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CROSS-CURRENCY EXOTICS

Smiling

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 inter-

est rates, but use the local volatility (constant elasticity of variance

(CEV)-type) process for the forex dynamics. This avoids introduc-

ing any more stochastic factors, keeping the speed and accuracy of

valuation the same as in the ‘standard’, lognormal model. Most of

hybrids

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 instantane-

ously. The procedure is obtained by combining our recently devel-

oped techniques of skew averaging (see Piterbarg, 2005c and 2005d)

with derived Markovian representation of the dynamics of the for-

ward forex rate that is exact for European-style options.

In addition, the eﬀect of forex volatility skew on PRDC swaps

(cancellable and knock-out varieties) is studied, and is found to be

signiﬁcant. In particular, by analysing the shapes of the payouts of

Vladimir Piterbarg develops a multi-currency the securities, it is determined that the slope of the forex volatility

smile is a major factor aﬀecting the values, thus endorsing our focus

model with foreign exchange skew suitable on introducing skews into PRDC swap modelling.

for valuation and risk management of forex-

Limitations and alternatives

linked hybrids, in particular power-reverse The subject of PRDC swap modelling, despite its importance in prac-

dual-currency (PRDC) swaps. The emphasis tice, has received scant attention in the literature. Particularly disap-

pointing is the lack of published research on long-dated forex smile

of the article is on model calibration to forex modelling (the subject of this article) except for some interesting results

presented at conferences (see Balland, 2005). The model we develop is

options across diﬀerent maturities and strikes not intended as the ﬁnal answer to all forex smile-related problems. Sin-

gle-factor interest rate assumptions, while suﬃcient for PRDC swaps,

make the model unsuitable for some of the more complicated hybrids,

such as constant maturity swap-spread linked ones. For such deriva-

are by far the most widely

traded and liquid cross-currency exotics. Continuing interest in these

tives, a model similar to that of Schlogl (2002), in which Libor market

models are used for interest rates, yet with suﬃcient control over forex

smiles and a good forex option calibration algorithm (something that

structures, driven mainly by Japanese investors looking for higher Schlogl does not address) will probably need to be developed. In addi-

yields, has resulted in large books of PRDC swaps being accumulated tion, such a model would serve as a good platform to incorporate inter-

by most exotics dealers in the market. Large, concentrated exposures est rate volatility smiles by using, for example, skew-enhanced Libor

require sophisticated and robust models to risk-manage them properly. market models as in Andersen & Andreasen (2000).

PRDC swaps are essentially long-dated (30 years being quite typical) We note that the model we develop does not attempt to exactly

swaps with coupons that are options on the forex rate (most com- match implied forex volatilities for all strikes. In fact, since the CEV

monly a dollar/yen rate). They are often Bermuda-style callable, or speciﬁcation for local volatility is used, this would be impossible in

have knock-out provisions. PRDC swaps are exposed to moves in the most markets exhibiting convex smiles. Our focus is on developing a

foreign exchange rate and the interest rates in both currencies. By now, model in which the slope of the volatility skew can be controlled, thus

most dealers have standardised on a three-factor modelling framework allowing us to assess the skew exposure of PRDC swaps (which, as

(see, for example, Sippel & Ohkoshi, 2002), with the forex rate fol- mentioned above, is very signiﬁcant).

lowing a lognormal process, and the interest rates in the two currencies The CEV speciﬁcation is a typical choice for introducing volatility

driven by one-factor Gaussian models. Keeping the number of factors skews in many contexts (see, for example, Andersen & Andreasen,

to the minimum allows us to use partial diﬀerential equation (PDE)- 2000, where it is used for Libor market models). Theoretical limi-

based methods for valuation, an essential requirement for large books. tations (having non-zero probability of absorption at zero) rarely

The choice of Gaussian assumptions for the interest rates and lognor- present practical problems, as most securities have strikes and other

mality for the forex rate has allowed for a very eﬃcient, essentially interesting ‘features’ at levels strictly above zero. In particular, local

closed-form, calibration to at-the-money options on the forex rate. modiﬁcations of the power function around zero can easily eliminate

