CUTTING EDGE.

CROSS-CURRENCY EXOTICS

Smiling hybrids
Vladimir Piterbarg develops a multi-currency model with foreign exchange skew suitable for valuation and risk management of forexlinked hybrids, in particular power-reverse dual-currency (PRDC) swaps. The emphasis of the article is on model calibration to forex options across dierent maturities and strikes

calibration, exacerbated by the presence of stochastic interest rates. In this article, we build a cross-currency model that incorporates forex volatility smiles. We keep one-factor assumptions for the interest rates, but use the local volatility (constant elasticity of variance (CEV)-type) process for the forex dynamics. This avoids introducing any more stochastic factors, keeping the speed and accuracy of valuation the same as in the standard, lognormal model. Most of the focus is on the problem of calibrating forex options for various maturities and strikes simultaneously. The main aim of this article is a calibration procedure that can be performed essentially instantaneously. The procedure is obtained by combining our recently developed techniques of skew averaging (see Piterbarg, 2005c and 2005d) with derived Markovian representation of the dynamics of the forward forex rate that is exact for European-style options. In addition, the eect of forex volatility skew on PRDC swaps (cancellable and knock-out varieties) is studied, and is found to be signicant. In particular, by analysing the shapes of the payouts of the securities, it is determined that the slope of the forex volatility smile is a major factor aecting the values, thus endorsing our focus on introducing skews into PRDC swap modelling. Limitations and alternatives The subject of PRDC swap modelling, despite its importance in practice, has received scant attention in the literature. Particularly disappointing is the lack of published research on long-dated forex smile modelling (the subject of this article) except for some interesting results presented at conferences (see Balland, 2005). The model we develop is not intended as the nal answer to all forex smile-related problems. Single-factor interest rate assumptions, while sucient for PRDC swaps, make the model unsuitable for some of the more complicated hybrids, such as constant maturity swap-spread linked ones. For such derivatives, a model similar to that of Schlogl (2002), in which Libor market models are used for interest rates, yet with sucient control over forex smiles and a good forex option calibration algorithm (something that Schlogl does not address) will probably need to be developed. In addition, such a model would serve as a good platform to incorporate interest rate volatility smiles by using, for example, skew-enhanced Libor market models as in Andersen & Andreasen (2000). We note that the model we develop does not attempt to exactly match implied forex volatilities for all strikes. In fact, since the CEV specication for local volatility is used, this would be impossible in most markets exhibiting convex smiles. Our focus is on developing a model in which the slope of the volatility skew can be controlled, thus allowing us to assess the skew exposure of PRDC swaps (which, as mentioned above, is very signicant). The CEV specication is a typical choice for introducing volatility skews in many contexts (see, for example, Andersen & Andreasen, 2000, where it is used for Libor market models). Theoretical limitations (having non-zero probability of absorption at zero) rarely present practical problems, as most securities have strikes and other interesting features at levels strictly above zero. In particular, local modications of the power function around zero can easily eliminate the absorption problem, while having little or no impact on pricing and calibration. Moreover, dynamically, the CEV model is one of the soundest local-volatility models, implying self-similar behavior of the underlying (see Hagan et al, 2002). The use of so-called mixture models has been suggested in the literature for introducing volatility smiles. The merits of such models, and in particular their applicability to cancellable, knock-out or other dynamics-linked securities are discussed elsewhere (see, for example, Piterbarg, 2005a).

