Validation of RFR Bermuda Swaption Priced with Hull-White model
(2024) In Master's Theses in Mathematical Sciences FMSM01 20231Mathematical Statistics
- Abstract
- The transition from InterBank Offered Rates (IBORs) to Risk-Free Rates (RFRs) represents one of the most significant shifts in modern financial markets. This transition addresses concerns about the reliability and transparency of IBORs by adopting benchmarks based on actual market transactions. However, this change has far-reaching implications for the valuation of complex financial instruments, such as Bermuda swaptions, which allow multiple exercise opportunities over time.
This thesis evaluates the performance of the Hull-White model, a widely used short-rate model, in pricing Bermuda swaptions under the new RFR framework. The research systematically validates the model’s assumptions, calibration techniques, and pricing accuracy... (More) - The transition from InterBank Offered Rates (IBORs) to Risk-Free Rates (RFRs) represents one of the most significant shifts in modern financial markets. This transition addresses concerns about the reliability and transparency of IBORs by adopting benchmarks based on actual market transactions. However, this change has far-reaching implications for the valuation of complex financial instruments, such as Bermuda swaptions, which allow multiple exercise opportunities over time.
This thesis evaluates the performance of the Hull-White model, a widely used short-rate model, in pricing Bermuda swaptions under the new RFR framework. The research systematically validates the model’s assumptions, calibration techniques, and pricing accuracy using both historical market data and synthetic scenarios. The analysis includes the adaptation of the model’s partial differential equation (PDE) framework to account for the unique characteristics of RFRs, such as daily compounding and the absence of a fixed fixing date.
Key findings indicate that the Hull-White model can be successfully adapted to the RFR framework, providing robust pricing and calibration results. This validation ensures that financial institutions can rely on the model to manage risks and price derivatives effectively in the post-IBOR era. Additionally, the study highlights the impact of parameters such as mean reversion and volatility on pricing dynamics, offering practical insights for industry application.
This work contributes to the ongoing development of reliable financial models during this critical market transition, supporting transparency and stability in global financial systems. (Less) - Popular Abstract
- Imagine a world where the tools used to calculate the cost of loans or the price of a financial safety net suddenly become unreliable. This was the reality the financial world faced when concerns arose about traditional interest rate benchmarks like LIBOR (London InterBank Offered Rate). LIBOR, which underpinned everything from personal loans to complex financial contracts, was found to be opaque and prone to manipulation. In response, a new generation of benchmarks called Risk-Free Rates (RFRs), based on actual market transactions, was introduced, revolutionizing financial markets globally.
This transition affected not only basic loans but also highly specialized financial products like Bermuda swaptions—options that give investors... (More) - Imagine a world where the tools used to calculate the cost of loans or the price of a financial safety net suddenly become unreliable. This was the reality the financial world faced when concerns arose about traditional interest rate benchmarks like LIBOR (London InterBank Offered Rate). LIBOR, which underpinned everything from personal loans to complex financial contracts, was found to be opaque and prone to manipulation. In response, a new generation of benchmarks called Risk-Free Rates (RFRs), based on actual market transactions, was introduced, revolutionizing financial markets globally.
This transition affected not only basic loans but also highly specialized financial products like Bermuda swaptions—options that give investors flexible opportunities to manage their interest rate exposure. These options, which allow for multiple decision points, require sophisticated models to determine their fair price.
My thesis investigates whether one such model, the Hull-White model, can adapt to the demands of this new financial landscape. This model has been a workhorse for pricing complex products by simulating how interest rates might behave in the future. However, its assumptions and calculations needed rigorous testing to ensure they remain accurate with the shift to RFRs.
By comparing the Hull-White model's predictions against historical data and subjecting it to stress tests, I was able to validate its reliability. Through this research, I refined the model to work seamlessly with RFRs, providing financial institutions with a trustworthy tool to navigate these major changes.
Transitioning to RFRs promises greater transparency and fairness in financial markets. Ensuring that the tools used to price contracts remain accurate is crucial for investor confidence and the global economy's stability. This work not only supports this transition but also sets the stage for more robust financial modeling in a constantly evolving market. (Less)
Please use this url to cite or link to this publication:
http://lup.lub.lu.se/student-papers/record/9178044
- author
- Fouville, Fabien LU
- supervisor
- organization
- course
- FMSM01 20231
- year
- 2024
- type
- H2 - Master's Degree (Two Years)
- subject
- keywords
- Hull White, Risk Free Rates (RFR), LIBOR, Bermuda swaption, PDE, Calibration, Model Validation
- publication/series
- Master's Theses in Mathematical Sciences
- report number
- LUTFMS-3507-2024
- ISSN
- 1404-6342
- other publication id
- 2024:E75
- language
- English
- id
- 9178044
- date added to LUP
- 2024-11-19 12:36:34
- date last changed
- 2024-11-22 14:31:47
@misc{9178044,
abstract = {{The transition from InterBank Offered Rates (IBORs) to Risk-Free Rates (RFRs) represents one of the most significant shifts in modern financial markets. This transition addresses concerns about the reliability and transparency of IBORs by adopting benchmarks based on actual market transactions. However, this change has far-reaching implications for the valuation of complex financial instruments, such as Bermuda swaptions, which allow multiple exercise opportunities over time.
This thesis evaluates the performance of the Hull-White model, a widely used short-rate model, in pricing Bermuda swaptions under the new RFR framework. The research systematically validates the model’s assumptions, calibration techniques, and pricing accuracy using both historical market data and synthetic scenarios. The analysis includes the adaptation of the model’s partial differential equation (PDE) framework to account for the unique characteristics of RFRs, such as daily compounding and the absence of a fixed fixing date.
Key findings indicate that the Hull-White model can be successfully adapted to the RFR framework, providing robust pricing and calibration results. This validation ensures that financial institutions can rely on the model to manage risks and price derivatives effectively in the post-IBOR era. Additionally, the study highlights the impact of parameters such as mean reversion and volatility on pricing dynamics, offering practical insights for industry application.
This work contributes to the ongoing development of reliable financial models during this critical market transition, supporting transparency and stability in global financial systems.}},
author = {{Fouville, Fabien}},
issn = {{1404-6342}},
language = {{eng}},
note = {{Student Paper}},
series = {{Master's Theses in Mathematical Sciences}},
title = {{Validation of RFR Bermuda Swaption Priced with Hull-White model}},
year = {{2024}},
}