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Pricing and Hedging the Smile with SABR : Evidence from the Interest Rate Caps Market
Author(s) -
Wu Tao L.
Publication year - 2012
Publication title -
journal of futures markets
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.88
H-Index - 55
eISSN - 1096-9934
pISSN - 0270-7314
DOI - 10.1002/fut.21552
Subject(s) - sabr volatility model , econometrics , hedge , economics , stochastic volatility , implied volatility , volatility (finance) , interest rate , volatility smile , financial economics , actuarial science , monetary economics , ecology , biology
This is the first comprehensive study of the SABR (stochastic alpha‐beta‐rho) model (Hagan, Kumar, Lesniewski, & Woodward, 2002) on the pricing and hedging of interest rate caps. I implement several versions of the SABR interest rate model and analyze their respective pricing and hedging performance using two years of daily data with seven different strikes and ten different tenors on each trading day. In‐sample and out‐of‐sample tests show that the fully stochastic version of the SABR model exhibits excellent pricing accuracy and, more importantly, captures the dynamics of the volatility smile over time very well. This is further demonstrated through examining delta‐hedging performance based on the SABR model. My hedging result indicates that the SABR model produces accurate hedge ratios that outperform those implied by the B lack model. © 2012 Wiley Periodicals, Inc. Jrl Fut Mark 32:773‐791, 2012