Forex options exhibit a signiﬁcant volatility skew (induced in longer- the absorption problem, while having little or no impact on pricing

dated options, ironically, by dealers trying to hedge their PRDC swap and calibration. Moreover, dynamically, the CEV model is one of the

positions). Moreover, the structure of PRDC swaps, epitomised in the soundest local-volatility models, implying ‘self-similar’ behavior of

typical choice of strikes for the coupons, as well as the callability/knock- the underlying (see Hagan et al, 2002).

out features, makes them particularly sensitive to the forex volatility The use of so-called ‘mixture’ models has been suggested in the

skew. Incorporating a skew in a model is by no means trivial. While literature for introducing volatility smiles. The merits of such mod-

various mechanisms for including a skew in the model are well known els, and in particular their applicability to cancellable, knock-out or

(local volatility, stochastic volatility and/or jumps), their applicability other dynamics-linked securities are discussed elsewhere (see, for

in the context of PRDC swap modelling is hindered by the problem of example, Piterbarg, 2005a).

The model Calibration

An economy with two currencies, ‘domestic’ and ‘foreign’, is consid- ■ Overview. The parameters deﬁning the volatility structures of inter-

ered. Let P be the domestic risk-neutral measure. Let Pi(t, T), i = d, est rates in both currencies, that is, the functions σd(t), σf(t), χd(t), χf(t),

f, be the prices, in their respective currencies, of the domestic and are typically chosen to match European swaption values in the respec-

foreign zero-coupon discount bonds. Also let ri(t), i = d, f, be the tive currencies. Methods for doing this are well known from (single-

short rates in the two currencies. Let S(t) be the spot forex rate, ex- currency) interest rate modelling literature and are covered elsewhere

pressed in the units of domestic currency per one unit of the foreign (see, for example, Brigo & Mercurio, 2001).1 The correlation param-

currency. For future purposes, the forward forex rate (the break-even eters ρij, i, j = d, f, S, are typically chosen either by historical estimation

rate for a forward forex transaction) is denoted by F(t, T), with the or from occasionally observed prices of ‘quanto’ interest rate contracts

well-known relationship: (payouts made in domestic currency but linked to rates in foreign cur-

Pf (t , T ) rency). Of particular importance to PRDC swaps is how to calibrate

F (t , T ) = S (t ) (1) the volatility function of the forex rate γ(t, x). Options on the forex

Pd (t , T )

rate are traded across a wide range of maturities and strikes; this is the

following from no-arbitrage arguments. information to which γ(t, x) should be calibrated. For PRDC swaps

The following model is considered: and most other cross-currency derivatives, it is impossible to pick a

particular strike, or a particular maturity, of an forex option ‘relevant’

dPd (t , T ) / Pd (t , T ) = rd (t ) dt + σ d (t , T ) dWd (t ) for the security in question. Nor can cancellable/knock-out PRDC

dPf (t , T ) / Pf (t , T ) = r f (t ) dt − ρ fS σ f (t , T ) γ (t , S (t )) dt swaps be decomposed into simple forex options. Hence, the volatility

(2) function γ(t, x) needs to be calibrated to prices of all available forex

+ σ f (t , T ) dW f (t ) options across maturities and strikes.

( )

dS (t ) / S (t ) = rd (t ) − r f (t ) dt + γ (t , S (t )) dWS (t ) ■ 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

where (Wd(t), Wf(t), WS(t)) is a Brownian motion under P with the rate F (T, T) under the domestic T-forward measure PT. Moreover,

correlation matrix 〈dWi, dWj〉 = ρij, i, j = d, f, S (note the ‘quanto’ drift F(t, T) is a martingale under this measure. Given the model (2),

adjustment for dPf(t, T) arising from changing the measure from the there exists a Brownian motion dWF(t) such that (under PT):

foreign risk-neutral to the domestic risk-neutral). Gaussian dynamics dF (t , T )

for the rates are speciﬁed: = Λ (t , F (t , T ) D (t , T )) dWF (t ) (5)

F (t , T )

s

⌠ e − ∫t χi (u ) du ds,

T

σ i (t , T ) = σ i (t ) i = d, f (3) where Λ(t, x) = (a(t) + b(t)γ(t, x) + γ2(t, x))1/2, a(t), b(t) are determin-

