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Abstract substantial when only delta is hedged. In the SABR model, one usually specifies the

CEV exponent β and then selects the correlation parameter ρ to match the volatility

In this note we take a fresh look at the delta and vega risks within the SABR stochastic

skew. The delta risk (as specified in the original SABR paper) then depends on the β

volatility model Hagan et al. (2002). These risks can be hedged more precisely by

chosen. With the new term, the delta risk is much less sensitive to the particular value

adding new terms to the formulas contained in the original SABR paper. The effect of

of β , and depends mainly on the slope of the implied volatility curve.

these new terms is minimized when one hedges both vega risks and delta risks, but are

derived in Hagan (2002). Note that the implied volatility depends not

1 Introduction only on the strike K , but also on the forward f , the “SABR vol” α , and the

The SABR model Hagan et al. (2002) is given by the system of stochastic time-to-expiry T .

differential equations: Now in the SABR model, the underlying forward rate f rate is corre-

lated with the SABR vol α . Thus, whenever the forward rate f changes,

β

dft = αt ft dW t1 , the vol α also changes, at least on average. Accounting for this average

(1) change in α caused by movements in the forward f leads to a new term

dαt = ναt dW t2 ,

in the formula for the delta risk, a term not contained in the original

with the initial condition: SABR paper. One can hedge delta more precisely by adding this term into

the delta risk.

f0 = f , In this note we derive the new delta risk and show that:

(2) A) The effect of the new term is minimal when one hedges both vega risks

α0 = α.

and delta risks, but can be substantial when only delta is hedged.

B) Suppose one specifies β and then selects ρ to match the observed

The state variable ft represents a forward rate (say, a LIBOR forward, a for-

volatility skew. (This is the usual method for fitting the SABR model to

ward swap rate, or a forward yield on a bond), and αt , the “SABR vol” is a

market data). The delta risk (as specified in the original SABR paper)

volatility parameter. The movements in the underlying forward rate are

then depends on the β chosen. With the new term, the delta risk is less

correlated with the movements in the underlying volatility:

sensitive to the β chosen, depending mainly on the slope of the implied

vol curve.

E dW t1 dW t2 = ρdt. (3)

A martingale measure appropriate for the problem at hand is implicitly 2 Original Risk Formulas

assumed.

Consider an option on the forward rate f struck at K and expiring T In the original SABR paper, the delta hedge was calculated by shifting

years from now. It was shown in Hagan (2002) that the value of this op- the current value of the underlying while keeping the current value of α

tion under SABR is given by the modified Black formula: fixed:

V = B (f , K, σ (K; f , α, T) , T) . (4) f → f + f ,

(5)

α → α.

Here, B (f , K, σ, T) is the usual Black valuation formula for vanilla op-

tions. The implied volatility σB (K; f , α, T) is given by the SABR formula This scenario leads to the change in the option value

2 Wilmott magazine

TECHNICAL ARTICLE 1

∂B ∂B ∂σ ∂B ∂B ∂σ ∂σ ρν

V = + f , = + + . (14)

∂f ∂σ ∂f ∂f ∂σ ∂f ∂α f β

and thus the option delta is given by: This risk incorporates the average change in volatility caused by changes

in the underlying. Hedging this risk should be more effective than hedg-

∂B ∂B ∂σ ing the classic SABR delta risk.

= + . (6)

∂f ∂σ ∂f The new term in the delta risk,

The first term on the right hand side in the formula above is the original ∂B ∂σ ρν

, (15)

Black delta, and the second accounts for the systematic change in the im- ∂σ ∂α f β

plied volatility as the underlying changes.

Similarly, the vega risk was calculated from is just ρν/f β times the classic SABR vega risk. In a vega-hedged portfolio

this term is zero, so if the (classic) vega risk and delta risk are both hedged,

f → f, then the new delta risk is also hedged.

(7)

α → α + α, Let us now turn to the vega risk. We argue, as we did in the case of

delta, that the vega risk should be calculated from the scenario:

to be

f → f + δα f ,

∂B ∂σ (16)

= . (8) α → α + α,

∂σ ∂α

where δα f is the average change in f caused by the change in SABR vol. We

Formulas (6) and (8) are the classic SABR greeks. In the next section

find readily that

we derive modified SABR greeks which make a better use of the model

dynamics. ρf β

δα f = α. (!7)

ν

3 New Risk Formulas and thus the change in the option value is

Since α and f are correlated, whenever f changes, on average α changes as

well. A delta scenario which is more realistic than (5) is thus ∂B ∂σ ∂σ ρf β

V = + α. (18)

∂σ ∂α ∂f ν

f → f + f ,

(9)

α → α + δ f α. Hedging out the vega risk means constructing portfolios where the net

Here δ f α is the average change in α caused by the change in the underly- ∂B ∂σ ∂σ ρf β

ing forward. In order to calculate δ f α , we write the SABR dynamics in

= + (19)

∂σ ∂α ∂f ν

terms of independent Brownian motions Wt and Zt 1:

summed over all deals is zero. This is the new vega hedge which replaces

dft =

β

αt ft dW t , the classic SABR vega.

