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FTBB_MD_VOLA_COMPUTE - Define Interpolation of Volatilities

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In this IMG activity, you enter coding for the interpolation of volatilities when volatilities are read from the volatility database. A business add-in (BAdI) is provided for you to add your own coding.

The BAdI interface is the interface that is used in the central volatilities database for the interpolation of volatilities (volatilities with moneyness). The volatilities are stored there in terms of the residual maturity of options, residual maturity of underlyings, and moneyness. When the NPV is calculated for a transaction, the price calculator sends a query about the volatility of this transaction to the volatilities database. The volatilities database does not usually contain complete data about the volatility of a transaction because data is not supplied from the market for all combinations of the parameters given above. Therefore, for certain combinations of these parameters, the system derives the volatility from the values that do exist. The BAdI enables you to define how the existing values are interpolated.

Values for volatility are interpolated particularly in the case of option valuation. The nearest neighborhood search, which is the standard setting, uses non-constant interpolation of volatility values. If you use the BAdI, you can define your own interpolation, which interpolates the volatility values in a constant way. This may be a better method for value-at-risk evaluations using the delta or delta/gamma method.

Notes:

• In the interpolation process, the system uses only the values for volatility delivered with the market data, and not values that were interpolated values themselves.

• Once the system has found the volatility value required, it saves this value in a buffer table. The next time a query with the same parameter values is sent for this value, the system does not start interpolation again. Instead, it reads the value from the buffer table.

• Note that your BAdI implementation will affect the performance of the system. Under certain circumstances, values for volatility are interpolated for multiple transactions in each valuation.

If you do not store your own BAdI implementation, then the system uses the nearest neighborhood search method. In this method, the system chooses a volatility value from the volatilities database. This value is the closest match for the combination of parameter values that were transferred. The distance between two points in what is known as the volatility data cube is calculated as follows: The relative deviation is determined for each dimension. For the residual maturity of the option, or the residual maturity of the underlying, this is the difference in days divided by the value that was transferred for the respective residual maturity. The total distance is the total of the moneyness and the relative deviations of both residual maturities. For the combination of parameters that the system is looking for, the program calculates this distance for each point within the volatility data cube. It then takes the volatility of the nearest neighbor as the interpolated value.

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