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CROSS-CURRENCY EXOTICS
Smiling
calibration, exacerbated by the presence of stochastic interest rates.
In this article, we build a cross-currency model that incorporates
forex volatility smiles. We keep one-factor assumptions for the inter-
est rates, but use the local volatility (constant elasticity of variance
(CEV)-type) process for the forex dynamics. This avoids introduc-
ing any more stochastic factors, keeping the speed and accuracy of
valuation the same as in the ‘standard’, lognormal model. Most of
hybrids
the focus is on the problem of calibrating forex options for various
maturities and strikes simultaneously. The main aim of this article is
a calibration procedure that can be performed essentially instantane-
ously. The procedure is obtained by combining our recently devel-
oped techniques of skew averaging (see Piterbarg, 2005c and 2005d)
with derived Markovian representation of the dynamics of the for-
ward forex rate that is exact for European-style options.
In addition, the effect of forex volatility skew on PRDC swaps
(cancellable and knock-out varieties) is studied, and is found to be
significant. In particular, by analysing the shapes of the payouts of
Vladimir Piterbarg develops a multi-currency the securities, it is determined that the slope of the forex volatility
smile is a major factor affecting the values, thus endorsing our focus
model with foreign exchange skew suitable on introducing skews into PRDC swap modelling.
for valuation and risk management of forex-
Limitations and alternatives
linked hybrids, in particular power-reverse The subject of PRDC swap modelling, despite its importance in prac-
dual-currency (PRDC) swaps. The emphasis tice, has received scant attention in the literature. Particularly disap-
pointing is the lack of published research on long-dated forex smile
of the article is on model calibration to forex modelling (the subject of this article) except for some interesting results
presented at conferences (see Balland, 2005). The model we develop is
options across different maturities and strikes not intended as the final answer to all forex smile-related problems. Sin-
gle-factor interest rate assumptions, while sufficient for PRDC swaps,
make the model unsuitable for some of the more complicated hybrids,
such as constant maturity swap-spread linked ones. For such deriva-
risk.net 67
30y
19.32
20.56
63
72
σF =
T
T
∫0 Λ ( ( ))
(11)
Note: as calibrated to market-implied Black volatilities of forex options from table A by matching the where cBlack(F, K, σ, T) is the Black formula value for a call option with
value and the slope of the forex volatility smile for each expiry forward F, strike K, volatility σ and time to maturity T.
dF (t , T ) This result fully resolves the problem of approximately pricing
= Λ (t , F (t , T )) dWF (t ) (7) options on the forex rate in the cross-currency model (2). For a given
F (t , T ) expiry T and strike K, the pricing formula (10) is used with the ‘effec-
This result is very intuitive – the Markovian dynamics is defined by tive’ volatility of the forward forex rate σF defined by (11), and the
the diffusion coefficient that is the expected value of the original diffu- ‘effective’ skew of the forward forex rate δF given by (9).
sion coefficient conditioned on the underlying. We emphasise that the ■ The algorithm. The first step of forex volatility calibration is to
result is exact for all derivatives with European-style payouts. fit the displaced-diffusion model (10) to forex options across strikes
To use it in practice, however, the conditional expectations have to separately for each maturity Tn, 0 = T0 < T1 < ... < TN. Then, from the
be calculated or, at least, approximated. The necessary calculations obtained set of market volatilities σ*n and market skew parameters δ*n,
are performed in Piterbarg (2005b), where it is shown that to a good n = 1, ... , N, the model parameters, the time-dependent functions
approximation, the following SDE can be used instead: ν(t) and β(t) for t ∈ [0, TN] can be obtained by solving the equations
( ) = Λˆ t , F t ,T dW t
dF t , T (11), (9) (assuming, for example, that ν(t) and β(t) are piecewise con-
F (t ,T )
( ( )) F ( ) (8) stant). The calculations can be organised into N sequential problems,
each one involving only a two-dimensional root search, with ν(Tn) and
where: β(Tn) found on step n and reused on consecutive steps. In practice, the
calibration is fast and robust. Fitting the model to, for example, forex
( ) ( ( ) ( ) ( ) ( ))
1/ 2
ˆ t , x = a t + b t γˆ t , x + γˆ 2 t , x
Λ options for seven strikes and 10 maturities (as in the example in the
β( t )−1
section below) takes about 0.1 seconds on a modern computer.
D0 ( t , T )
1 + (β ( t ) − 1) r ( t )
x From (9), it follows that δF is a linear function of β(·); thus, the
γˆ ( t , x ) = ν ( t ) x − 1
L ( t ) F ( 0, T ) equations for β(·) can always be solved. The fit of volatilities, how-
ever, may fail if the market volatilities do not increase fast enough,
and r(t) is some deterministic function (see Piterbarg, 2005b). It is just like for the ‘standard’ lognormal model. Intuitively, the market
worth noting that had we used the simplistic approximation (6), the volatility is a sum of volatilities of interest rate and forex components
corresponding formula would simply be: of the forward forex rate. If the market volatility is too small com-
pared with the interest rate volatility components (a situation possi-
( ) ( )
β t −1
D t,T ble especially for longer-dated maturities), then the forex spot volatil-
( ) ()
γˆ t , x = ν t x 0 ity cannot be found. Such problems are usually solved by adjusting
L t ( ) one’s correlation assumptions.
