The new normal

A common way of quoting a swaption price is referring to its 'implied volatility' rather than the price itself. The implied volatility for the swaption is the volatility parameter required in a benchmark pricing model, which allows for closed-form prices, for the modelled price to replicate the market price of the swaption. The benefit of this method of quotation is that it removes the effect of the parameters not related to volatility that are contributing to the swaption price, such as the underlying yield curve, its strike, maturity, and tenor. Implied-volatility quotation therefore allows for a comparison of swaption prices among all different swaptions and over time. For insurance companies writing interest-rate-related guarantees and options, the swaption implied volatility is a particularly relevant risk factor. Swaption implied volatility is a measure of the market volatility of the interest rate yield curve, which directly affects the costs of these interest rate guarantees and options. Therefore, for both valuation and risk models used to assess the costs of these guarantees and options, insurance companies rely on these quotes. Typically many insurance companies have been using the Black model as a benchmark pricing model to derive the implied volatility quote, which is thus often referred to as Black volatility. The interest rate movements for the euro in the past six to nine months, however, have unveiled a major drawback of the Black volatility quote, which can affect current best practice approaches of insurance companies’ risk and valuation models in a significant way. This white paper analyses and explains the challenges facing the Black model in the current interest rate environment and introduces an alternative model to address them. The paper concludes by demonstrating which parts of insurance companies’ risk and valuation models are affected.