⌡t

istic functions of model parameters (see Piterbarg, 2005b) and D(t, T)

with σd(t), σf(t), χd(t), χf(t) deterministic functions. The forex skew @ Pd(t, T)/Pf(t, T).

in the model is imposed via the local volatility function γ(t, x). The We note that if γ(t, x) is a function of time t only, γ(t, x) = γ(t),

‘standard’ Gaussian framework, as developed in, for example, Demp- then F(T, T) is lognormally distributed, forex options can be valued

ser & Hutton (1997), is recovered by using the function γ(t, x) that is using the Black formula, and the function γ(.) can be implied from

independent of x, γ(t, x) = γ(t). the at-the-money forex option prices easily. In the general case of

For stability of calibration, it is essential to use a parametric form of γ(t, x) depending on x, the term distribution of F(., T) is not easy

the local volatility function. The following parametrisation is used: to identify. The diﬀusion coeﬃcient of dF/F depends not only on F,

but also on D(t, T), another stochastic variable. In what follows we

β(t ) −1

x reduce the complexity of the diﬀusion coeﬃcient step by step, ulti-

γ (t , x ) = ν (t )

(4) mately bringing it into a recognisable form.

L (t )

■ Markovian representation for forward forex rate dynamics. The

where ν(t) is the relative volatility function, β(t) is a time-dependent ﬁrst step in simplifying the dynamics of the forward forex rate is ‘clos-

CEV parameter and L(t) is a time-dependent scaling constant (‘lev- ing out’ the stochastic diﬀerential equation (SDE) for F, by which we

el’). Our choice of the parametric form is motivated by well-known mean writing the SDE in a form that contains F as the only stochastic

problems (see Andersen & Andreasen, 2002) with the dynamics, variable. The simplest approach to this is to replace D(t, T) in (5) with

and subsequent hedging performance, of models with ‘U-shaped’ lo- its ‘along the forward’ deterministic approximation:

cal volatility functions. Among more ‘ﬂat’ functions, most choices ( )

Pd 0, t , T

are essentially equivalent, with the CEV speciﬁcation being slightly ( )

D t , T ≈ D0 t , T , ( ) where ( )

D0 t , T =

Pf ( 0, t , T )

(6)

more technically convenient.

The volatility structures of zero-coupon discount bonds deﬁned by and Pi(s, t, T), i = d, f, are forward prices of corresponding zero-cou-

(3) can be recognised as arising from the one-factor Gaussian Heath- pon discount bonds. This approach, in addition to being rather ad

Jarrow-Morton model (sometimes called the Hull-White or extended hoc, also produces approximations of low accuracy. Instead, an auton-

Vasicek model (see Hull & White, 1994)). Such a model admits a omous representation of the forward forex rate process that is exact

Markovian representation in the short rate. Hence, the model (2) for European-style options can be derived. It follows from Gyöngy

admits a Markovian representation in three variables, the domestic (1986) (and can also be derived from the ideas of Dupire, 1994, as in

~ ~

and foreign short rates and the forex spot. The value of any security Piterbarg, 2005b) that, if we deﬁne Λ(t, x) by Λ2(t, x) = ET0(Λ2(t, F (t,

can then be calculated by solving a three-dimensional PDE (most T)D(t, T))|F(t, T) = x), then European-style option prices in the model

eﬃciently solved by utilising a level-splitting scheme, such as an (5) exactly match the ones in the following model:

alternating-direction implicit scheme from Craig & Sneyd (1988)).

1

For given mean-reversion functions χd (t), χ f (t), the ﬁt of volatility functions σd (t), σf (t) may fail if the

While valuation in such a model is (at least conceptually) simple, market volatilities are steeply downward sloping. Such problems can always be addressed by increasing

calibration is much less so. mean reversions

risk.net 67

CUTTING EDGE. CROSS-CURRENCY EXOTICS

A Market-implied Black volatilities of forex options for γ (t, x) around

adjustment to the slope of the local volatility function ^

strikes from equation (12) (%) the forward x = F(0, T).