1y 3y 8.42 –115
The volatility parameters for the interest rate evolution in both curren- 3y 5y 8.99 –65
cies are given by:
5y 7y 10.18 –50
σ d (t ) ≡ 0.70%, χ d (t ) ≡ 0.0%, σ f (t ) ≡ 1.20%, χ f (t ) ≡ 5.0% 7y 10y 13.30 –24
For each expiry and strike, an implied Black volatility of the cor- 1y –0.06 –0.06 –0.07 –0.06 –0.03 0.03 0.14
responding forex option is given in table A. This set of parameters is 3y 0.14 0.07 0.00 –0.02 0.01 0.11 0.28
regarded as ‘the market’. 5y 0.17 0.11 0.04 0.00 0.03 0.12 0.30
For each expiry Tn, n = 1, ... , N, we fit a displaced-diffusion model 7y 0.21 0.16 0.07 0.02 0.03 0.12 0.29
with a constant volatility σ*n and a constant skew parameter δ*n, n = 1,
... , 10 (see section above for notations). The skews are fitted to match
10y 0.19 0.19 0.11 0.04 0.03 0.08 0.20
The cross-currency model is calibrated to these parameters, as out- 30y –0.82 –0.42 –0.18 –0.06 0.02 –0.05 –0.06
lined in the section above. The resulting parameters ((νn, βn), n = 1, ... , Note: calculated using the PDE method and the approximation method from ‘Skew averaging’
N) are summarised in table C. section
risk.net 69
1 Market and model values of forex options, in implied Black volatilities, versus strikes, for a number of expiries
12 16
14
10
12
8
10
6 8
%
%
6
4
4
2 Black volatility, market, expiry = 6m Black volatility, market, expiry = 7y
2
Black volatility, model, expiry = 6m Black volatility, model, expiry = 7y
0 0
80 90 100 110 120 40 60 80 100 120 140
25 30
25
20
20
15
% 15
%
10
10
5
Black volatility, market, expiry = 15y 5 Black volatility, market, expiry = 25y
Black volatility, model, expiry = 15y Black volatility, model, expiry = 25y
0 0
20 40 60 80 100 120 140 0 20 40 60 80 100 120
plicated and do require a model. One type, a cancellable PRDC ■ They start in one year (T1 = 1) and have a total maturity of 30 years
swap, gives the issuer (the payer of the PRDC swap coupons) the (TN = 30).
right to cancel the swap on any of the dates T1, ... , T N – 1 (or a subset ■ All pay an annual PRDC swap coupon (τn = 1, n = 1, ... , N – 1) and
thereof). The other popular type is a knock-out PRDC swap, stipu- receive the domestic (yen) Libor rate.
lating that the swap knocks out (disappears) if the spot forex rate on ■ The floor is zero and there is no cap, bl = 0, bu = +∞.
any of the dates T1, ... , T N – 1 exceeds a pre-agreed level. Both features ■ All have a time-dependent schedule of s = sn. In particular:
are designed to limit the downside for the issuer, and also allow the
investor to monetise the options to cancel/knock-out in the form of sn = F (0, Tn ) , n = 1,…, N − 1
receiving high fixed coupons over the initial (no-call) period [0, T1]. This choice simplifies the structure of coupons, clarifying certain
Assuming bu = +∞, bl = 0 (the most commonly used settings), the conclusions.
PRDC swap coupon can be represented as a call option on the forex ■ Cancellable variants give a Bermuda-style option to cancel the swap on
rate: each of the dates T1, ... , TN – 1 to the payer of the PRDC swap coupons.
sg d gf ■ Knock-out variants are up-and-out forex-linked barriers. In particu-
( )
Cn ( S ) = h max S (Tn ) − k , 0 , k =
gf
, h=
s
lar, the swap disappears on the first date among T1, ... , TN – 1 on which
the forex rate S(Tn) exceeds a given barrier. Note that the barriers are
The option notional h determines the overall level of coupon payment, different for the three cases.
and the strike k determines the likelihood of the coupon paying a non- The domestic and foreign coupons are chosen to provide different
zero amount. The relationship of the strike to the forward forex rate amounts of leverage, while keeping the total value of the underly-
to Tn determines the leverage of the PRDC swap. If the strike k is low, ing swap roughly the same for all three cases. Table E provides the
then the coupon has a relatively high chance of paying a non-zero remaining details of the securities.
amount. The option notional in this case is, typically, low. This is a The values of securities are in percentage points of the notional.
low-leverage situation. If the strike is high relative to the forward forex Valuation results for two models are presented. One is the standard
rate, the probability that the coupon will pay a non-zero amount is lognormal three-factor model calibrated to the at-the-money forex
low. The notional h, in this case, is typically higher. This is a high- options of expiries from table A. The other model is the skew-cali-
leverage situation. brated one as described above. The values (to the payer of PRDC
In the analysis below, PRDC swaps of different leverage are used to swap coupons) of underlying PRDC swaps, cancellable PRDC swaps
demonstrate the smile impact. We consider cancellable and knock-out and knock-out PRDC swaps are reported.
versions of three PRDC swaps, a low-leverage, a medium-leverage and The value of cancellable and knock-out swaps increases with lever-
a high-leverage one. The three swaps share many features, namely: age. This is of course not surprising, as higher volatility in the value of
Trade details
40
Foreign coupon 4.50% 6.25% 9.00%
Cancellable value
30
Barrier 110.00 120.00 130.00
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risk.net 71