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Diagnosing a Euro Floor Volatility and Forward Curve Mismatch

Article Quant Q&A · Author: hariboy13
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Summary

The document describes a curve-building problem encountered while trying to infer implied volatility for a short-maturity Euro floor. The floor price covers the remaining unfixed floorlets, but for some strikes the market quote is below the model price even when volatility is set to zero. The author suspects that the EURIBOR three-month forward curve is too low and asks whether futures-to-FRA conversion, swaps, interpolation, smoothing, or OIS discounting could explain the mismatch.

The curve is assembled from cash instruments, short-dated futures converted to FRAs, and swaps at longer maturities. The text supplies no answer or resolution, so it does not establish which construction choice is responsible. It illustrates a practical calibration diagnostic: when a quoted option price lies below the model’s zero-volatility value, review the underlying curve inputs, discounting, conventions, and instrument treatment before attempting to solve for implied volatility.

Key ideas

  • An implied volatility may fail to exist when the model price at zero volatility already exceeds the market quote.
  • The example involves a Euro floor priced from its remaining unfixed floorlets.
  • The author builds a EURIBOR forward curve from cash instruments, futures converted to FRAs, and swaps.
  • Potential sources of mismatch include curve construction, interpolation, smoothing, and discounting choices.
  • The document raises these questions but provides no diagnosis or confirmed solution.

Tags

Fixed incomeOptionsDerivatives pricing
Full text
# forward curve and cap/floors in nowadays environment


# forward curve and cap/floors in nowadays environment












I'm currently trying to get the implied volatility of a vanilla Euro floor with maturity 1Y with data from bloom.

I have the price ( which is not supposed to take into account the first floorlet which has already fixed, but takes into account only the three remaining optional floorlet.) of the floor and all the convetions which are supposed to be correct ( Act/360, floor starting 2 open days after fixing, etc...). I manage to get this implied volatility for somes strikes and even for all strikes some day, but quite often I have floors with strike ( say 4%) that I cannot get the implied vol from.

It turns out actually that my forward rates are too low and so I get a floor too high for the quoted price. Even a zero volatility get me a price above the market quote. I also price the same floorlet in Bloom and get a price above the market quote even for zero vol. So the problem I think lies in my EUR3M forward curve.The worst thing is that I was not even using EONIA curve for discounting my floorlet coupon so actually I should be even further from the quoted price.

I construct my forward curve, with cash ( euribor 3M), futures with 3M maturity ( that I turn into FRA) up to maturity 2 years and then swaps. This is the way Bloom is doing. A priori OIS should not impact in this case my curve for maturity below 2 years. So I'm wondering wha'ts wrong with my forward curve? Should I remove the futures and keep only swaps? Is it the interpolation of rates? Should I smoothe my curve? Should I use in some ways EONIA below 2y for boostrapping? Thank you for your help

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.