Expiry Vol 1 Vol 2 Vol 3 Vol 4 Vol 5 Vol 6 Vol 7 The next step is to be able to eﬀectively price European-style

6m 11.41 10.49 9.66 9.02 8.72 8.66 8.68 options with the model (8), a one-dimensional diﬀusion with time-

1y 12.23 10.98 9.82 8.95 8.59 8.59 8.65 and space-dependent volatility function.

3y 12.94 11.35 9.89 8.78 8.34 8.36 8.46 ■ Skew averaging. The approach of ‘parameter averaging’ (see Pit-

5y 13.44 11.84 10.38 9.27 8.76 8.71 8.83

erbarg, 2005c and 2005d) is well suited for the next step. With this

approach, time-dependent parameters are replaced with ‘eﬀective’,

7y 14.29 12.68 11.23 10.12 9.52 9.37 9.43

time-constant ones, thus allowing us to relate model and market pa-

10y 16.43 14.79 13.34 12.18 11.43 11.07 10.99

rameters directly without actually performing any option calculations.

15y 20.93 19.13 17.56 16.27 15.29 14.65 14.29 Applying the method, we ﬁnd that to value options on the forex rate

20y 22.96 21.19 19.68 18.44 17.50 16.84 16.46 with maturity T, the forward forex rate can be approximated by the

25y 23.97 22.31 20.92 19.80 18.95 18.37 18.02 following SDE:

30y 25.09 23.48 22.17 21.13 20.35 19.81 19.48 (t , F (0, T )) (δ F (t , T ) + (1 − δ ) F (0, T )) dW (t )

dF (t , T ) = Λ F F F

the displaced-diﬀusion model (%)

T

δ F = 1 + ∫0 w t ()

() () ( ( )) ( ) dt

b t η t + 2 γˆ t , F 0, T η t

Expiry Volatility Skew

2

6m 9.02 –200

2 Λ̂

1y 8.94 –180 and w(t), η(t) are simple functions of model parameters (see Piterbarg,

3y 8.78 –110 2005b, for details). In particular, F(·, T) follows a standard displaced-

5y 9.25 –60 diﬀusion SDE with the skew parameter δF. The value of a call option

7y 10.09 –30

on the forex rate with maturity T and strike K is equal to:

F (0, T ) 1 − δF

10y 12.11 0

c (T , K ) = Pd (0, T ) cBlack ,K + F (0, T ) , σ F δ F , T (10)

15y 16.03 30 δF δF

20y 18.05 50

1/ 2

1 ˆ 2 t , F 0, T dt

25y

30y

19.32

20.56

63

72

σF =

T

T

∫0 Λ ( ( ))

(11)

Note: as calibrated to market-implied Black volatilities of forex options from table A by matching the where cBlack(F, K, σ, T) is the Black formula value for a call option with

value and the slope of the forex volatility smile for each expiry forward F, strike K, volatility σ and time to maturity T.

dF (t , T ) This result fully resolves the problem of approximately pricing

= Λ (t , F (t , T )) dWF (t ) (7) options on the forex rate in the cross-currency model (2). For a given

F (t , T ) expiry T and strike K, the pricing formula (10) is used with the ‘eﬀec-

This result is very intuitive – the Markovian dynamics is deﬁned by tive’ volatility of the forward forex rate σF deﬁned by (11), and the

the diﬀusion coeﬃcient that is the expected value of the original diﬀu- ‘eﬀective’ skew of the forward forex rate δF given by (9).

sion coeﬃcient conditioned on the underlying. We emphasise that the ■ The algorithm. The ﬁrst step of forex volatility calibration is to

result is exact for all derivatives with European-style payouts. ﬁt the displaced-diﬀusion model (10) to forex options across strikes

To use it in practice, however, the conditional expectations have to separately for each maturity Tn, 0 = T0 < T1 < ... < TN. Then, from the

be calculated or, at least, approximated. The necessary calculations obtained set of market volatilities σ*n and market skew parameters δ*n,

are performed in Piterbarg (2005b), where it is shown that to a good n = 1, ... , N, the model parameters, the time-dependent functions

approximation, the following SDE can be used instead: ν(t) and β(t) for t ∈ [0, TN] can be obtained by solving the equations

( ) = Λˆ t , F t ,T dW t

dF t , T (11), (9) (assuming, for example, that ν(t) and β(t) are piecewise con-

F (t ,T )

( ( )) F ( ) (8) stant). The calculations can be organised into N sequential problems,

each one involving only a two-dimensional root search, with ν(Tn) and

where: β(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

( ) ( ( ) ( ) ( ) ( ))

1/ 2

ˆ t , x = a t + b t γˆ t , x + γˆ 2 t , x

Λ options for seven strikes and 10 maturities (as in the example in the

β( t )−1

section below) takes about 0.1 seconds on a modern computer.

