Podcast: Antonov on pricing not-so-vanilla rates products

New model makes it easier to coherently price correlated derivatives

Contracts written on the same underlying need to be priced in a consistent manner to avoid arbitrage. That’s easier said than done when dealing with semi-exotic products, such as spread options and mid-curve swaptions, as Alexandre Antonov, chief quant analyst at Danske Bank, explains in this episode of Quantcast.

The payoff on spread options depends on the difference between two rates, while mid-curve swaptions confer the right to enter an interest rate swap at a future date. These instruments are based on the same rate distribution and they are both sensitive to the volatility of the yield curve. “[So] it’s important to model them in a coherent way [and to] have their two marginal distributions linked in the most rigorous mathematical way,” says Antonov.

Quantcast – a Risk.net Cutting Edge podcast · Alexandre Antonov – 21/10/21

In his paper, Black basket analytics for mid-curves and spread options, Antonov proposes a solution to this problem using the so-called Black basket, a sum of log-normal processes.

The standard approach to determining the correlation of two rates is to use Gaussian copulas, which offer limited flexibility and can be difficult to calibrate. But when both the rates underlying mid-curve swaptions and spread options are represented as Black baskets, their correlation can be derived from the correlations between the components of the two Black baskets. This approach offers flexibility and makes it easier to calibrate market prices more precisely.

Antonov describes the performance of the model, the ease with which it can be calibrated and the stable parameters it produces. And he explains how this approach could be used to price the whole term structure – an exercise that could become particularly important in the near future if high inflation pushes up rates.

Antonov also discusses his current research projects – including a collaboration with Vladimir Piterbarg, head of quantitative analytics at NatWest Markets – and his ambitious plans to devise an explainable alternative to neural networks.

Index:

00:00 Introduction to pricing semi-exotics

02:20 Spread options and mid-curve swaptions.

05:55 The need for a joint distribution

07:55 The Black basket

10:25 Standard solutions

11:40 How do black baskets work?

12:55 Model performance

18:00 Term-structure models and other applications

22:16 Current research projects

To hear the full interview, listen in the player above, or download. Future podcasts in our Quantcast series will be uploaded to Risk.net. You can also visit the main page here to access all tracks, or go to the iTunes store or Google Podcasts to listen and subscribe.

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