Greenwood PDF

6/9/2010
Risk and Investment Conference 2010

Mark Greenwood and Simona Svoboda
LPI swaps
Pricing and Trading
13-15 June 2010
© 2010 The Actuarial Profession  www.actuaries.org.uk
Agenda
1. What is LPI?
2. The inflation options
p market
3. The inflation volatility smile
4. Modelling the inflation volatility smile
5. SABR
6. A simple LPI model
7. Conclusion and discussion

1
1
6/9/2010
Types of LPI
LPI, Limited Price Indexation, is the RPI link in pensions

Following Wilkie(1988),
Wilkie(1988) we define various types of LPI indexation:
– Type 1: LPIt = RPIt
– Type 2: LPIt = max[RPI0*(1+floor%)^t , RPIt ]
– Type 3: LPIt = max[RPI0, RPI1…,RPIt ]
– Type 4: LPIt = LPIt-1* min[max[1+floor%, RPIt /RPIt-1], 1+cap%]
– Type 5: LPIt = LPIt-1 * [1+participation% * ( RPIt/RPIt-1-1 )]
For 0% floors, Type 1 < Type 2 < Type 3 < Type 4

2
Illustration of types of LPI

RPIt RPIt 0% floor Type 2 floor at 0% Type 3 floor at 0% Type 4 floor at 0%
t (Type 1) y/y% indext pension increase pension increase pension increase
0 100.00 100.00 100.00 100.00 100.00
1 101 00
101.00 1 0%
1.0% 100 00
100.00 101 00
101.00 1 0%
1.0% 101 00
101.00 1 0%
1.0% 101 00
101.00 1 0%
1.0%
2 103.53 2.5% 100.00 103.53 2.5% 103.53 2.5% 103.53 2.5%
3 99.90 -3.5% 100.00 100.00 -3.4% 103.53 0.0% 103.53 0.0%
4 98.90 -1.0% 100.00 100.00 0.0% 103.53 0.0% 103.53 0.0%

115
5 104.84 6.0% 100.00 104.84 4.8% 104.84 1.3% 109.74 6.0%
110
with floor
indexed pension w
105
100
Type 4 0% floor, no cap
Type 3 floor
95
Type 2 0% floor
Type 1 (no floor)
90
© 2010 The Actuarial Profession  www.actuaries.org.uk 0 1 2 3 4 5 3
year
2
6/9/2010
The UK inflation options market
• The building blocks of the RPI derivatives market are zero

coupon inflation swaps. These are a hedge for type-1 LPI.
• Three forms of “vanilla” RPI inflation options trade:
1. ‘Year-on-year (y/y) RPI caps and floors. The cap has T caplets
with payoffs max[ 0, (RPIt/RPIt-1-1) – K% ] at times t=1,2, …,T.
2. RPI index caps and floors with a single payoff at maturity. The
cap payoff is max[ 0, RPIt/RPI0 -(1+K%)T ]. Hedge for LPI type-
2 liabilities
liabilities.
3. LPI swaps hedge LPI type-4 liabilities. The most common collar
strikes traded are [0%,5%], [0%,3%] and [0%,∞] (i.e. no cap).

4
The UK inflation options market
• Participants
• Maturities
• Liquidity
• Equilibrium
• Execution costs
• Price transparency

5
3
6/9/2010
Inflation options screens
Source:
Bloomberg
6 June
2010
6
The implied inflation volatility smile
• Inflation options trade on price, not volatility

• Prices can be inverted to implied volatilities using the
conventional options pricing formulae for each market
• For RPI index options, it is natural to use the Black Scholes
(lognormal) model to price since the index is always positive and
is expected to grow exponentially:

7
4
6/9/2010
Implied RPI index volatility smile
Type-2 LPI liabilities can be priced directly from the implied volatility given
the strike and maturity
17.5%
30y RPI index option vol smile
s implied index volatility
15.0% 20y RPI index option vol smile

10y RPI index option vol smile
12.5% 5y RPI index option vol smile
10.0%
7.5%
Black Scholes
Source:
5.0%
Bloomberg
composite
2.5% 6 June
2010
0.0%
-1.0% 0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0%

index option strike (rate) 8
The inflation implied volatility smile: y/y options
• For RPI y/y options, the y/y rate may be negative so the Black
Scholes lognormal model is not appropriate
• The market convention is to assume the underlying y/y rate has
a normal distribution and use the Bachelier(1900) model. The
resulting vol  is called the normal vol or basis point vol:
See VBA code in the spreadsheet on the conference website.