D0 ( t , T )

1 + (β ( t ) − 1) r ( t )

x From (9), it follows that δF is a linear function of β(·); thus, the

γˆ ( t , x ) = ν ( t ) x − 1

L ( t ) F ( 0, T ) equations for β(·) can always be solved. The ﬁt of volatilities, how-

ever, may fail if the market volatilities do not increase fast enough,

and r(t) is some deterministic function (see Piterbarg, 2005b). It is just like for the ‘standard’ lognormal model. Intuitively, the market

worth noting that had we used the simplistic approximation (6), the volatility is a sum of volatilities of interest rate and forex components

corresponding formula would simply be: of the forward forex rate. If the market volatility is too small com-

pared with the interest rate volatility components (a situation possi-

( ) ( )

β t −1

D t,T ble especially for longer-dated maturities), then the forex spot volatil-

( ) ()

γˆ t , x = ν t x 0 ity cannot be found. Such problems are usually solved by adjusting

L t ( ) one’s correlation assumptions.

Test results

C Model volatilities and skews (νn, βn), n = 1, ... , N, as

To demonstrate the performance of the approximations we developed,

tests have been carried out for a standardised set of market data. The calibrated to the market ones from table B (%)

interest rate curves in the domestic (yen) and foreign (dollar) econo- Start period End period Volatility Skew

6m 1y 8.87 –172

1y 3y 8.42 –115

The volatility parameters for the interest rate evolution in both curren- 3y 5y 8.99 –65

cies are given by:

5y 7y 10.18 –50

σ d (t ) ≡ 0.70%, χ d (t ) ≡ 0.0%, σ f (t ) ≡ 1.20%, χ f (t ) ≡ 5.0% 7y 10y 13.30 –24

The correlation parameters are given by:

15y 20y 16.73 38

ρdf = 25.00%, ρdS = −15.00%, ρ fS = −15.00%

20y 25y 13.51 38

The initial spot forex rate (yen per dollar) is set at 105. For calibration, 25y 30y 13.51 38

we use the expiries T1, ... , T10 as in the ﬁrst column of table A, and the

strikes Ki(Tn) of options as calculated by the formulas: D Diﬀerences, in implied Black volatilities, between

( ) (

K i Tn = F 0, Tn exp ) ( 0.1 × Tn1/ 2 × δi ) (12)

values of forex options (%)

Expiry Error 1 Error 2 Error 3 Error 4 Error 5 Error 6 Error 7

where δ i = −1.5, −1.0, −0.5, 0.0, 0.5,1.0,1.5 6m –0.26 –0.16 –0.12 –0.10 –0.07 –0.02 0.05

For each expiry and strike, an implied Black volatility of the cor- 1y –0.06 –0.06 –0.07 –0.06 –0.03 0.03 0.14

responding forex option is given in table A. This set of parameters is 3y 0.14 0.07 0.00 –0.02 0.01 0.11 0.28

regarded as ‘the market’. 5y 0.17 0.11 0.04 0.00 0.03 0.12 0.30

For each expiry Tn, n = 1, ... , N, we ﬁt a displaced-diﬀusion model 7y 0.21 0.16 0.07 0.02 0.03 0.12 0.29

with a constant volatility σ*n and a constant skew parameter δ*n, n = 1,

... , 10 (see section above for notations). The skews are ﬁtted to match

10y 0.19 0.19 0.11 0.04 0.03 0.08 0.20

the slopes of the market forex volatility smiles for each expiry, and

20y –0.39 –0.17 –0.08 –0.05 –0.06 –0.08 –0.11

the volatilities are ﬁtted to the at-the-money volatilities. The result-

ing parameters are summarised in table B. 25y –0.62 –0.31 –0.15 –0.06 –0.03 –0.02 –0.02