Power-reverse

dual-currency (PRDC) swaps are by far the most widely traded and liquid cross-currency exotics. Continuing interest in these structures, driven mainly by Japanese investors looking for higher yields, has resulted in large books of PRDC swaps being accumulated by most exotics dealers in the market. Large, concentrated exposures require sophisticated and robust models to risk-manage them properly. PRDC swaps are essentially long-dated (30 years being quite typical) swaps with coupons that are options on the forex rate (most commonly a dollar/yen rate). They are often Bermuda-style callable, or have knock-out provisions. PRDC swaps are exposed to moves in the foreign exchange rate and the interest rates in both currencies. By now, most dealers have standardised on a three-factor modelling framework (see, for example, Sippel & Ohkoshi, 2002), with the forex rate following a lognormal process, and the interest rates in the two currencies driven by one-factor Gaussian models. Keeping the number of factors to the minimum allows us to use partial dierential equation (PDE)based methods for valuation, an essential requirement for large books. The choice of Gaussian assumptions for the interest rates and lognormality for the forex rate has allowed for a very ecient, essentially closed-form, calibration to at-the-money options on the forex rate. Forex options exhibit a signicant volatility skew (induced in longerdated options, ironically, by dealers trying to hedge their PRDC swap positions). Moreover, the structure of PRDC swaps, epitomised in the typical choice of strikes for the coupons, as well as the callability/knockout features, makes them particularly sensitive to the forex volatility skew. Incorporating a skew in a model is by no means trivial. While various mechanisms for including a skew in the model are well known (local volatility, stochastic volatility and/or jumps), their applicability in the context of PRDC swap modelling is hindered by the problem of

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The model An economy with two currencies, domestic and foreign, is considered. Let P be the domestic risk-neutral measure. Let Pi(t, T), i = d, f, be the prices, in their respective currencies, of the domestic and foreign zero-coupon discount bonds. Also let ri(t), i = d, f, be the short rates in the two currencies. Let S(t) be the spot forex rate, expressed in the units of domestic currency per one unit of the foreign currency. For future purposes, the forward forex rate (the break-even rate for a forward forex transaction) is denoted by F(t, T), with the well-known relationship: F (t , T ) = Pf (t , T ) Pd (t , T ) S (t )

(1)

following from no-arbitrage arguments. The following model is considered: dPf (t , T ) / Pf (t , T ) = r f (t ) dt fS f (t , T ) (t , S (t )) dt + f (t , T ) dW f (t ) dS (t ) / S (t ) = rd (t ) r f (t ) dt + (t , S (t )) dWS (t ) where (Wd(t), Wf(t), WS(t)) is a Brownian motion under P with the correlation matrix dWi, dWj = ij, i, j = d, f, S (note the quanto drift adjustment for dPf(t, T) arising from changing the measure from the foreign risk-neutral to the domestic risk-neutral). Gaussian dynamics for the rates are specied:
T (u ) du i (t , T ) = i (t ) e t i ds,
s

dPd (t , T ) / Pd (t , T ) = rd (t ) dt + d (t , T ) dWd (t )

(2)

Calibration Overview. The parameters dening the volatility structures of interest rates in both currencies, that is, the functions d(t), f(t), d(t), f(t), are typically chosen to match European swaption values in the respective currencies. Methods for doing this are well known from (singlecurrency) interest rate modelling literature and are covered elsewhere (see, for example, Brigo & Mercurio, 2001).1 The correlation parameters ij, i, j = d, f, S, are typically chosen either by historical estimation or from occasionally observed prices of quanto interest rate contracts (payouts made in domestic currency but linked to rates in foreign currency). Of particular importance to PRDC swaps is how to calibrate the volatility function of the forex rate (t, x). Options on the forex rate are traded across a wide range of maturities and strikes; this is the information to which (t, x) should be calibrated. For PRDC swaps and most other cross-currency derivatives, it is impossible to pick a particular strike, or a particular maturity, of an forex option relevant for the security in question. Nor can cancellable/knock-out PRDC swaps be decomposed into simple forex options. Hence, the volatility function (t, x) needs to be calibrated to prices of all available forex options across maturities and strikes. Forward forex rate. The value of a call option on the forex rate can be represented as a European-style option on the forward forex rate F (T, T) under the domestic T-forward measure PT. Moreover, F(t, T) is a martingale under this measure. Given the model (2), there exists a Brownian motion dWF(t) such that (under PT): dF (t , T ) = (t , F (t , T ) D (t , T )) dWF (t ) F (t , T )

(5)

i = d, f

(3)

with d(t), f(t), d(t), f(t) deterministic functions. The forex skew in the model is imposed via the local volatility function (t, x). The standard Gaussian framework, as developed in, for example, Dempser & Hutton (1997), is recovered by using the function (t, x) that is independent of x, (t, x) = (t). For stability of calibration, it is essential to use a parametric form of the local volatility function. The following parametrisation is used: x (t , x ) = (t ) L (t )
(t ) 1

