What Can Go Wrong During Caplet Stripping ?

Paper: arXiv 2605.05140

Authors: Fabien Le Floc’h

Abstract

We study exact and near exact extraction of caplet volatilities from market cap quotes and identify why some common choices produce extreme oscillations or negative vols. Interpolation scheme and node placement are shown to be the primary drivers of instability, which can be amplified by isolated bad quotes. We propose practical, production ready remedies: continuous flat-linear and C1 flat-smooth kernels that preserve bootstrap equivalence, midpoint node placement with a global solver, positivity enforcement via an exponential reparametrization or Hyman non-negative C1 splines. We also introduce simple data quality checks. Numerical experiments demonstrate substantially reduced oscillations, robust positive caplet curves, and negligible repricing error, delivering a fast and stable caplet stripping workflow suitable for real-world use.

Complexity vs Empirical Score

• Math Complexity: 4.5/10
• Empirical Rigor: 8.0/10
• Quadrant: Street Traders — practical and empirical, lighter on theory

Why this score: The paper focuses on solving practical production-grade challenges in financial engineering using interpolation kernels and numerical optimization with a strong emphasis on implementation, data quality, and stability. While it includes necessary mathematical definitions and formal properties, the primary value is in the robust, backtest-ready algorithmic improvements for daily trading workflows.

Research Flowchart

  flowchart TD
    A[<b>Goal:</b> Stable/Accurate Caplet Stripping] --> B[<b>Data:</b> Market Cap Quotes]
    B --> C[<b>Process:</b> Core Bootstrapping & Kernel Analysis]
    C --> D[<b>Problem:</b> Identify Instability (Oscillations/Negative Vols)]
    D --> E[<b>Solutions:</b> Flat-Smooth Kernels, Midpoint Nodes, Hyman Splines]
    E --> F[<b>Outcomes:</b> Robust/Positive Curves & Minimal Repricing Error]

Cited References (13)

1. Eight ways to strip your caplets: An introduction to caplet stripping (2014)
2. Interest rates benchmark reform and options markets (2020)
3. Benchmark reform goes non-linear (2020)
4. Numerical optimization (2006)
5. Nonnegativity-, monotonicity-, or convexity-preserving cubic and quintic Hermite interpolation (1989)
6. Typo in Hyman non-negative constraint - 28 years later (2017)
7. Detecting outliers: Do not use standard deviation around the mean, use absolute deviation around the median (2013)
8. Volume 16: how to detect and handle outliers, The ASQC basic references in quality control: statistical techniques, Edward F. Mykytka (1993)

0 of 13 cited works are in the corpus; resolved via arXiv source bundles, Semantic Scholar and OpenAlex. Corpus-wide: 2518 linked papers.