Cutting edge: Interest rate derivatives

SABR symmetry

ricing options using partial dierential equations (PDEs) suers from the so-called curse of dimensionality: as the number of variables involved increases, the complexity and the computational costs do so exponentially. So, if a multi-factor model is to be used, one that has analytic pricing formulas available is always preferred. This is one of the reasons why the stochastic alpha beta rho (SABR) model (Hagan et al, 2002, Hagan, Lesniewski & Woodward, 2005, Antonov & Spector, 2012) is popular among practitioners in modelling interest rate options. It has two factors, one for the forward rate and the other for its volatility, and has rich enough dynamics to produce realistic volatility skew and smiles. At the same time, there exist analytic approximate formulas (Hagan et al, 2002, Hagan, Lesniewski & Woodward, 2005, Berestycki, Busca & Florent, 2004, Henry-Labordre, 2009, Oblj, 2008, Paulot, 2009) that price options almost instantaneously. These formulas are generally obtained by small-time asymptotic expansion approximations and, even though they are known to be good for short-dated options, they produce inaccurate and inconsistent prices for long-dated options. To get accurate and consistent option prices, one may try to solve the Kolmogorov backward equation for the model. However, this PDE is threedimensional one for time and the other two for the risk factors of the model and the computational costs of solving it directly would be too high for commercial applications. In this article, we will show how to use the scaling symmetry of the model to eectively reduce the dimensionality of the problem by one. Specically, if the forward rate is multiplied by a xed positive number, and the volatility by a certain power of that number, the equation is unchanged invariant, in mathematical jargon. This implies solutions for certain payouts have convenient functional relationships. These particular cases can then be used to derive a simpler, two-dimensional PDE, and so achieve a reduction in computation costs. A generic payout can be decomposed into a sum of variations of these particular ones via Fourier series, and the scaling symmetry results in a functional relationship between solutions for dierent payouts. This can be used to price swaptions across all strikes by valuing just one. In the following section, we introduce the SABR model and briey look at its properties; the next introduces the symmetry and shows its implications, rst for a particular class of amenable payouts, then for generic payouts, and nally for vanilla swaptions. The next section presents numerical examples of using the reduced-form PDEs. We focus on a test case where the model is calibrated to the dollar swaption market on the day of the Lehman bankruptcy. Our method and Monte Carlo simulation generate virtually identical swaption prices while the analytic asymptotic formula in Oblj (2008) produces relative errors as high as 400%.

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SABR model

The SABR model is one of the most commonly used models to price European swaptions. It is a two-factor model with stochastic volatility and is described by a pair of coupled stochastic dierential equations (SDEs):

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d t = t dW2,t dFt = t FtdW1,t

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Typical implementations of the stochastic alpha beta rho model involve asymptotic expansion approximations, which can generate inaccurate prices for long-dated options. But directly solving a pricing partial differential equation incurs high computational costs. Hyukjae Park shows how the models symmetry can be harnessed to reduce the complexity of the calculation and improve accuracy over expansions

(1)