(4)

where (t) is the relative volatility function, (t) is a time-dependent CEV parameter and L(t) is a time-dependent scaling constant (level). Our choice of the parametric form is motivated by well-known problems (see Andersen & Andreasen, 2002) with the dynamics, and subsequent hedging performance, of models with U-shaped local volatility functions. Among more at functions, most choices are essentially equivalent, with the CEV specication being slightly more technically convenient. The volatility structures of zero-coupon discount bonds dened by (3) can be recognised as arising from the one-factor Gaussian HeathJarrow-Morton model (sometimes called the Hull-White or extended Vasicek model (see Hull & White, 1994)). Such a model admits a Markovian representation in the short rate. Hence, the model (2) admits a Markovian representation in three variables, the domestic and foreign short rates and the forex spot. The value of any security can then be calculated by solving a three-dimensional PDE (most eciently solved by utilising a level-splitting scheme, such as an alternating-direction implicit scheme from Craig & Sneyd (1988)). While valuation in such a model is (at least conceptually) simple, calibration is much less so.

where (t, x) = (a(t) + b(t)(t, x) + 2(t, x))1/2, a(t), b(t) are deterministic functions of model parameters (see Piterbarg, 2005b) and D(t, T) @ Pd(t, T)/Pf(t, T). We note that if (t, x) is a function of time t only, (t, x) = (t), then F(T, T) is lognormally distributed, forex options can be valued using the Black formula, and the function (.) can be implied from the at-the-money forex option prices easily. In the general case of (t, x) depending on x, the term distribution of F(., T) is not easy to identify. The diusion coecient of dF/F depends not only on F, but also on D(t, T), another stochastic variable. In what follows we reduce the complexity of the diusion coecient step by step, ultimately bringing it into a recognisable form. Markovian representation for forward forex rate dynamics. The rst step in simplifying the dynamics of the forward forex rate is closing out the stochastic dierential equation (SDE) for F, by which we mean writing the SDE in a form that contains F as the only stochastic variable. The simplest approach to this is to replace D(t, T) in (5) with its along the forward deterministic approximation: D t , T D0 t , T ,

( )

( )

where

D0 t , T =

( )

Pd 0, t , T Pf 0, t , T

and Pi(s, t, T), i = d, f, are forward prices of corresponding zero-coupon discount bonds. This approach, in addition to being rather ad hoc, also produces approximations of low accuracy. Instead, an autonomous representation of the forward forex rate process that is exact for European-style options can be derived. It follows from Gyngy (1986) (and can also be derived from the ideas of Dupire, 1994, as in ~ ~ Piterbarg, 2005b) that, if we dene (t, x) by 2(t, x) = ET (2(t, F (t, 0 T)D(t, T))|F(t, T) = x), then European-style option prices in the model (5) exactly match the ones in the following model:
1

( (

) )

(6)

For given mean-reversion functions d (t), f (t), the t of volatility functions d (t), f (t) may fail if the market volatilities are steeply downward sloping. Such problems can always be addressed by increasing mean reversions

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A Market-implied Black volatilities of forex options for strikes from equation (12) (%)
Expiry 6m 1y 3y 5y 7y 10y 15y 20y 25y 30y Vol 1 11.41 12.23 12.94 13.44 14.29 16.43 20.93 22.96 23.97 25.09 Vol 2 10.49 10.98 11.35 11.84 12.68 14.79 19.13 21.19 22.31 23.48 Vol 3 9.66 9.82 9.89 10.38 11.23 13.34 17.56 19.68 20.92 22.17 Vol 4 9.02 8.95 8.78 9.27 10.12 12.18 16.27 18.44 19.80 21.13 Vol 5 8.72 8.59 8.34 8.76 9.52 11.43 15.29 17.50 18.95 20.35 Vol 6 8.66 8.59 8.36 8.71 9.37 11.07 14.65 16.84 18.37 19.81 Vol 7 8.68 8.65 8.46 8.83 9.43 10.99 14.29 16.46 18.02 19.48

