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

Journal Of Investment Management (JOIM), Third Quarter 2011

Posted: 24 Aug 2011

See all articles by Sanjay K. Nawalkha

Sanjay K. Nawalkha

University of Massachusetts Amherst - Isenberg School of Management

Riccardo Rebonato

Royal Bank of Scotland

Multiple version iconThere are 2 versions of this paper

Date Written: August, 24 2011

Abstract

Does the selection of a specific interest rate model to use for pricing, hedging, and riskreturn 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: LMM-SABR model, interest rate models, affine models, quadratic models, caps, swaptions

JEL Classification: G00

Suggested Citation

Nawalkha, Sanjay K. and Rebonato, Riccardo, What Interest Rate Models to Use? Buy Side Versus Sell Side (August, 24 2011). Journal Of Investment Management (JOIM), Third Quarter 2011, Available at SSRN: https://ssrn.com/abstract=1916189

Sanjay K. Nawalkha (Contact Author)

University of Massachusetts Amherst - Isenberg School of Management ( email )

Amherst, MA 01003-4910
United States
413-687-2561 (Phone)

Riccardo Rebonato

Royal Bank of Scotland ( email )

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