9
5
6/9/2010
The RPI y/y inflation options market
RPI y/y atm inflation vol > GBP LIBOR atm caplet floorlet vol out to 5 years
2 00%
2.00%
Implied at-the--money normal volatility
GBP RPI y/y normal vol

1.75%
GBP LIBOR6m normal vol
1.50%
1.25%
1.00%
0 75%
0.75%
Source:
0.50% RBS,
6 June
0.25% 2010
0.00%
0 5 10 15 20 25 30
maturity 10
The RPI y/y inflation options market
RPI y/y inflation vol smile compared with LIBOR cap floor vol smile
2 00%
2.00%
20 year atm LIBOR atm flat vol
1.75% 20 year atm RPI y/y flat vol
1.50%
ormal volatility
1.25%
1.00%
0 75%
0.75%
no
Source:
0.50% Bloomberg
composite
0.25% 6 June
2010
0.00%
-2.0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0%
strike 11
6
6/9/2010
Modelling the implied volatility smile
• Historically, the implied volatility smile first appeared in

equity option markets
• Techniques developed for equities have subsequently
been used in interest rate and inflation markets
– Alternate stochastic process
– Local volatility models
– Stochastic volatility models
– Lévy processes

12
Volatility smiles - alternate stochastic process
• The presence of a smile may interpreted as a deviation

from lognormality
g y in the dynamics
y of the underlying
y g
• Popular processes include the CEV (constant elasticity
of variance) process
dS   dt   S  dW where 0    1
• And the shifted-lognormal (displaced-diffusion) process
d S      dt  S    dW
• Both processes allow a monotonically downward sloping

skew, however alternate techniques are needed to
introduce curvature.

13
7
6/9/2010
Volatility smiles – local volatility models
• Volatility is a function of the underlying itself, hence

dS   Sdt   t , S dW
• First introduced by Dupire(1994) and Derman and
Kani(1994).

14
Stochastic volatility models
• The underlying and its volatility are driven by correlated

Brownian motions
• A well known stochastic volatility model is due to Heston(1993)
dS t   S t dt  v t S t dW t1
dv t     v t dt   v t dW t 2 where dW t1 dW t 2   dt
• Semi-analytical option prices may be found via Fourier

transform techniques as
C S , v , t   SP1  KP t , T P2
where P(t,T) is the T-maturity discount bond and P1 and P2 are

the associated probabilities evaluated via numerical integration.

15
8
6/9/2010
Lévy processes
• General class of processes with independent and stationary

increments
• This includes familiar processes such as Brownian motion and
Poisson process which introduces random jumps into the
dynamics
• All other Lévy processes are generalisations of a Brownian
motion and a possibly infinite number of Poisson processes.

16
Lévy processes
Lévy processes that have become popular in finance include:

– Jump-diffusion
p – dynamics
y are driven by
y a diffusion and a
finite number of Poisson processes,
– Variance-gamma – may be interpreted as a Brownian motion
evaluated at a time given by a gamma process, see Madan
et. al. (1990,1991,1998),
– Normal-Inverse-Gaussian – may be interpreted as a
Brownian motion evaluated at a time given by an Inverse-
Inverse
Gaussian process, see Barndorff-Nielsen (1997,1998).

17
9
6/9/2010
SABR (Stochastic Alpha Beta Rho) model
• This stochastic volatility model is the market standard for fitting

an implied volatility smile,
dF t   t F t  dW t1 , F0  f
d  t   t dW t , 2
0  
where dW t1 dW t 2   dt and ,  are constants such that 0    1

and   0 .
• It is not a true stochastic volatility model since a separate set of
parameters ,  and  are associated with each maturity.
• The great advantage is that the equivalent Black-Scholes
(lognormal) implied volatility may be approximated analytically
by B(K,f) defined as follows:

18
SABR (Stochastic Alpha Beta Rho) model
  z 
σ B K,f    
      z  
  
2 4
 fK 

1  
f f
2
log 2 K log 2 K
 24 1920 
  2 2 1  2  3 2 2  
 1       T  
  24  fK  4  fK  2

24  
where   1   and
 1  2 z  z 2  z   
  
z  fK  2 log
l f   z   log  
 K
 1   

19
10
6/9/2010
SABR Normal model
• For options on the RPI y/y rate, we use a normal model of the
underlying and the normal option pricing formula of Bachelier.
Hence: 1
dF t   t dW t , F0  f
d  t   t dW t , 2
0  
where dW t1 dW t 2   dt and  is constant such that   0 .

