curve to use for discounting. This dissertation will initially aim to give a succinct, yet thorough overview of the changes affecting interest rate modelling as a result of the financial crisis. In particular pricing methods that are consistent with the multi-curve framework are presented. Adaptations of the popular Libor Market Model (LMM) and Stochastic Alpha-Beta-Rho (SABR) consistent with the new market framework are also presented. The second aim of the dissertation is to outline and implement methods of transforming volatilities within this new market framework. The market quotes available for caps/floors and swaptions often assume a particular payment tenor, for example swaption volatilities are typically quoted assuming payment legs of six months. As such, if one wanted to price an identical swaption based on payment legs of three months, or even monthly payments, some form of transformation is needed. The methods presented and implemented are largely based on the work of Kienitz (2013). The methods described are implemented to transform six month cap and swaption volatility surfaces to three month surfaces.

Includes bibliographical references