Tuning the FMMSABR for RFR caplets

Tuning the FMMSABR for RFR caplets

• Author
• Marcelo Taipe
• Abstract

• We review the extension to the Forward-Market-Model proposed by Willems (2020) to accommodate backward and forward-looking caplets within the same model. While theoretically intuitive, this extension offers very limited flexibility when calibrated to market data. We find that the backward and forward-looking smiles must share the same skew parameter. Moreover, the level and curvature parameters are only allowed to move in the same scale and direction by a bounded amount determined by the maturity. To address these limitations, we define new effective parameters by revisiting the SABR model with time dependent coefficients of Hagan et al. (2018). These new parameters allow the model to incorporate both kinds of caplets with less restrictions.

• Keywords
• RFR, SABR, IBOR Replacement, Interest Rate Cap Floor
• Subject Area
• Asset pricing, investments, and Derivatives

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