Negative Rates: An Unorthodox Experiment
PRMIA and FINCAD recently co-hosted an event in New York City focused on the growing global trend towards negative interest rates as an unconventional means of sparking economic growth. The seminar was titled, “Negative Rates: Dealing with an Unorthodox Experiment,” and was led by Russell Goyder PhD, Director of Quantitative Research and Development, FINCAD.
The event offered a great opportunity to hear perspectives from various senior financial professionals regarding how negative rates are impacting their firms.
Despite the fact that negative rates are seemingly a counterintuitive concept, they are increasingly becoming the new normal. Needless to say, this reality has introduced serious challenges for many financial institutions around the globe. In the presentation, Russell explained that the process of pricing and risk managing derivatives and bonds has become more complex since most firms’ models and systems have been designed to assume non-negative rate dynamics. These assumptions can be hard-coded into legacy technology, or worse, many models make a fundamental assumption of positive rates. Therefore fixing them has been very tedious for many firms.
Russell went on to explain that the challenges associated with modeling negative interest rates are felt most acutely in the world of swaptions. In modeling swaptions, SABR is the model of choice. Unfortunately, traditional SABR does not admit negative rates, so most of the industry has moved to a shifted SABR model. This is a pragmatic approach at many firms because of minimal implementation effort and the shift is included as part of the quote. Alternative forms of the SABR model have also been developed, but Russell showed that the ability to accurately capture the market smile does not differentiate them from shifted SABR. As a result, it is unlikely that the performance loss and higher implementation costs of these models will be welcomed by practitioners.
To demonstrate the pain felt by firms when refactoring their systems to adapt to negative rates, Russell outlined the many steps that typical sell-side quant teams have to undergo. One example Russell gave was related to making adjustments for the Vol cube and SABR modeling. Often, firms will have to go through and change their lognormal implied volatility functions in their entire analytics library, one function at a time. This sort of refactoring of code and redevelopment of processes is highly time-intensive, and unnecessary if you are using systems with a modular object-oriented framework.
All in all, adapting to this new world of negative rates continues to be challenging for many institutions, particularly those that are operating with systems and spreadsheets that assume non-negative rates. The best way forward is to adopt sophisticated analytics solutions that can help you weather negative interest rates and other comparable challenges with ease—and without constant recoding of systems.
Such solutions should offer appropriate treatment of all inputs, and flexible curve-building capabilities that not only handle negative rates, but allow any curve to be built from any market instrument—among other advantages necessary to remaining competitive in the current market landscape.
For more information on negative rates, download our ebook: Mastering Negative Rates.