Clearly, accounting for the stochastic nature of D(t, T) introduced an adjustment to the slope of the local volatility function ^(t, x) around the forward x = F(0, T). The next step is to be able to eectively price European-style options with the model (8), a one-dimensional diusion with timeand space-dependent volatility function. Skew averaging. The approach of parameter averaging (see Piterbarg, 2005c and 2005d) is well suited for the next step. With this approach, time-dependent parameters are replaced with eective, time-constant ones, thus allowing us to relate model and market parameters directly without actually performing any option calculations. Applying the method, we nd that to value options on the forex rate with maturity T, the forward forex rate can be approximated by the following SDE: dF (t , T ) = (t , F (0, T )) ( F F (t , T ) + (1 F ) F (0, T )) dWF (t ) where: F = 1 + 0 w t
T

B Market volatilities and skews (* , * ), n = 1, ... , 10, of n n the displaced-diusion model (%)
Expiry 6m 1y 3y 5y 7y 10y 15y 20y 25y 30y Volatility 9.02 8.94 8.78 9.25 10.09 12.11 16.03 18.05 19.32 20.56 Skew 200 180 110 60 30 0 30 50 63 72

()

b t t + 2 t , F 0, T t 2 2 t , F 0, T

() ()

and w(t), (t) are simple functions of model parameters (see Piterbarg, 2005b, for details). In particular, F(, T) follows a standard displaceddiusion SDE with the skew parameter F. The value of a call option on the forex rate with maturity T and strike K is equal to:
F (0, T ) 1 F ,K + c (T , K ) = Pd (0, T ) cBlack F (0, T ) , F F , T (10) F F

( ( )) ( ) dt ( ( ))

(9)

Note: as calibrated to market-implied Black volatilities of forex options from table A by matching the value and the slope of the forex volatility smile for each expiry

dF (t , T ) = (t , F (t , T )) dWF (t ) F (t , T )

(7)

This result is very intuitive the Markovian dynamics is dened by the diusion coecient that is the expected value of the original diusion coecient conditioned on the underlying. We emphasise that the result is exact for all derivatives with European-style payouts. To use it in practice, however, the conditional expectations have to be calculated or, at least, approximated. The necessary calculations are performed in Piterbarg (2005b), where it is shown that to a good approximation, the following SDE can be used instead: dF t , T where: t, x = a t + b t t, x + 2 t, x

( ) = t , F t ,T dW t ( ( )) F ( ) F (t ,T )
1/ 2

(8)

( ) ( ) ( ) ( )) ( t )1 D0 ( t , T ) x (t , x ) = (t ) x 1 1 + ( ( t ) 1) r ( t ) L (t ) F ( 0, T ) ( )

and r(t) is some deterministic function (see Piterbarg, 2005b). It is worth noting that had we used the simplistic approximation (6), the corresponding formula would simply be: D t,T t, x = t x 0 L t

( ) ()

( ) ( ) ()

t 1

where cBlack(F, K, , T) is the Black formula value for a call option with forward F, strike K, volatility and time to maturity T. This result fully resolves the problem of approximately pricing options on the forex rate in the cross-currency model (2). For a given expiry T and strike K, the pricing formula (10) is used with the eective volatility of the forward forex rate F dened by (11), and the eective skew of the forward forex rate F given by (9). The algorithm. The rst step of forex volatility calibration is to t the displaced-diusion model (10) to forex options across strikes separately for each maturity Tn, 0 = T0 < T1 < ... < TN. Then, from the obtained set of market volatilities *n and market skew parameters *n, n = 1, ... , N, the model parameters, the time-dependent functions (t) and (t) for t [0, TN] can be obtained by solving the equations (11), (9) (assuming, for example, that (t) and (t) are piecewise constant). The calculations can be organised into N sequential problems, each one involving only a two-dimensional root search, with (Tn) and (Tn) found on step n and reused on consecutive steps. In practice, the calibration is fast and robust. Fitting the model to, for example, forex options for seven strikes and 10 maturities (as in the example in the section below) takes about 0.1 seconds on a modern computer. From (9), it follows that F is a linear function of (); thus, the equations for () can always be solved. The t of volatilities, however, may fail if the market volatilities do not increase fast enough, just like for the standard lognormal model. Intuitively, the market volatility is a sum of volatilities of interest rate and forex components of the forward forex rate. If the market volatility is too small compared with the interest rate volatility components (a situation possible especially for longer-dated maturities), then the forex spot volatility cannot be found. Such problems are usually solved by adjusting ones correlation assumptions.

