Research In Brief | Negative Rates: The Challenge and the Opportunity
In this research paper, Dr. Ion Mihai, Quantitative Analyst at Numerix, explores how negative interest rates have recently become a critically important issue in finance, as they impact some of the most basic calculations and procedures used by the financial community. Two prominent examples are the quotation of option volatilities and volatility smile interpolation models—both of which we will explore further in this paper.
Clearly, pricing methodologies must continue to adjust to the unchartered waters of the negative rate phenomenon. This paper discusses the challenges that negative rates continue to pose to the financial community and looks at how market practices are in fact evolving and becoming more innovative to address these challenges.
Highlights of the paper include:
- An overview of the Swiss National Bank, European Central Bank, and Danmarks Nationalbank movement to negative rates.
- How negative rates impact some of the most basic calculations and procedures used by the financial community.
- Why negative rates impact the quotation of option volatilities and volatility smile options and the related challenges.
- An exploration of a new range of market practices and solutions to address the challenges presented by the negative rate environment—including two alternatives to the lognormal volatility quotation convention.
- Impact of negative rates on smile interpolation models, such as SABR.
- Basic introduction of the free-boundary SABR model as a natural extension to negative rates.
Author: Dr. Ion Mihai
In this research paper, Dr. Ion Mihai, Quantitative Analyst at Numerix, explores how negative interest rates have recently become a critically important issue in finance, as they impact some of the most basic calculations and procedures used by the financial community. Two prominent examples are the quotation of option volatilities and volatility smile interpolation models—both of which we will explore further in this paper.
Clearly, pricing methodologies must continue to adjust to the unchartered waters of the negative rate phenomenon. This paper discusses the challenges that negative rates continue to pose to the financial community and looks at how market practices are in fact evolving and becoming more innovative to address these challenges.
Highlights of the paper include:
- An overview of the Swiss National Bank, European Central Bank, and Danmarks Nationalbank movement to negative rates.
- How negative rates impact some of the most basic calculations and procedures used by the financial community.
- Why negative rates impact the quotation of option volatilities and volatility smile options and the related challenges.
- An exploration of a new range of market practices and solutions to address the challenges presented by the negative rate environment—including two alternatives to the lognormal volatility quotation convention.
- Impact of negative rates on smile interpolation models, such as SABR.
- Basic introduction of the free-boundary SABR model as a natural extension to negative rates.
Author: Dr. Ion Mihai
Authors
Ion Mihai, PhD
Ion Mihai is a Quantitative Analyst for Numerix. His focus is on developing solutions around CVA, FVA, and Numerix’s CrossAsset Server platform, as well as working with clients and prospects as a pre-sales quant on bespoke solutions and training. He recently co-authored a paper on Funding Value Adjustment with Drs. Alexander Antonov and Marco Bianchetti. Prior to Numerix, Dr. Mihai started his career as a research scientist in Algebraic Geometry at the Weizmann Institute, Israel, following a PhD in Mathematics from the Fourier Institute in Grenoble. After joining the financial software industry, he worked as a quant developer on LMM and other fixed income models, and performed independent valuation for a wide range of derivatives, including: structured rates, short- and long-dated equity exotics, equity baskets and structured credit products.
