What Interest Rate Models to Use? Buy Side Versus Sell Side

Abstract

Does the selection of a specific interest rate model to use for pricing, hedging, and risk-return analysis depend upon whether the user is a buy-side institution or a sell-side dealer bank? Sanjay Nawalkha and Riccardo Rebonato debate this question in this paper and provide some insightful conclusions. Responding to Nawalkha’s [2010] critique of the LMM-SABR model, Rebonato argues that the LMM-SABR model is currently the best available model for the sell-side dealer banks for pricing and hedging large portfolios of complex interest rate derivatives within tight time constraints. Nawalkha in his rejoinder argues that the LMM-SABR model is useless at best and dangerous at worst for the buy-side institutions, and these institutions must use time-homogeneous fundamental and single-plus interest rate models (e.g., such as affine and quadratic term structure models) for risk-return analysis under the physical measure, as this cannot be done using the time-inhomogeneous double-plus and triple-plus versions of the LMM-SABR model.

Keywords: Interest rate models, affine, quadratic, LMM, SABR, caps, swaptions

JEL Classification: G10, G11, G12, G13