The cross-currency model is calibrated to these parameters, as out- 30y –0.82 –0.42 –0.18 –0.06 0.02 –0.05 –0.06

lined in the section above. The resulting parameters ((νn, βn), n = 1, ... , Note: calculated using the PDE method and the approximation method from ‘Skew averaging’

N) are summarised in table C. section

diﬀerence of implied Black volatilities, calculated by the approxima- S (Tn )

tions above and by using the PDE method, for maturities and strikes Cn ( S ) = min max g f − g d , bl , bu , n = 1,…, N − 1

s

as deﬁned previously. The ﬁt is excellent, with errors less than 0.1%

for at-the-money options and less than 0.2% for almost all others. Quantities gf and gd are called the foreign and the domestic coupons,

Let us next consider how well the model ﬁts the market as given and bl and bu are the ﬂoor and the cap on the payout. In the classical

by the implied Black volatilities in table A. We calculate the values of structure, bl = 0 and bu = +∞, that is, the payout is ﬂoored at zero and

forex options in the model (2) (with parameters given in table C) using there is no cap. The scaling factor s is often called the initial forex rate.

the PDE method, and compare them with the market volatilities. The All the parameters can vary from coupon to coupon, that is, depend

diﬀerences are reported in ﬁgure 1 for selected maturities. Clearly, the on n, n = 1, ... , N – 1.

calibration algorithm works as intended, with an excellent ﬁt to the An initial ﬁxed-rate coupon is often paid to the investor (the

at-the-money options and to the slopes of the volatility smiles for each receiver of PRDC swap coupons). It is not included in the deﬁnition

expiry. The ﬁt to individual forex options is not very good for some above as its valuation is straightforward.

points, which is more of a limitation of the model speciﬁcation used With the domestic currency being the yen, and the foreign one being

than the calibration algorithm. Still, the smiles produced by the model the dollar, S(·) is expressed in yen per dollar. The investor receives a

are much closer to the market than the ones generated by the lognor- positive coupon as long as S(·) is high, that is, as long as the dollar is

mal model. In particular, the ﬁt, compared with the lognormal model, strong (or strong enough). Because of the signiﬁcant interest rate dif-

is much better for low-strike (in-the-money call) options. ferential between the two currencies, the forward forex rate curve F(0,

t), t ≥ 0, is strongly downward sloping, predicting a signiﬁcant weak-

Skew impact on PRDC swaps ening of the dollar. Thus, the party receiving the structured coupon

A PRDC swap (see Sippel & Ohkoshi, 2002, and Jeﬀery, 2003, for exten- in a PRDC swap is essentially betting that the dollar is not going to

sive discussions) pays forex-linked coupons in exchange for ﬂoating-rate weaken (or not as much) as predicted by the forward forex curve, a bet

payments. Let us deﬁne it more formally.2 Suppose a tenor structure: that many Japanese investors are comfortable to make.

The standard PRDC swap can be seen as a collection of simple

0 < T1 < < TN , τ n = Tn +1 − Tn

forex options, and as such does not require a sophisticated model to

is given. A forex-linked, or PRDC swap, coupon for the period price. The varieties that are most popular, however, are more com-

[Tn, Tn + 1], n = 1, ... , N – 1, pays the amount τnCn(S(Tn)) (on a unit 2

A large variety of PRDC swaps is available. We only present the basic structure, as relevant for our

notional in domestic currency) at time Tn, where: analysis

risk.net 69

CUTTING EDGE. CROSS-CURRENCY EXOTICS

1 Market and model values of forex options, in implied Black volatilities, versus strikes, for a number of expiries

12 16

14

10

12

8

10

6 8

%

%

6

4

4

2 Black volatility, market, expiry = 6m Black volatility, market, expiry = 7y

2

Black volatility, model, expiry = 6m Black volatility, model, expiry = 7y

0 0

80 90 100 110 120 40 60 80 100 120 140

25 30

25

20

20

15

% 15

%

10

10

5

Black volatility, market, expiry = 15y 5 Black volatility, market, expiry = 25y

Black volatility, model, expiry = 15y Black volatility, model, expiry = 25y

0 0

20 40 60 80 100 120 140 0 20 40 60 80 100 120

plicated and do require a model. One type, a cancellable PRDC ■ They start in one year (T1 = 1) and have a total maturity of 30 years

swap, gives the issuer (the payer of the PRDC swap coupons) the (TN = 30).