1 F = T

2 t , F 0, T dt

( ( ))

1/ 2

(11)

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Test results To demonstrate the performance of the approximations we developed, tests have been carried out for a standardised set of market data. The interest rate curves in the domestic (yen) and foreign (dollar) economies are given by: Pd (0, T ) = exp ( 0.02 T ) , Pf (0, T ) = exp ( 0.05 T ) The volatility parameters for the interest rate evolution in both currencies are given by: d (t ) 0.70%, d (t ) 0.0%, f (t ) 1.20%, f (t ) 5.0% The correlation parameters are given by: df = 25.00%, dS = 15.00%, fS = 15.00% The initial spot forex rate (yen per dollar) is set at 105. For calibration, we use the expiries T1, ... , T10 as in the rst column of table A, and the strikes Ki(Tn) of options as calculated by the formulas:
1 K i Tn = F 0, Tn exp 0.1 Tn / 2 i

C Model volatilities and skews (n, n), n = 1, ... , N, as calibrated to the market ones from table B (%)
Start period 0m 6m 1y 3y 5y 7y 10y 15y 20y 25y End period 6m 1y 3y 5y 7y 10y 15y 20y 25y 30y Volatility 9.03 8.87 8.42 8.99 10.18 13.30 18.18 16.73 13.51 13.51 Skew 200 172 115 65 50 24 10 38 38 38

( )

D Dierences, in implied Black volatilities, between values of forex options (%)

Expiry 6m 1y 3y 5y 7y 10y 15y 20y 25y 30y Error 1 0.26 0.06 0.14 0.17 0.21 0.19 0.01 0.39 0.62 0.82 Error 2 0.16 0.06 0.07 0.11 0.16 0.19 0.08 0.17 0.31 0.42 Error 3 0.12 0.07 0.00 0.04 0.07 0.11 0.07 0.08 0.15 0.18 Error 4 0.10 0.06 0.02 0.00 0.02 0.04 0.01 0.05 0.06 0.06 Error 5 0.07 0.03 0.01 0.03 0.03 0.03 0.04 0.06 0.03 0.02 Error 6 0.02 0.03 0.11 0.12 0.12 0.08 0.08 0.08 0.02 0.05 Error 7 0.05 0.14 0.28 0.30 0.29 0.20 0.09 0.11 0.02 0.06

where i = 1.5, 1.0, 0.5, 0.0, 0.5,1.0,1.5

(12)

For each expiry and strike, an implied Black volatility of the corresponding forex option is given in table A. This set of parameters is regarded as the market. For each expiry Tn, n = 1, ... , N, we t a displaced-diusion model with a constant volatility *n and a constant skew parameter *n, n = 1, ... , 10 (see section above for notations). The skews are tted to match the slopes of the market forex volatility smiles for each expiry, and the volatilities are tted to the at-the-money volatilities. The resulting parameters are summarised in table B. The cross-currency model is calibrated to these parameters, as outlined in the section above. The resulting parameters ((n, n), n = 1, ... , N) are summarised in table C. The errors of the approximations are presented in table D as the dierence of implied Black volatilities, calculated by the approximations above and by using the PDE method, for maturities and strikes as dened previously. The t is excellent, with errors less than 0.1% for at-the-money options and less than 0.2% for almost all others. Let us next consider how well the model ts the market as given by the implied Black volatilities in table A. We calculate the values of forex options in the model (2) (with parameters given in table C) using the PDE method, and compare them with the market volatilities. The dierences are reported in gure 1 for selected maturities. Clearly, the calibration algorithm works as intended, with an excellent t to the at-the-money options and to the slopes of the volatility smiles for each expiry. The t to individual forex options is not very good for some points, which is more of a limitation of the model specication used than the calibration algorithm. Still, the smiles produced by the model are much closer to the market than the ones generated by the lognormal model. In particular, the t, compared with the lognormal model, is much better for low-strike (in-the-money call) options. Skew impact on PRDC swaps A PRDC swap (see Sippel & Ohkoshi, 2002, and Jeery, 2003, for extensive discussions) pays forex-linked coupons in exchange for oating-rate payments. Let us dene it more formally.2 Suppose a tenor structure: 0 < T1 < < TN , n = Tn +1 Tn is given. A forex-linked, or PRDC swap, coupon for the period [Tn, Tn + 1], n = 1, ... , N 1, pays the amount nCn(S(Tn)) (on a unit notional in domestic currency) at time Tn, where:

