Arbitrage-Free Construction of the Swaption Cube

Abstract:     
In this paper we look at two areas in the interest rate options market where arbitrage could be hiding. In the first section we derive a no-arbitrage condition for swaption prices with complementary expiry dates and tenors within the swaption cube. In the second section we propose an alternative European option approximation for the widely used SABR dynamics that reduces the possibility of arbitrage for long maturities and low strikes.

Number of Pages in PDF File: 13

Keywords: Option Pricing, Volatility Smile, Swaption, SABR model, Arbitrage

JEL Classification: C3, C5, C6

working papers series