SABR volatility model

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In mathematical finance, the SABR model is a stochastic volatility model, which attempts to capture the volatility smile in derivatives markets. The name stands for "stochastic alpha, beta, rho", referring to the parameters of the model. The SABR model is widely used by practitioners in the financial industry, especially in the interest rate derivative markets. It was developed by Patrick S. Hagan, Deep Kumar, Andrew Lesniewski, and Diana Woodward.


The SABR model describes a single forward F, such as a LIBOR forward rate, a forward swap rate, or a forward stock price. The volatility of the forward F is described by a parameter \sigma. SABR is a dynamic model in which both F and \sigma are represented by stochastic state variables whose time evolution is given by the following system of stochastic differential equations:

dF_t=\sigma_t F^\beta_t\, dW_t,
d\sigma_t=\alpha\sigma^{}_t\, dZ_t,

with the prescribed time zero (currently observed) values F_0 and \sigma_0. Here, W_t and Z_t are two correlated Wiener processes with correlation coefficient -1<\rho<1:

dW_t dZ_t = \rho dt

The constant parameters \beta,\;\alpha satisfy the conditions 0\leq\beta\leq 1,\;\alpha\geq 0.

The above dynamics is a stochastic version of the CEV model with the skewness parameter \beta: in fact, it reduces to the CEV model if \alpha=0 The parameter \alpha is often referred to as the volvol, and its meaning is that of the lognormal volatility of the volatility parameter \sigma.

Asymptotic solution[edit]

We consider a European option (say, a call) on the forward F struck at K, which expires T years from now. The value of this option is equal to the suitably discounted expected value of the payoff \max\left(F_T-K,\;0\right) under the probability distribution of the process F_t.

Except for the special cases of \beta=0 and \beta=1, no closed form expression for this probability distribution is known. The general case can be solved approximately by means of an asymptotic expansion in the parameter \varepsilon=T\alpha^2. Under typical market conditions, this parameter is small and the approximate solution is actually quite accurate. Also significantly, this solution has a rather simple functional form, is very easy to implement in computer code, and lends itself well to risk management of large portfolios of options in real time.

It is convenient to express the solution in terms of the implied volatility of the option. Namely, we force the SABR model price of the option into the form of the Black model valuation formula. Then the implied volatility, which is the value of the lognormal volatility parameter in Black's model that forces it to match the SABR price, is approximately given by:

\left\{1+\left[\frac{2\gamma_2-\gamma_1^2+1/F_{\text{mid}}^2}{24}\;\left(\frac{\sigma_0 C\left(F_{\text{mid}}\right)}{\alpha}\right)^2+\frac{\rho\gamma_1}{4}\;\frac{\sigma_0 C\left(F_{\text{mid}}\right)}{\alpha}+\frac{2-3\rho^2}{24}

where, for clarity, we have set C\left(F\right)=F^\beta. The value F_{\text{mid}} denotes a conveniently chosen midpoint between F_0 and K (such as the geometric average \sqrt{F_0 K} or the arithmetic average \left(F_0+K\right)/2). We have also set





The function D\left(\zeta\right) entering the formula above is given by


Alternatively, one can express the SABR price in terms of the normal Black's model. Then the implied normal volatility can be asymptotically computed by means of the following expression:

\left\{1+\left[\frac{2\gamma_2-\gamma_1^2}{24}\;\left(\frac{\sigma_0 C\left(F_{\text{mid}}\right)}{\alpha}\right)^2+\frac{\rho\gamma_1}{4}\;\frac{\sigma_0 C\left(F_{\text{mid}}\right)}{\alpha}+\frac{2-3\rho^2}{24}

It is worth noting that the normal SABR implied volatility is generally somewhat more accurate than the lognormal implied volatility.

SABR for the negative rates[edit]

The SABR model can be modified to cover also Negative interest rate:

dF_t=\sigma_t |F_t|^\beta\, dW_t,
d\sigma_t=\alpha\sigma_t\, dZ_t,

for 0\leq\beta\leq 1/2 and a free boundary condition for F=0. Its exact solution for the zero correlation as well as an efficient approximation for a general case are available.[1]

Another SABR model extension for negative rates that gained popularity in the recent years is the shifted SABR model, where shifted forward rate is assumed to follow a SABR process

dF_t=\sigma_t (F_t+s)^\beta\, dW_t,
d\sigma_t=\alpha\sigma_t\, dZ_t,

for some positive shift s. An obvious drawback of this approach is the a priori selection of the shift, and the resulting possibility of needing to adjust this shift further once the rates go still more negative.

See also[edit]


  1. ^ Antonov, Alexandre and Konikov, Michael and Spector, Michael, The Free Boundary SABR: Natural Extension to Negative Rates (January 28, 2015). Available at SSRN: