Arbitrage-Free Construction of the Swaption Cube

13 Pages Posted: 22 Jan 2009  

Simon Johnson

Commerzbank Corporates & Markets

Bereshad Nonas

Commerzbank Corporates & Markets

Date Written: January 5, 2009

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.

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

JEL Classification: C3, C5, C6

Suggested Citation

Johnson, Simon and Nonas, Bereshad, Arbitrage-Free Construction of the Swaption Cube (January 5, 2009). Available at SSRN: https://ssrn.com/abstract=1330869 or http://dx.doi.org/10.2139/ssrn.1330869

Simon Johnson (Contact Author)

Commerzbank Corporates & Markets ( email )

60 Gracechurch Street
London, EC3V 0HR
United Kingdom
+44 20 7469 3348 (Phone)
+44 20 7645 7448 (Fax)

Bereshad Nonas

Commerzbank Corporates & Markets ( email )

60 Gracechurch Street
London, EC3V 0HR
United Kingdom

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