(10)

dαt = ναt ρdW t + 1 − ρ 2 dZt .

This implies that 4 Example

Figures 1-4 analyze the market data for the 3M into 10Y Euro swaptions

ρν

dαt = β

dft + ναt 1 − ρ 2 dZt . (11) on January 23, 2006. The relatively short tenor (3M) has been chosen so

ft that the implied volatilities exhibit a substantial smile. The 10Y tenor has

In other words, the time evolution of αt can be decomposed into two in- been chosen due to its liquidity. To obtain these figures, we first selected

dependent components: one due to the change of ft and one due to the β and then fitted the remaining SABR parameters (α , ρ , and ν ) to the mar-

idiosyncratic change in αt . The average change in α due to a change in the ket’s implied volatility curve. Shown are the results for β = 0.0, 0.25,

forward is therefore given by 0.50, 0.75, and 1.0.

ρν Figure 1 shows the theoretical volatilities σ (K) obtained from the

δf α = f . (12) market fit. All five curves fit the observed implied volatility reasonably

fβ

well. Figure 2 graphs the time value of the swaptions as a function of

The change in the option value is K for these five curves; the coincidence of these time-values demonstrates

that the differences between the volatility curves σ (K) for different β are

∂B ∂B ∂σ ∂σ ρν

V = + + f , (13) immaterial. We conclude that it is difficult to determine which β should

∂f ∂σ ∂f ∂α f β

be used based solely from fitting the market smile, as reported in the

^

and so the new delta risk is given by original SABR paper Hagan (2002).

Wilmott magazine 3

TECHNICAL ARTICLE 1

SABR vols for different beta hedge relatively insensitive to the particular value of β chosen, especially

near the ATM point.

Vols

Since αf β dW = α/f 1−β fdW , we can interpret α/f 1−β as the “effective

20%

local volatility.” If β < 1, this local volatility changes immediately with

beta = 1 any changes in the forward f . Similarly, if ρ = 0 then on average, the

18% beta = 0 volatility α changes when the f changes. Thus we can interpret figure 4 as

beta = 0 beta = 1 showing that the delta hedges are not overly sensitive to which fraction of

16% the skew/smile is arises from deterministic changes in the local volatility,

2.5% 3.0% 3.5% 4.0% 4.5% 5.0% and which arise from average changes in the local volatility.

Strike

Figure 1: SABR implied volatility smiles fitted to market data Original d sigma / df

(solid dots) for β = 0, 0.25, 0.50, 0.75, and 1. 4 d sigma / df

beta = 1

0

beta = 1

Time values for different beta 2.5% 3.0% 3.5% 4.0% 4.5% 5.0%

beta = 0 -4

12 bps

beta = 0

9 -8

beta = 1 Strike

6

beta = 1 Figure 3: Systematic change in implied vol, ∂σ /∂ f, specified in

3 the original paper for all five β ’s.

beta = 0 beta = 0

0

2.5% 3.0% 3.5% 4.0% 4.5% 5.0%

Strike New d sigma / df

for β = 0, 0.25, 0.50, 0.75, 1.0 coincide to within the width beta = 0

3

of the line. beta = 1

0 beta = 0

2.5% 3.0% 3.5% 4.0% 4.5% 5.0%

-3

beta = 1

Figure 3 shows the ∂σ/∂ f term from the original SABR article. This term

-6

represents the systematic change in the implied vol curve σB (K; f , α, T) due Strike

to changes in the forward f , and leads to the delta risk proposed in the orig-

Figure 4: Proposed replacement, ∂σ /∂ f + ( ρν /f β ) ∂σ/∂ α for

inal SABR paper. This term, and thus the delta risks of the original SABR

the systematic change in implied vol for all five β ’s.

paper, varies substantially depending on which value is chosen for β .

Figure 4 shows our proposed replacement,

FOOTNOTE & REFERENCE

dσ/df = ∂σ/∂ f + ρν/f β ∂σ/∂ α,

for calculating delta risks. The new term accounts for the average change 1. Explicitly, W1t = Wt, W2t = ρ Wt + 1 − ρ 2 Zt .

in α that occurs when f changes. Clearly this new term is about the same

■ Hagan, P., Kumar, D., Lesniewski, A., and Woodward, D.: Managing smile risk, Wilmott

size as the original ∂σ/∂ f , and should not be neglected. In addition, com-

Magazine, September, 84–108 (2002).

paring Figure 3 to Figure 4 shows that this term also makes the delta

4 Wilmott magazine

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