• The equivalent normal implied volatility may be approximated
analytically as
 z   2  3 2 2 
σ N K,f        1   T  
  z    24 
where  1  2 z  z 2  z   
  
z   f  K ,  z   log  
  1  
20
Weaknesses of the SABR model
• These analytic approximations are derived via singular

perturbation techniques
p q relying
y g on a ‘small volatility’
y expansion,
p ,
hence assuming both volatility  and volatility-of-volatility  are
small.
• For extreme parameter values and strikes far away-from-the-
money, these approximations break down.
• This is well known by the market and each market participant
has their own set of proprietary ‘fixes’
fixes .
• The breakdown of these approximations is most clearly visible
if one examines the probability density function derived from
call spreads using implied volatilities, which becomes negative
at extreme parameter values and away-from-the-money.
21
11
6/9/2010
SABR model: negative probabilities
SABR model implied density for F=3.63%, =1.25%, =50%, =15%, =22%
SABR implied
p density
y for 30y
y 6-month LIBOR rate
5.0%
4.0%
obability density
3.0%
2.0%
pro
1.0%
0.0%
-1.0%
0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00%
rate (forward = 3.63%)
22
Simple LPI model: RPI y/y history and forward rates
historical rate market forward rate

10%
9%
8%
7%
6%
5% 5%
RPI y/y rate
4%
3% 3%
2%
1%
0% 0%
-1%
-2%
-3%
1980 1990 2000 2010 2020 2030 2040 2050

calendar year 23
12
6/9/2010
SABR normal volatility smiles: effect of parameters
1.75%
base: atmvol=0.60%, =0%, =40%
higher atmvol: atmvol=0.80%, =0%, =40%
1.50% negative skew: atmvol=0.60%, =-40%, =40%
less smile: atmvol=0.60%, =0%, =20%
1.25%
normal vol
1.00%
0.75%
0.50%
0.25%
-1.0% 0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0%
strike
24
Simple LPI model
• Type 4: LPIt = LPIt-1* min[max[1+floor%, RPIt /RPIt-1], 1+cap%]

• A 30y LPI swap has 60 RPI y/y options embedded in the swap:
LPI30 = LPI0* (RPI1 /RPI0 -1 + floor1 - cap1)
* (RPI2 /RPI1 -1 + floor2 - cap2)
: : :
* (RPI30 /RPI29 -1 + floor30 - cap30)
• Most LPI swap trades use 3 strikes: [0,5], [0,3] and [0,]. SABR
RPI y/y normal model has 3 parameters: ,  and (in our
example spreadsheet we reparameterise as: atm vol,  and )
• In practice a unique fit can be usually identified
25
13
Slide 26
m2 mark greenwood, 08/06/2010

6/9/2010
Simple LPI model

1. FIND SABR
PARAMETERS
2. TO GIVE BEST FIT

26
Simple LPI model: LPI[0,5] fit good
0.15%
[[0,5]
, ] SABR simple
p LPI
0.10%
[0,5] market
p spread to RPI swap
0.05%
0.00%
0 10 20 30 40 50
bp
-0.05%
-0.10%
maturity

27
14
Slide 27
Slide 28

6/9/2010
Simple LPI model: LPI[0,] fit good
0.50%
0.40%
bp spread to RPI swap
0.30%
0.20%
b
0.10% [0,inf] SABR simple LPI

[0,inf] market
0.00%
0 10 20 30 40 50
maturity

28
Simple LPI model: LPI[0,3] fit good
0.00%
0 10 20 30 40 50
-0.20%
[0,3] SABR simple LPI
-0.40% [0,3] market
-0.60%
-0.80%
bp
-1.00%
-1.20%
maturity

29
15
Slide 29
Slide 30

6/9/2010
Simple LPI model: LPI[0,2.5] fit good
0.00%
0 10 20 30 40 50
-0.20%
0.20%
-0.40% [0,2.5] SABR simple LPI

bp spread to RPI swap
-0.60% [0,2.5] market
-0.80%
model -1.317%
-1.00% vs
market -1.323%
1 323%
-1.20%
-1.40%
-1.60%
maturity