right to cancel the swap on any of the dates T1, ... , T N – 1 (or a subset ■ All pay an annual PRDC swap coupon (τn = 1, n = 1, ... , N – 1) and

thereof). The other popular type is a knock-out PRDC swap, stipu- receive the domestic (yen) Libor rate.

lating that the swap knocks out (disappears) if the spot forex rate on ■ The ﬂoor is zero and there is no cap, bl = 0, bu = +∞.

any of the dates T1, ... , T N – 1 exceeds a pre-agreed level. Both features ■ All have a time-dependent schedule of s = sn. In particular:

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 sn = F (0, Tn ) , n = 1,…, N − 1

receiving high ﬁxed coupons over the initial (no-call) period [0, T1]. This choice simpliﬁes the structure of coupons, clarifying certain

Assuming bu = +∞, bl = 0 (the most commonly used settings), the conclusions.

PRDC swap coupon can be represented as a call option on the forex ■ Cancellable variants give a Bermuda-style option to cancel the swap on

rate: each of the dates T1, ... , TN – 1 to the payer of the PRDC swap coupons.

sg d gf ■ Knock-out variants are up-and-out forex-linked barriers. In particu-

( )

Cn ( S ) = h max S (Tn ) − k , 0 , k =

gf

, h=

s

lar, the swap disappears on the ﬁrst date among T1, ... , TN – 1 on which

the forex rate S(Tn) exceeds a given barrier. Note that the barriers are

The option notional h determines the overall level of coupon payment, diﬀerent for the three cases.

and the strike k determines the likelihood of the coupon paying a non- The domestic and foreign coupons are chosen to provide diﬀerent

zero amount. The relationship of the strike to the forward forex rate amounts of leverage, while keeping the total value of the underly-

to Tn determines the leverage of the PRDC swap. If the strike k is low, ing swap roughly the same for all three cases. Table E provides the

then the coupon has a relatively high chance of paying a non-zero remaining details of the securities.

amount. The option notional in this case is, typically, low. This is a The values of securities are in percentage points of the notional.

low-leverage situation. If the strike is high relative to the forward forex Valuation results for two models are presented. One is the standard

rate, the probability that the coupon will pay a non-zero amount is lognormal three-factor model calibrated to the at-the-money forex

low. The notional h, in this case, is typically higher. This is a high- options of expiries from table A. The other model is the skew-cali-

leverage situation. brated one as described above. The values (to the payer of PRDC

In the analysis below, PRDC swaps of diﬀerent leverage are used to swap coupons) of underlying PRDC swaps, cancellable PRDC swaps

demonstrate the smile impact. We consider cancellable and knock-out and knock-out PRDC swaps are reported.

versions of three PRDC swaps, a low-leverage, a medium-leverage and The value of cancellable and knock-out swaps increases with lever-

a high-leverage one. The three swaps share many features, namely: age. This is of course not surprising, as higher volatility in the value of

E Parameters of PRDCs and their values, in percentage 2 Value of a cancellable PRDC as a function of the forex

points of the notional, using the standard lognormal rate at T = 5 (in percentage points of the notional)

model and the skew-calibrated model

50

Leverage Low Medium High

Trade details

40

Foreign coupon 4.50% 6.25% 9.00%

Cancellable value

30

Barrier 110.00 120.00 130.00

20

Underlying –8.66 –9.24 –9.35

Knock-out 4.16 8.08 14.12 Forex rate

PV, skew model 0

Underlying –10.67 –11.66 –10.86 0 25 50 75 100 125 150

Cancellable 11.90 14.62 20.37 –10

Knock-out 1.52 2.89 6.32

rate on that date. A sample payout is presented in ﬁgure 2. Clearly,

Underlying –2.01 –2.43 –1.52 it is optimal to cancel the swap if the forex rate is high enough. The

Cancellable –1.71 –2.51 –2.79 payout is concave for S < forward, reﬂecting the negative convex-

