Interest rate derivatives in the negative-rate environment
Pricing with a shift
In recent times the ECB and other central banks have set their key lending rate to the negative domain. This is an exceptional measure designed to stir the economy. However, this brings in a significant stir into the valuations of even simple financial derivatives. Traditional models (such as the Black model) break down if the market forward rate or the strike of the option are negative.
This article describes a valuation methodology for pricing simple vanilla interest-rate derivatives in the current negative-rate environment.
To do this, a shift is introduced in the SABR model which can then be used to extract a volatility in the negative strike domain.
Various advantages of this method are being discussed and some snapshots of the Deloitte valuation tool are presented.