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where Ft is the forward swap rate, at is the stochastic volatility, W1,t and W2,t are Brownian motions with correlation r, 0 b 1 is the skew parameter, and n 0 is the lognormal volatility of the stochastic volatility at. The dynamics are under the forward swap annuity measure, where Ft is a martingale. We will only work in this measure, and all payouts and valuations are expressed in the unit of the measures numeraire, namely, the forward swap annuity. When b < 1, Ft can reach zero with non-zero probability. Once it hits zero, Ft must stay there to maintain its martingale property, which is known as the absorbing boundary condition at {Ft = 0}. at is the lognormal process and can be easily solved: 1 t = 0 exp W2,t 2t (2) 2 Valuation of an European option whose payout at maturity is a function of Ft and at is a Markovian problem. The price of the option can be obtained by solving the Kolmogorov backward equation, which we call the SABR PDE. This PDE is three-dimensional: one dimension for time and two dimensions for Markovian state variables: Ft and at. Unfortunately, no closed-form solutions to this equation are known except for some special cases. Instead, asymptotic expansions in n2t can be calculated analytically and are commonly used to price European swaptions, but their convergence is not guaranteed. One can easily see that, with any non-zero value of n2t, the probability of Ft hitting zero is non-zero, which cannot be obtained from the series expansion in n2t around zero. When r = 0, there are semi-analytic solutions to the PDE (Islah, 2009, Antonov & Spector, 2012). Conditioned on a path of at, Ft becomes a timechanged constant elasticity of variance (CEV) process. Closed-form solutions to the CEV PDE are known since a simple change of variable would transform this PDE into the Cox-Ingersoll-Ross PDE (Antonov & Spector, 2012). The solutions will depend on the path of at only through the elapsed time, T a2dt. The distribution of this integral is also known semi-analytically 0 t (Antonov & Spector, 2012, Yor, 1992, Linetsky, 2004, Dufresne, 1989, 1990, Carmona, Petit & Yor, 1997, Donati-Martin, Ghomrasni & Yor, 2001). Therefore, the unconditional solutions to the SABR PDE will be given as integrals of the CEV solutions over this distribution.

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Symmetry argument
We introduce the scaling symmetry of the SABR model and examine its consequences in pricing European options. Special attention will be paid to swaption pricing. Scaling symmetry. SABR SDEs are invariant under the following scaling transformation: Ft Ft

2 2 2 ZZ = (1 ) 2 (1 ) z + z

2 ZX = 2 XX

t 1 t

(3)

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With these variables, it is easier to analyse the scaling properties of the solutions. Under the scaling, Zt is invariant while Xt Xt + h, where h = log l. When b < 1, the change of variables from (Ft, at) to (Zt, Xt) becomes singular at locus {Ft = 0}. This means that not all the solutions of the SABR PDE can be expressed as a function of Zt and Xt. For our applications, we will only consider payout functions that are independent of aT when FT = 0. This, together with the absorbing boundary condition at {Ft = 0}, guarantees that the solutions are also independent of at when Ft = 0. In such cases, the variables Zt and Xt can be used to express the solutions. Special payout. The scaling symmetry can be utilised to reduce the complexity of solving the SABR PDE. To understand this, lets consider a European option whose payout at maturity T is f(ZT)exp(kXT) for some function f and a real number k. Fm an is an example of such payouts. Though not T T really traded, they are a convenient ction, as they transform multiplicatively under the scaling. Later, variations of these functions will be used as a basis of decomposing more generic payouts. The value of this option at time t is the expected value of the payout conditioned on Ft, the ltration generated by all information available by time t:

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with:
k

for any l > 0. Instead of Ft and at, it is convenient to use the following variables: F1 Zt = t t (4) Xt = log Ft

A similar PDE for payout Fm has been derived in Islah (2011). Instead T of the symmetry argument used here, Islah noted that the SDE for Zt is uncoupled from Xt and used the measure change to derive the PDE. The above PDE has a singularity at z = 0, due to the singularity of the change of variables. For a solution to exist, f(z) should go to zero fast enough as z 0. The PDE in equation (8) is two-dimensional since p(Zt, t) does not depend on Xt. p(Zt, t) can be obtained by solving it with terminal condition p(ZT, T) = f(ZT). So, using the symmetry, we have reduced the complexity of the problem by one dimension. Generic payout. The payouts we have considered so far are rather limited. For more generic payouts, the benet of the symmetry is much more subtle. Consider a generic payout function f(ZT, XT). To value this option, we discretise the variable Xt and impose the periodic boundary condition on the payout function in the Xt direction. Now, we can decompose the payout function into a Fourier series:

f ( ZT , XT ) = ak ( ZT ) exp (ikXT )

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(1 ) Z = 2 z (1 ) 2z 1 2 X = XX 2

1 z 1 = 2 z

(9)

(10)

ak ( ZT ) =

1 f ( ZT , x ) exp ( ikx ) NX x

(11)

Pf ( Zt , Xt , t , T ) = E f ( ZT ) exp ( kXT ) Ft

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Since the problem is Markovian, the solution depends on Ft only through Zt and Xt. Using the symmetry, we see easily that:

Pf ( Zt , Xt , t , T ) = exp ( k ) Pf ( Zt , Xt , t , T )

(6)

for any real value h. In particular, one can choose h = Xt and conclude:

where x takes a value from the discretised grid for Xt, k is from the dual grid and NX is the number of points in the grid. The dual grid is dened as {kkx = 2pn for some integer n x in the grid}. The Fourier series used here needs to be seen as an approximation of the original payout function. It agrees with the payout on the grid points and is a good approximation between them though this may fail outside the grid. When b < 1, the locus {FT = 0} is of special concern. FT = 0 implies XT = , which is outside the grid, and it can be reached with non-zero probability. To make sure that the Fourier series is still a good approximation for this case, we slightly change the denition of ak(ZT) when ZT = 0:
if k 0 0 ak ( 0 ) = f ( 0, ) if k = 0

Pf ( Zt , Xt , t , T ) = exp ( kXt ) Pf ( Zt , 0, t , T ) = exp ( kXt ) p ( Zt , t )

(7)

(12)

for some function p. Note that Pf(Zt, Xt, t, T) is a solution to the backward Kolmogorov equation for the SABR model, which is three-dimensional. By applying the SABR PDE to the right-hand side of equation (7), we obtain another PDE that p(Zt, t) satises:
1 2 2 1 2 2 2 t + 2 ZZ z 2 + Z + ZX k z + 2 XX k + X k p ( z, t ) = 0 (8)

Changing ak(0) can be understood as modifying the payout function around ZT = 0. For example, the following change in f(ZT, XT) with very small e > 0 would produce the desired change in ak(0):

f ( ZT , XT ) 1{Z

T >

Z Z , X + log T } f ( ZT , XT ) + 1{ZT } f T T

(13)

where:

The modied payout function will dier from the original when ZT is very small and XT is nite. Since it implies aT is very large and FT is non-zero, the
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Cutting edge: Interest rate derivatives

Pf ( Zt , Xt , t , T ) = E f ( ZT , XT ) Ft

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(
Ft + t

= E ak ( ZT ) exp (ikXT ) Ft

(14)

C ( Ft , t , K , t , T ) =

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probability of this happening is very small and it will not introduce much error in pricing. As discussed above, we only consider payouts that are independent of aT when FT = 0. For such payouts, a0(0) = f(0, ) is the value of the payout function at FT = 0 since FT = 0 also implies ZT = 0. With the modied denition of ak(0), the Fourier series matches the payout function value when FT = 0. When XT is large and outside the grid, the Fourier series may not be a good approximation. For this, we need to make sure the grid is large enough so that the probability of reaching such XT is very small. The value of the option at time t, Pf(Zt, Xt, t, T), is given by the expected value of the payout. Interchanging the summation and the expectation, we obtain:

whole class of options whose payout functions are related to the original payout function by convolution. Swaption valuation. The argument above can be applied to swaption valuation and we can price swaptions with all strikes at once by solving the PDEs for one strike. To show this explicitly, we consider the payer swaption with strike K:

Using the symmetry, one can show:

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(

+ C ( Ft , t , K , t , T ) = E ( FT K ) Ft

(20)

C ( Ft , t , K , t , T ) = C 1Ft , (1 ) t , 1K , t , T

(21)

for any l > 0. We choose l = K/K0 for some xed K0 and obtain:
1 K K 0 K0 C Ft , t , K0 , t, T K K0 K

Pf ( Zt , Xt , t , T ) = exp (ikXt ) pk ( Zt , t )
k

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These PDEs are obtained by replacing k in equation (8) with ik. pk(Zt, t)s can be obtained by solving the PDEs with terminal condition pk(ZT, t) = ak(ZT). With the symmetry argument, we have reduced the complexity of the problem from solving a three-dimensional PDE to solving the NX uncoupled two-dimensional PDEs. Since they are uncoupled, they can be solved in parallel, independent from each other. We can go further with the symmetry argument. Once the pk(Zt, t) are calculated, we can use them to price other options. Consider an option whose payout function is a convolution of f(ZT, XT) with another function g(XT). For this payout:

( f g )( ZT , XT ) = f ( ZT , XT y ) g ( y )
= N X ak ( ZT ) bk exp ( ikXT )
k y

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1 2 2 1 2 2 2 t + 2 ZZ z 2 + Z + i ZX k z 2 XX k + i X k pk ( z, t ) = 0 (16)

with:

bk =

1 g ( x ) exp ( ikx ) NX x

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where pk(Zt, t) represent solutions of two-dimensional PDEs that are all uncoupled from each other:

where x and y are taken from the grid and k is from the dual grid. Interchanging expectation and summation, one can show the option value is:

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Now, the same symmetry argument used above applies and we can use this to separate the Xt dependency:

1 K K K C0 0 Ft , 0 t , t , T = K K0 K

(22)

(15)

where C0(Ft, at, t, T) = E[(FT K0)+Ft] is the value of the payer swaption with strike K0. Therefore, once we calculate the value of this swaption, for example, following the steps highlighted above, the swaption values for all strikes can be obtained. To the best of our knowledge, this is the rst time the scaling property of the SABR swaption prices has been published.

Numerical tests

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We numerically tested the swaption valuation method developed in the previous section. We will call this method the PDE and symmetry method. We rst solve the PDEs for the at-the-money swaption. Then apply equation (22) to obtain swaption prices for dierent strikes. To solve the PDEs, we discretise time and stochastic variables. We denote by NT, NZ and NX the numbers of points used to discretise time, Zt and Xt. The decomposition of the payout in equation (11) and the recombination in equation (15) are done using the fast Fourier transform algorithm. There are NZ independent transformations, which can be solved in parallel. Each fast Fourier transform takes O(NX log NX) operations. Usually, this is negligible compared with solving the NX PDEs, each of which takes O(NTNZ) operations. These PDEs can be solved in parallel independent from each other. The method takes O(NTNZNX) steps to price across all NK strikes compared with O(NKNT NZNX) for an explicit scheme 3 3 and O(NK NT N Z N X) for a simple implicit scheme for the backward Kolmogorov equation. Of course, there are more ecient schemes available. Monte Carlo simulation. To test our method, we compared our pricing results with the Monte Carlo simulation. We used the Euler scheme to generate Monte Carlo paths and adjusted them for the absorbing boundary condition:
1 t + t = t exp t Z1 2 t 2 Ft+ t = Ft + t Ft t Z1 + 1 2 Z 2

N X bk exp ( ikXt ) pk ( Zt , t )
k

(19)

So with the pk(Zt, t) already calculated, the option value can be obtained without solving any more PDEs. By pricing one option, we can price a

Ft Ft+ t F t +t if Ft+ t > 0 and U > exp 2 2 F 2t t t = otherwise 0

(23)

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Cutting edge: Interest rate derivatives

0.4 0.3 0.2 0.1 0 0 1 2 3

= 0, = 0.0%, = 0.0%, 0 = 1.0%, F0 = 5.0%, T = 5

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Strike 0.50 Monte Carlo 0.01 0.01 1.00 0.03 0.03 1.50 2.00 2.50 3.00 3.50 4.00 4.50 5.00 5.50 6.00 0.06 0.09 0.15 0.23 0.34 0.48 0.66 0.89 0.66 0.48 0.33 0.23 0.15 0.09 0.05 0.03 0.02 0.01 0.06 0.10 0.15 0.23 0.34 0.48 0.66 0.89 0.66 0.48 0.33 0.23 0.15 0.09 0.06 0.03 0.02 0.01

is obtained as follows (Glasserman & Staum, 2001). Between time t and t + Dt, Ft is approximated with a normal process by keeping its drift and volatility constant to values given at time t. Then, we use the measure change to get rid of its drift and use the reection principle of the Brownian motion to calculate the probability of hitting zero. For a small value of b, this adjustment is not insignicant and sometimes changes swaption values by as much as a few basis points. Analytic limit. As a rst test, we looked at a special limit of the SABR model where prices of swaptions are known analytically:

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4 5 6 Strike (%)
PDE and symmetry PDE 0.01 0.03 0.06 0.10 0.15 0.23 0.34 0.48 0.66 0.89 0.66 0.48 0.33 0.23 0.15 0.09 0.06 0.03 0.02 0.01

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7 8 9 10
Asymptotic 0.02 0.03 0.06 0.09 0.15 0.23 0.34 0.48 0.66 0.89 0.66 0.48 0.34 0.23 0.15 0.09 0.06 0.03 0.02 0.01 Analytic 0.01 0.03 0.06 0.09 0.15 0.23 0.34 0.48 0.66 0.89 0.66 0.48 0.34 0.23 0.15 0.09 0.06 0.03 0.02 0.01

where Z1 and Z2 are standard normal random variables and U is a uniform random variable; all are uncorrelated. Note that the above scheme consists of two steps. In the rst step, we follow the standard Euler step to generate values for at and Ft at the next time step t + Dt. In the second step, we adjust Ft+Dt for the absorbing boundary condition at zero. The uniform random variable U is used to compensate for the probability of hitting zero between t and t + Dt even if Ft+Dt > 0. The approximate value of the probability: F F (24) exp 2 2t t2+t t Ft t

1 Swaption prices at the analytic limit

0.9 0.8 0.7 0.6 Price (%) 0.5 Asymptotic Correct price

Note: the time values of swaptions expressed in the unit of forward swap annuity using different valuation methods, as a function of K, using the model parameters in equation (25). There is widespread agreement except at low strikes where the asymptotic method loses accuracy

A.Swaption prices at the analytic limit (%)

C ( Ft , t , K , t , T ) = t T t n ( d+ ) n ( d )

where:

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The time values of swaptions in the unit of forward swap annuity:

d+ =

Ft K Ft K and d = t T t t T t

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) (26) + Ft ( N ( d + ) + N ( d )) K ( N ( d + ) N ( d ))

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(27)

Here, the parameter values are shown in their natural units. at is constant since n = 0.0%. This, together with b = 0, implies Ft is a normal process with the absorbing boundary condition at zero. The analytic swaption price is obtained by applying the reection principle of the Brownian motions:

+ + E ( FT K ) Ft ( Ft K )

6.50 7.00 7.50 8.00 8.50 9.00 9.50 10.00

were calculated using the following methods: Monte Carlo simulation: Monte Carlo method developed above. PDE and symmetry method. PDE: solving the PDEs for each strike separately. Asymptotic: the rst-order asymptotic expansion shown in Oblj (2008). Analytic: analytic solution in equation (26). We included the PDE method to test how well the symmetry is respected in the numerical solutions of the PDEs. In this method, the swaption prices were calculated by solving the PDEs for each strike separately. Note that numerically calculated solutions do not necessarily show the symmetry since the discretisation of the variables breaks it. The results are shown in gure 1 and table A. The asymptotic series shows a small dierence from the other methods at very low strikes. All other methods produced virtually identical prices. Dollar swaption. In Park (2013), we compared the PDE and symmetry method with the Monte Carlo simulation in an actual dollar swaption valuation. We chose the following dates to represent various market conditions: October 9, 2007, when the S&P 500 index reached its highest before the so-called great recession.

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Note: the time values of swaptions expressed in the unit of forward swap annuity using different valuation methods, and the SABR model parameters in equation (25)

September 15, 2008, when Lehman Brothers led for bankruptcy protection. March 9, 2009, when the S&P 500 index reached its lowest during the great recession. October 29, 2013, the recent market. The model was manually calibrated to the dollar swaption market for various expiry-tenor combinations on these dates. Swaptions with one-year expiry and one-year tenor, ve-year expiry and ve-year tenor, 10-year expiry and 10-year tenor, and 20-year expiry and 20-year tenor were considered. Once the calibration was done, swaption prices were calculated using dierent

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B. Dollar swaption lognormal volatilities with 20-year expiry and 20-year tenor: September 15, 2008 (%)
Strike Vol 2.55 22.51 3.55 16.71 4.05 14.88 4.30 14.13 4.55 13.73 4.80 13.43 5.05 13.12 5.55 12.76 6.55 12.36