Note: calculated using the PDE method and the approximation method from Skew averaging section

S (Tn ) Cn ( S ) = min max g f g d , bl , bu , n = 1,, N 1 s Quantities gf and gd are called the foreign and the domestic coupons, and bl and bu are the oor and the cap on the payout. In the classical structure, bl = 0 and bu = +, that is, the payout is oored at zero and there is no cap. The scaling factor s is often called the initial forex rate. All the parameters can vary from coupon to coupon, that is, depend on n, n = 1, ... , N 1. An initial xed-rate coupon is often paid to the investor (the receiver of PRDC swap coupons). It is not included in the denition above as its valuation is straightforward. With the domestic currency being the yen, and the foreign one being the dollar, S() is expressed in yen per dollar. The investor receives a positive coupon as long as S() is high, that is, as long as the dollar is strong (or strong enough). Because of the signicant interest rate differential between the two currencies, the forward forex rate curve F(0, t), t 0, is strongly downward sloping, predicting a signicant weakening of the dollar. Thus, the party receiving the structured coupon in a PRDC swap is essentially betting that the dollar is not going to weaken (or not as much) as predicted by the forward forex curve, a bet that many Japanese investors are comfortable to make. The standard PRDC swap can be seen as a collection of simple forex options, and as such does not require a sophisticated model to price. The varieties that are most popular, however, are more comA large variety of PRDC swaps is available. We only present the basic structure, as relevant for our analysis
2

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1 Market and model values of forex options, in implied Black volatilities, versus strikes, for a number of expiries
12 10 8 6 4 2 0 80 25 20 15 % 10 5 0 % Black volatility, market, expiry = 6m Black volatility, model, expiry = 6m 90 100 110 120 % % 16 14 12 10 8 6 4 2 0 40 Black volatility, market, expiry = 7y Black volatility, model, expiry = 7y 60 80 100 120 140

30 25 20 15 10 Black volatility, market, expiry = 15y Black volatility, model, expiry = 15y 20 40 60 80 100 120 140 5 0 Black volatility, market, expiry = 25y Black volatility, model, expiry = 25y 0 20 40 60 80 100 120

plicated and do require a model. One type, a cancellable PRDC swap, gives the issuer (the payer of the PRDC swap coupons) the right to cancel the swap on any of the dates T1, ... , T N 1 (or a subset thereof). The other popular type is a knock-out PRDC swap, stipulating that the swap knocks out (disappears) if the spot forex rate on any of the dates T1, ... , T N 1 exceeds a pre-agreed level. Both features are designed to limit the downside for the issuer, and also allow the investor to monetise the options to cancel/knock-out in the form of receiving high xed coupons over the initial (no-call) period [0, T1]. Assuming bu = +, bl = 0 (the most commonly used settings), the PRDC swap coupon can be represented as a call option on the forex rate: Cn ( S ) = h max S (Tn ) k , 0 , k =

(TN = 30). All pay an annual PRDC swap coupon (n = 1, n = 1, ... , N 1) and receive the domestic (yen) Libor rate. The oor is zero and there is no cap, bl = 0, bu = +. All have a time-dependent schedule of s = sn. In particular: sn = F (0, Tn ) , n = 1,, N 1

They start in one year (T1 = 1) and have a total maturity of 30 years

gf sg d , h= gf s

The option notional h determines the overall level of coupon payment, and the strike k determines the likelihood of the coupon paying a nonzero amount. The relationship of the strike to the forward forex rate to Tn determines the leverage of the PRDC swap. If the strike k is low, then the coupon has a relatively high chance of paying a non-zero amount. The option notional in this case is, typically, low. This is a low-leverage situation. If the strike is high relative to the forward forex rate, the probability that the coupon will pay a non-zero amount is low. The notional h, in this case, is typically higher. This is a highleverage situation. In the analysis below, PRDC swaps of dierent leverage are used to demonstrate the smile impact. We consider cancellable and knock-out versions of three PRDC swaps, a low-leverage, a medium-leverage and a high-leverage one. The three swaps share many features, namely:

