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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

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-

Power-reverse dual-currency (PRDC) swaps

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).

66 Risk May 2006

piterbarg.indd 66 3/5/06 11:28:33

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 )
⌠ e − ∫t χi (u ) du ds,
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-
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 )
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)).
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 67

piterbarg.indd 67 3/5/06 11:28:36


Clearly, accounting for the stochastic nature of D(t, T) introduced an

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

B Market volatilities and skews (σ*n, δ*n), n = 1, ... , 10, of where:

the displaced-diffusion model (%)
δ F = 1 + ∫0 w t ()
() () ( ( )) ( ) dt
b t η t + 2 γˆ t , F 0, T η t

(t, F (0,T )) (9)

Expiry Volatility Skew
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 



σF = 
∫0 Λ ( ( )) 

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.

68 Risk May 2006

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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

mies are given by: 0m 6m 9.03 –200

Pd (0, T ) = exp ( −0.02 × T ) , Pf (0, T ) = exp ( −0.05 × T )

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

10y 15y 18.18 10

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

15y –0.01 0.08 0.07 0.01 –0.04 –0.08 –0.09

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

The errors of the approximations are presented in table D as the

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 69

piterbarg.indd 69 3/5/06 11:28:45


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

12 16
6 8


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


% 15


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 =
, h=
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

70 Risk May 2006

piterbarg.indd 70 3/5/06 11:28:47

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
Leverage Low Medium High

Trade details
Foreign coupon 4.50% 6.25% 9.00%

Domestic coupon 2.25% 4.36% 8.10%

Cancellable value
Barrier 110.00 120.00 130.00

PV, lognormal model

Underlying –8.66 –9.24 –9.35

Cancellable 13.61 17.13 23.16 10

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

Diff, skew - lognormal

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:

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