D. Pricing method comparison for dollar 20-year/20-year swaptions: September 15, 2008 (%)
Strike 0.05 Monte Carlo 0.01 0.09 0.18 0.27 0.37 0.47 0.59 0.73 PDE and symmetry 0.01 0.09 0.18 0.27 PDE 0.01 0.09 0.18 0.27 Asymptotic 0.05 0.51 0.83 1.04 1.18 1.29 1.38 1.46 1.57 1.64 1.72 1.57 1.35 1.20 1.11 1.05 1.01 0.98 0.96 0.94 0.92 0.91 0.90

Strike 2.55 3.55 4.05 4.30 4.55 4.80 5.05 5.55 6.55

Black-Scholes 0.56 0.74 0.89 0.98 1.10 0.98 0.87 0.70 0.45

SABR 0.47 0.73 0.89 0.99 1.10 0.98 0.87 0.69 0.47

2.05 2.55 3.05 3.55 4.05 4.30 4.55

0.89

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0.89 0.99 1.10 0.98 0.77 0.62 0.51 0.43 0.37 0.32 0.29 0.25 0.23 0.21 0.19

0.99

4.80

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0.98 0.77 0.62 0.51 0.43 0.37 0.32 0.28 0.25 0.22 0.20 0.18

1.10

5.30

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6.80 7.30 7.80 8.30 8.80 9.30 9.80 10.30

Note: the time values of swaptions expressed in the unit of forward swap annuity were calculated. For Black-Scholes, the linearly interpolated implied volatilities were used. For SABR, the PDE and symmetry method was used, with the parameters in equation (28)

5.80

6.30

swaptions: September 15, 2008

1.6 1.4 1.2 Price (%) 1.0 0.8 0.6 0.4 0.2 0 0

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2 Pricing method comparison for dollar 20-year/20-year

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PDE, Monte Carlo, PDE and symmetry Asymptotic

Note: the time values of swaptions expressed in the unit of forward swap annuity using various pricing methods, and the SABR model parameters in equation (28). Note the large errors of the asymptotic method

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5 6 7 8 9 10 Strike (%) Note: the time values of swaptions expressed in the unit of forward swap annuity using various pricing methods, and the SABR model parameters in equation (28)

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model parameters that match volatilities at all strikes. The implied volatility (22.51%) at the lowest strike (2.55%) seems to be too high for the SABR model to match. Hence, we calibrated the model to try to better match market prices of swaptions at other strikes. We obtained the following values of parameters:

= 0.0, = 50.0%, = 25.0%, 0 = 0.72%, F0 = 4.55%, T = 20 (28)

As before, the above parameters are in their natural units. Table C shows the quality of the calibration. With the calibration done, we priced swaptions with dierent strikes using various pricing methods. The results are shown in gure 2 and table D. With a long expiry (20 years) and large value (50.0%) of n, the asymptotic formula produced swaption prices quite dierent from the other methods pricing results. All other methods produced virtually identical prices. If we assume the Monte Carlo simulation results are correct, the asymptotic formula generated relative errors as large as 400%. Although not shown here, all other tests done in Park (2013) yielded similar results. Our PDE and symmetry method matched the Monte Carlo simulation results with reasonably small error, under 1bp of the forward swap annuity, while the asymptotic formula showed some dierence from the Monte Carlo simulation. The discrepancy tends to increase as the maturity gets longer. Since swaption prices generated by the Monte Carlo simula-

pricing methods and the results were compared to test the performance of the methods. In this article, we show one of the test results. For more extensive test results, see Park (2013). The test presented here is the valuation of the dollar swaptions with 20-year expiry and 20-year tenor as of September 15, 2008. This test was chosen since the calibration of the model was the most dicult among the tests done in Park (2013) and the value of n was the largest. As noted in Hagan et al (2002), b and r aect swaption prices in similar ways and it is dicult to determine both by tting the market prices. So, we arbitrarily set b to zero and calibrated the rest of the model parameters by tting market prices. Table B shows the dollar swaption lognormal volatilities for various strikes. The observed forward swap rate was 4.55%. For the calibration, the PDE and symmetry method was used. As noted earlier, the calibration results were not very good. We could not nd the