This choice simplies the structure of coupons, clarifying certain conclusions. Cancellable variants give a Bermuda-style option to cancel the swap on each of the dates T1, ... , TN 1 to the payer of the PRDC swap coupons. Knock-out variants are up-and-out forex-linked barriers. In particular, the swap disappears on the rst date among T1, ... , TN 1 on which the forex rate S(Tn) exceeds a given barrier. Note that the barriers are dierent for the three cases. The domestic and foreign coupons are chosen to provide dierent amounts of leverage, while keeping the total value of the underlying swap roughly the same for all three cases. Table E provides the remaining details of the securities. The values of securities are in percentage points of the notional. Valuation results for two models are presented. One is the standard lognormal three-factor model calibrated to the at-the-money forex options of expiries from table A. The other model is the skew-calibrated one as described above. The values (to the payer of PRDC swap coupons) of underlying PRDC swaps, cancellable PRDC swaps and knock-out PRDC swaps are reported. The value of cancellable and knock-out swaps increases with leverage. This is of course not surprising, as higher volatility in the value of

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E Parameters of PRDCs and their values, in percentage points of the notional, using the standard lognormal model and the skew-calibrated model
Leverage Trade details Foreign coupon Domestic coupon Barrier PV, lognormal model Underlying Cancellable Knock-out PV, skew model Underlying Cancellable Knock-out Di, skew - lognormal Underlying Cancellable Knock-out 2.01 1.71 2.64 2.43 2.51 5.19 1.52 2.79 7.80 10.67 11.90 1.52 11.66 14.62 2.89 10.86 20.37 6.32 8.66 13.61 4.16 9.24 17.13 8.08 9.35 23.16 14.12 4.50% 2.25% 110.00 6.25% 4.36% 120.00 9.00% Low Medium High

2 Value of a cancellable PRDC as a function of the forex rate at T = 5 (in percentage points of the notional)
50 40 Cancellable value 30 20 10 0 0 10 25 50 75 100 125 150

8.10% 130.00

Forex rate

the underlying swap (resulting from higher leverage) increases the value of the option to cancel it (and the knock-out option in this case). PRDC swaps consist of (short) forex call options with low strikes (low means weak dollar for the analysis in this section). Introduction of the skew increases the implied volatility of low-strike options, thus pushing the value of PRDC swaps down (for the issuer). The same holds true for the cancellable swaps as well, with the (negative) impact uniformly increasing with the increased leverage. The eect is quite substantial, comparable with typical prots booked by the issuer. Hence, not accounting for the forex skew can easily show a prot on a trade that was actually a loss. The conclusion is not surprising: accounting for the forex skew, for example in the way developed in this article, is absolutely critical for proper pricing and risk-managing the PRDC swap book. To understand the skew impact on cancellable PRDCs, let us look at its value at an intermediate date as a function of the spot forex

rate on that date. A sample payout is presented in gure 2. Clearly, it is optimal to cancel the swap if the forex rate is high enough. The payout is concave for S < forward, reecting the negative convexity of short forex option positions, the PRDC swap coupons due to the issuer. For S > forward, the payout is convex, reecting the cancel option at higher strike. In particular, accounting for the skew aects the value of a cancellable swap in two ways. First, the higher volatility for lower strikes means that the left, concave side of the payout is valued lower. The lower volatility for high strikes means that the right, convex side of the payout is also valued lower. Hence, the skew impact on cancellable PRDCs is compounded. The prole of the cancellable PRDC is similar to a call spread, a payout that is very sensitive to the skew of the volatility smile. With the model developed in this article, the skew of the smile can be nicely controlled, thus allowing us to capture the main risk factors aecting these types of security very well.
Vladimir Piterbarg is head of xed-income quantitative research at Barclays Capital in London. He would like to thank Jesper Andreasen and Leif Andersen for their thoughtful comments, and anonymous referees who made suggestions that greatly improved the article. E-mail: vladimir.piterbarg@barcap.com

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