30
Simple LPI model: LPI[3,5] fit poor in 50y
0.70% model -0.442%

0.60%
vs
market -0.409%
0.50%
0.40%
0.30%
0.20%
bp
[3,5] SABR simple LPI

0.10%
[3,5] market
0.00%
0 10 20 30 40 50
maturity

31
16
Slide 31
Slide 32

6/9/2010
Simple LPI model: pros and cons
+ recovers RPI and main LPI swap rates and allows alternative
strikes, maturities and RPI reference dates to be priced quickly
+ risk to the model parameters (the greeks) is quick and simple

32
Simple LPI model: the greeks
DELTA AND SABR VEGA LADDERS

per £1m notional LPI swap
DELTA DELTA VEGA VEGA VEGA

notional('£m) DELTA 1bp notional('£m) atmvol 1bp 1% 1%
RPI zc LPI[0,5] LPI[0,5] LPI[0,5] LPI[0,5] LPI[0,5]
30y 30y 30y 30y 30y 30y
5y 498 -11 -0.02 63 251 -251
10y 944 -12 -0.01 207 214 -309
15y 1339 45 0.03 170 230 -467
20y 1756 -40 -0.02 237 243 -625
25y 2186 -72 -0.03 48 270 -667
30y 2620 2094 0.80 -56 169 -432
40y 3436 0 0.00 0 0 0
50y 4204 0 0.00 0 0 0
TOTAL 2003 669 1376 -2752
RPI zc swap notionals (in

£’m) to delta hedge
£1million LPI[0,5] liability 33
17
Slide 33

6/9/2010
Simple LPI model: pros and cons
+ recovers RPI and main LPI swap rates and allows alternative
strikes, maturities and RPI reference dates to be priced quickly
+ risk to the model parameters (the greeks) is quick and simple
+ effects on LPI swap rates and greeks of RPI swap scenarios or
curve moves are readily explored
- is not a true model, recovers RPI zc swap rates but does not
recover market prices of y/y and index options
- does not price other types of LPI swaps or other inflation
derivatives

34
RPI vs LPI[0,5] swap market rates
4.50% 0.15%
30y RPI zc swap rate (LHS)
30y LPI zc spread to RPI swap (RHS)
zc RPII swap rate / LPI spread
4.25% 0.10%
4.00% 0.05%
3.75% 0.00%
3.50% -0.05%
3.25% -0.10%
Source:
3.00% -0.15% RBS
Oct 09 Nov 09 Jan 10 Mar 10 May 10
trade date
35
18
Slide 35
Slide 36

6/9/2010
Conclusion and discussion
• The implied RPI volatility smile is an important feature of the

inflation options market. The skew towards expensive
fl
floors/cheaper
/ h caps iis extreme
t as a resultlt off lack
l k off natural
t l
supply of floors
• LPI models proposed in literature have had far more general
applicability, but have not emphasised the effect of the smile
• The simple type-4 LPI model presented may assist with
“interpolating”
p g values for LPI liabilities, calculation delta and
vega risks and understanding dealer execution charges for
these greeks.

36
Questions or comments?
Expressions of individual views by

members of The Actuarial Profession
and its staff are encouraged.
The views expressed in this presentation
are those of the presenter.

37
19
6/9/2010
References
LPI
WlLKIE, A.D. (1988). The use of option pricing theory for valuing benefits with cap and collar guarantees.
Transactions of the 23rd International Congress of Actuaries.
BEZOOYEN, J.T.S., EXLEY, C.J. and SMITH, A.D. (1997). A market-based approach to valuing LPI liabilities.
Paper presented to the Joint Institute and Faculty of Actuaries Investment Conference.
OPTION PRICING MODELS

BLACK, F. and SCHOLES, M. (1973). The Pricing of Options and Corporate Liabilities. Journal of Political
Economy 81, 637-659.
BACHELIER, L. (1900). Théorie de la spéculation, Annales Scientifiques de l’École Normale Supérieure.
VOLATILTY MODELS
DUPIRE, B. (1994). Pricing With a Smile. Risk 7(1), 18-20.
DERMAN, E. and KANI I. (1994). Riding on a Smile. Risk 7(2), 32-39.
HESTON, S. (1993). A Closed-Form Solution for Options with Stochastic Volatility with Application to Bond and
Currency Options. Review of Financial Studies 6(2), 327-343.