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0.37 0.37 0.47 0.47 0.59 0.59 0.73 0.73 0.89 0.99 1.10 0.98 0.77 0.62 0.51 0.43 0.37 0.32 0.29 0.26 0.23 0.21 0.19

C. Calibration results for dollar 20-year/20-year swaptions: September 15, 2008 (%)

0.55 1.05 1.55

Cutting edge: Interest rate derivatives

REFErENCES
Antonov A and M Spector, 2012 Advanced analytics for the SABR model
Available at http://ssrn.com/abstract=2026350

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tion are arbitrage-free, we conclude that our PDE and symmetry method generates accurate arbitrage-free swaption prices in various market conditions. It does this with signicantly less computational eort than the conventional method of solving the SABR PDE requires. As with any numerical methods, our method will not work for all possible values of the model parameters. Large values of n are of special concern since they can make FT very volatile, creating a dicult environment for any PDE-based method such as ours. To test this, we increased the value of n to 200% from (28). The value of a0 was also changed to 2.37% to match the market price of the at-the-money swaption. Even with this extreme value, our method performed well and matched the results of the Monte Carlo simulation with decent accuracy. The largest dierence was 1.2bp of the forward swaption annuity. However, to achieve this accuracy, we had to use an extremely large number of points for the grid (NZ = 8,000 and NX = 256). Since the number of operations is proportional to NZNX, this makes our method very slow. For this value of the model parameter, it would be better to use the Monte Carlo simulation. All numerical routines have a trade-o between performance and accuracy. We can always speed up the routine at the expense of accuracy. That being said, we believe that the performance of our implementation is good enough for commercial applications. The routine was implemented in Scala (version 2.10.2) and was tested on a six-core hyper-threading enabled Intel Xeon processor E5-1650 running at 3.20GHz. With reasonable accuracy, again with error under 1bp of the forward swap annuity, 10-year swaptions can be priced in as little as 25 milliseconds with NT = 240, NZ = 50 and NX = 256. This should be fast enough to allow realtime calibration and pricing. In comparison, a fully parallel Monte Carlo simulation of 100,000 paths, which generally has the same magnitude of error, takes one to two seconds.

Conclusion
While the industry norm of implementing SABR through small-time asymptotic expansions is popular and intuitive, it is inaccurate for longdated options. But solving the Kolmogorov backward equation places a heavy computational burden on banks, because the curse of dimensionality means exponential growth in computing time as the number of factors increases. By taking advantage of the scaling invariance of the forward rate and stochastic volatility of the SABR model, the complexity of the problem can be eectively reduced by one dimension and computational eciency increased. The symmetry relates the option price of one payout to others whose payouts are a convolution of the original. In simpler terms, one can price all other strike options, given one. The method produces arbitrage-free prices of swaptions for various maturity-tenor combinations, and closely matches the results of Monte Carlo simulation in a variety of scenarios. In particular, it hugely outperforms the Hagan expansion in stress scenarios such as the default of Lehman Brothers, when the high volatility-of-volatility makes it overprice options. While it can produce accurate prices for the high volatility-of-volatility case, it does so when a large number of grid points are used. This tends to slow things down. Monte Carlo simulation may be a better choice in such a case, but for a reasonable range of parameters, the SABR symmetry technique is not only accurate, but is also an order of magnitude faster. R

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Dufresne D, 1989 Weak convergence of random growth processes with applications to insurance
Insurance: Mathematics and Economics 8(3), pages 187201, available at http://dx.doi.org/ 10.1016/0167-6687(89)90056-5

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Hyukjae Park is an executive director of xed income and commodities at Morgan Stanley in New York. The views represented herein are the authors own views and do not necessarily represent the views of Morgan Stanley or its afliates, and are not a product of Morgan Stanley Research. Email: hyukjae.park@morganstanley.com

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