No-Arbitrage Dynamics for a Tractable SABR Term Structure Libor Model

Abstract:     
The SABR closed-form formula (Hagan et. al 2002) is the standard for smile-consistent pricing in the swaption market. Here we address the issue of turning SABR assumptions into a consistent and arbitrage-free term structure model in the BGM/Libor Market Model framework. We compute the joint dynamics followed by Libor rates and stochastic volatility of SABR kind under the general pricing measures used for interest rate derivatives, and we observe that the volatility dynamics is non-standard. Based on the analysis of the equation found, we develop and justify theoretically a few approximations aimed at making these no-arbitrage dynamics compatible with the use of the SABR closed-form formula. Then the formulas developed above are confronted both with alternative numerical implementations and with market data. We verify that the formulas for no-arbitrage corrections are acceptably precise, maintain good fitting, and produce regular Libor parameters. Finally we verify that the no-arbitrage corrections to the volatility dynamics make the out-of-calibration-sample prices implied by the model closer to market quotations, compared to prices implied by a trivial multivariate SABR neglecting such corrections.

Keywords: stochastic volatility, SABR, no-arbitrage,libor market model, BGM

JEL Classifications: G13, C63

Working Paper Series