Knock-out –2.64 –5.19 –7.80 ity of short forex option positions, the PRDC swap coupons due to

the issuer. For S > forward, the payout is convex, reﬂecting the can-

the underlying swap (resulting from higher leverage) increases the value cel option at higher strike. In particular, accounting for the skew

of the option to cancel it (and the knock-out option in this case). aﬀects the value of a cancellable swap in two ways. First, the higher

PRDC swaps consist of (short) forex call options with low strikes volatility for lower strikes means that the ‘left’, concave side of the

(‘low’ means ‘weak dollar’ for the analysis in this section). Introduc- payout is valued lower. The lower volatility for high strikes means

tion of the skew increases the implied volatility of low-strike options, that the ‘right’, convex side of the payout is also valued lower. Hence,

thus pushing the value of PRDC swaps down (for the issuer). The the skew impact on cancellable PRDCs is compounded. The proﬁle

same holds true for the cancellable swaps as well, with the (nega- of the cancellable PRDC is similar to a call spread, a payout that

tive) impact uniformly increasing with the increased leverage. The is very sensitive to the skew of the volatility smile. With the model

eﬀect is quite substantial, comparable with typical proﬁts booked developed in this article, the skew of the smile can be nicely control-

by the issuer. Hence, not accounting for the forex skew can easily led, thus allowing us to capture the main risk factors aﬀecting these

show a proﬁt on a trade that was actually a loss. The conclusion is types of security very well. ■

not surprising: accounting for the forex skew, for example in the way

developed in this article, is absolutely critical for proper pricing and Vladimir Piterbarg is head of ﬁxed-income quantitative research at Barclays

risk-managing the PRDC swap book. Capital in London. He would like to thank Jesper Andreasen and Leif Andersen

To understand the skew impact on cancellable PRDCs, let us look for their thoughtful comments, and anonymous referees who made sugges-

at its value at an intermediate date as a function of the spot forex tions that greatly improved the article. E-mail: vladimir.piterbarg@barcap.com

References

Andersen L and J Andreasen, 2000 Computers and Mathematics with Hagan P, D Kumar, A Lesniewski and Piterbarg V, 2005b

Volatility skews and extensions of the Applications 16(4), pages 341–350 D Woodward, 2002 A multi-currency model with FX

Libor market model Managing smile risk volatility skew

Applied Mathematical Finance 7, March, Dempster M and J Hutton, 1997 Wilmott Magazine, September, pages SSRN working paper

pages 1–32 Numerical valuation of cross-currency 84–108

swaps and swaptions Piterbarg V, 2005c

Andersen L and J Andreasen, 2002 In Mathematics of Derivative Securities, Hull J and A White, 1994 Stochastic volatility model with time-

Volatile volatilities edited by M Dempster and S Pliska, Numerical procedures for implementing dependent skew

Risk December 2002, pages 163–168 pages 473–503, Cambridge University term structure models I: Single-factor Applied Mathematical Finance 12(2),

Press models June, pages 147–185

Balland P, 2005 Journal of Derivatives 2, pages 7–16

Stochastic volatility for hybrids Dupire B, 1994 Piterbarg V, 2005d

World Business Strategies workshop Pricing with a smile Jeﬀery C, 2003 Time to smile

on hybrids Risk January 1994, pages 18–20 The problem with power-reverse duals Risk May 2005, pages 71–75

Risk October 2003, pages 20–22

Brigo D and F Mercurio, 2001 Gyöngy I, 1986 Schlogl E, 2002

Interest-rate models – theory and Mimicking the one-dimensional Piterbarg V, 2005a A multicurrency extension of the

practice marginal distributions of processes Mixture of models: a simple recipe for a lognormal interest rate models

Springer Verlag having an Ito diﬀerential ... hangover? Finance and Stochastics 6(2), pages

Probability Theory and Related Fields Wilmott Magazine, January, pages 173–196

Craig J and A Sneyd, 1988 71, pages 501–516 72–77

An alternating-direction implicit Sippel J and S Ohkoshi, 2002

scheme for parabolic equations with All power to PRDC notes

mixed derivatives Risk October, pages S31–S33

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