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Against rising rates

YASN provides transparency by extracting and isolating all of the component options of a struc­tured note: caps, floors, ranges and the embedded Bermudan calls.

 

Caps, which can be used to hedge against rising rates, are essentially a series of Euro­pean call options, called caplets that grant the right but not the obligation to pay a specified interest rate on a sequence of dates.

 

Similarly, floors are a series of put options that grant the right to receive a speci­fied rate. European options, the simplest type, can be exercised at maturity, while American options can be exercised at any time through expiration. Bermudans lie between the two and can be exercised on a series of specified dates.

Against rising rates

Simple structures, such as capped and floored floaters and range accruals on a sin­gle index, can be decom­posed into a portfolio of caps and floors. Since valuation of such structures is thus fundamentally determined by levels of interest rates and implied volatilities, it’s crucial to have accurate rate and volatility quotes.

 

Taking into account the volatility skew, the differences in implied volatility across various strike prices, is also key.

 

Models that are globally cali­brated to station volatilities will typically exhibit substantial calibration error through most volatility, thus mispricing such structures. (Calibration is It method for adjusting the parameters of a model to fit market data, such as volatility quotes for stations, which are options on interest-rate swaps.)

 

To correctly appraise option premiums that make up simple structures, YASN calibrates to option prices extracted from Bloomberg’s proprietaryvola­tffity cube, which you can view or customize by typing CUB <Go>.

 

The Interest Rate Volatili­ty Cube function uses market-standard mathematical models, such as the SABR model, to interpolate and extrapolate from market quotes of caps, floors and stations to the prices of arbitrary European options on interest rates.