Alternative Swaption Price Modeling for Low Rate Environments

Abstract

In the wake of the 2007-09 financial crisis, aggressive conventional and unconventional expansionary monetary policies implemented by central banks around the world resulted in an era of low interest rates that lasted several years, and in some cases interest rates fell below zero. The impact that sustained levels of low interest rates have on swaption pricing is not well documented, though research suggests that alternative swaption pricing models might be better equipped to handle pricing in times of extremely low rates. This thesis seeks to analyze an alternative swaption pricing model (the jump-diffusion model) and compare it to a traditional model (the Black-76 model) within the context of low interest rate environments, and examine how pricing discrepancies change as we vary the interest rate environment. Ultimately, we observe that as we lower rates we increase the output of the jump-diffusion model relative to the Black-76 model.