38
References
VOLATILTY MODELS cont.

MADAN, D.,
MADAN D CARR,
CARR P.
P and CHANG,
CHANG E.
E (1998).
(1998) The Variance Gamma Process and Option Pricing
Pricing, European
Finance Review 2, 79-105.
MADAN, D. and MILNE, F. (1991). Option Pricing with V.G. Martingale Components, Mathematical Finance 1 (4),
39-55.
MADAN, D. and SENETA, E. (1990). The Variance Gamma (V.G.) Model for Share Market Returns, Journal of
Business 63(4), 511-524.
BARNDORFF-NIELSEN, O. (1997). Normal Inverse Gaussian Distributions and Stochastic Volatility Modelling,
Scandinavian Journal of Statistics 24(1), 1-13.
HAGAN, P., KUMAR D., LESNIEWSKI A. and WOODWARD R. (2002). Managing Smile Risk, Wilmott
September 84-108.
September, 84 108

39
20

Greenwood PDF

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Greenwood PDF

Uploaded by

Copyright:

Available Formats

6/9/2010

Risk and Investment Conference 2010

© 2010 The Actuarial Profession  www.actuaries.org.uk

LPI, Limited Price Indexation, is the RPI link in pensions

For 0% floors, Type 1 < Type 2 < Type 3 < Type 4

© 2010 The Actuarial Profession  www.actuaries.org.uk

Illustration of types of LPI

t (Type 1) y/y% indext pension increase pension increase pension increase

0 100.00 100.00 100.00 100.00 100.00

2 103.53 2.5% 100.00 103.53 2.5% 103.53 2.5% 103.53 2.5%

3 99.90 -3.5% 100.00 100.00 -3.4% 103.53 0.0% 103.53 0.0%

4 98.90 -1.0% 100.00 100.00 0.0% 103.53 0.0% 103.53 0.0%

The UK inflation options market

• The building blocks of the RPI derivatives market are zero

© 2010 The Actuarial Profession  www.actuaries.org.uk

The UK inflation options market

© 2010 The Actuarial Profession  www.actuaries.org.uk

Inflation options screens

The implied inflation volatility smile

• Inflation options trade on price, not volatility

© 2010 The Actuarial Profession  www.actuaries.org.uk

Implied RPI index volatility smile

15.0% 20y RPI index option vol smile

© 2010 The Actuarial Profession  www.actuaries.org.uk

The inflation implied volatility smile: y/y options

See VBA code in the spreadsheet on the conference website.

The RPI y/y inflation options market

GBP RPI y/y normal vol

The RPI y/y inflation options market

Modelling the implied volatility smile

• Historically, the implied volatility smile first appeared in

© 2010 The Actuarial Profession  www.actuaries.org.uk

Volatility smiles - alternate stochastic process

• The presence of a smile may interpreted as a deviation

• Both processes allow a monotonically downward sloping

© 2010 The Actuarial Profession  www.actuaries.org.uk

Volatility smiles – local volatility models

• Volatility is a function of the underlying itself, hence

© 2010 The Actuarial Profession  www.actuaries.org.uk

Stochastic volatility models

• The underlying and its volatility are driven by correlated

• Semi-analytical option prices may be found via Fourier

where P(t,T) is the T-maturity discount bond and P1 and P2 are

© 2010 The Actuarial Profession  www.actuaries.org.uk

• General class of processes with independent and stationary

© 2010 The Actuarial Profession  www.actuaries.org.uk

Lévy processes that have become popular in finance include:

© 2010 The Actuarial Profession  www.actuaries.org.uk

SABR (Stochastic Alpha Beta Rho) model

• This stochastic volatility model is the market standard for fitting

where dW t1 dW t 2   dt and ,  are constants such that 0    1

© 2010 The Actuarial Profession  www.actuaries.org.uk

SABR (Stochastic Alpha Beta Rho) model

© 2010 The Actuarial Profession  www.actuaries.org.uk

SABR Normal model

where dW t1 dW t 2   dt and  is constant such that   0 .

Weaknesses of the SABR model

• These analytic approximations are derived via singular

SABR model: negative probabilities

Simple LPI model: RPI y/y history and forward rates

historical rate market forward rate

© 2010 The Actuarial Profession  www.actuaries.org.uk

SABR normal volatility smiles: effect of parameters