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    Chapter 4: Interest Rate Derivatives: 4.3 Swaptions

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    - Swaptions give the holder the right to enter into a payer or receiver swap at a predetermined strike rate. - Swaptions are classified as at-the-money, in-the-money, or out-of-the-money depending on the relationship between the strike rate and the prevailing swap rate. - Black's model and Bachelier's model provide formulas for pricing payer and receiver swaptions based on the underlying swap rate, strike rate, time to expiration, and a volatility parameter. - Swaption quotes in the market are typically provided in terms of implied Black or normal volatilities.

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    Chapter 4: Interest Rate Derivatives: 4.3 Swaptions

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    - Swaptions give the holder the right to enter into a payer or receiver swap at a predetermined strike rate. - Swaptions are classified as at-the-money, in-the-money, or out-of-the-money depending on the relationship between the strike rate and the prevailing swap rate. - Black's model and Bachelier's model provide formulas for pricing payer and receiver swaptions based on the underlying swap rate, strike rate, time to expiration, and a volatility parameter. - Swaption quotes in the market are typically provided in terms of implied Black or normal volatilities.

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    - Swaptions give the holder the right to enter into a payer or receiver swap at a predetermined strike rate. - Swaptions are classified as at-the-money, in-the-money, or out-of-the-money depending on the relationship between the strike rate and the prevailing swap rate. - Black's model and Bachelier's model provide formulas for pricing payer and receiver swaptions based on the underlying swap rate, strike rate, time to expiration, and a volatility parameter. - Swaption quotes in the market are typically provided in terms of implied Black or normal volatilities.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    75 views12 pages

    Chapter 4: Interest Rate Derivatives: 4.3 Swaptions

    Uploaded by

    z_k_j_v
    - Swaptions give the holder the right to enter into a payer or receiver swap at a predetermined strike rate. - Swaptions are classified as at-the-money, in-the-money, or out-of-the-money depending on the relationship between the strike rate and the prevailing swap rate. - Black's model and Bachelier's model provide formulas for pricing payer and receiver swaptions based on the underlying swap rate, strike rate, time to expiration, and a volatility parameter. - Swaption quotes in the market are typically provided in terms of implied Black or normal volatilities.

    Copyright:

    © All Rights Reserved
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    of 12

    Chapter 4: Interest Rate Derivatives

    4.3 Swaptions

    Interest Rate Models


    Damir Filipovic
    4.3 Swaptions

    Payer and receiver swaptions


    Moneyness
    Callable bonds
    Blacks price formula
    Bacheliers price formula
    Swaption quotes in terms of implied
    volatilities

    Interest Rate Models


    Swaptions

    A payer (receiver) swaption with strike


    rate K gives the holder right to enter a
    payer (receiver) swap with fixed rate K
    at swaption expiry date.

    Usually the swaption expiry date equals


    first reset date T0 of underlying swap. t T0 T1 Tn1 Tn

    Interest Rate Models


    Swaption Payoff

    The payer swaption payoff at expiry date T0 is


    n
    !+
    X
    Vp (T0 )+ = N P(T0 , Ti )(F (T0 , Ti1 , Ti ) K )
    i=1

    This payoff cannot be decomposed into more elementary payoffs.

    The dependence between different forward rates will enter valuation procedure.

    Interest Rate Models


    Moneyness

    An equivalent expression for the payer swaption payoff at expiry date T0 is


    n
    X
    N P(T0 , Ti ) (Rswap (T0 ) K )+ .
    i=1

    A payer (receiver) swaption is said to be


    at-the-money (ATM) if K = Rswap (t)
    in-the-money (ITM) if K < Rswap (t) (receiver: K > Rswap (t))
    out-of-the-money (OTM) if K > Rswap (t) (receiver: K < Rswap (t))

    The x y -swaption has expiry in x years and underlying swap length is y years.

    Interest Rate Models


    Application: Callable Bond

    Swaptions can be used to synthetically


    create callable bonds.

    Example: company issued 10-year bond


    with 4% annual coupon and principal N.
    It wants to add the right to call
    5 6 9 10
    (prepay) the bond at par after 5 years.
    But it cannot change original bond. 4% 4% 4%

    Time-5 value of bond


    P 
    p(5) = N 10
    P(5, k) 4% + P(5, 10) N
    k=6

    Interest Rate Models


    Application: Callable Bond

    Solution: buy a 5 5 receiver swaption


    with strike rate 4%:
    The fixed leg of the swap cancels the
    fixed coupon payments.
    The exchange of notionals between
    t = 5 and T = 10 is equivalent to 5 6 9 10
    paying floating. 4% 4% 4%

    Time-5 value of swaption

    Vr (5)+ = (p(5) N)+ N

    Interest Rate Models


    Black's Formula for Swaptions

    Blacks formula for payer and receiver swaptions price is

    Swptp (t) = N ni=1 P(t, Ti ) (Rswap (t)(d1 ) K (d2 ))


    P

    Pn
    Swptr (t) = N i=1 P(t, Ti ) (K (d2 ) Rswap (t)(d1 ))

    where is the standard normal cumulative distribution function and


    h i
    log Rswap
    K
    (t)
    12 2 (T0 t)
    d1,2 = .
    T0 t

    : Black (or relative) volatility

    Interest Rate Models


    Bachelier's Formula for Swaptions

    Bacheliers formula for payer and receiver swaptions price is



    Swptp (t) = N ni=1 P(t, Ti ) T0 t (D(D) + (D))
    P

    Pn
    Swptr (t) = N i=1 P(t, Ti ) T0 t (D(D) + (D))

    where is the standard normal cumulative distribution function, = 0 , and

    Rswap (t) K
    D= .
    T0 t

    : normal (basis point, absolute) volatility

    Interest Rate Models


    Swaption Quotes

    Swaption prices are quoted in terms of Black or normal implied volatilities.

    The accrual period = Ti Ti1 for underlying swap can differ from prevailing
    for caps within the same market region.

    E.g. euro zone: caps are written on semiannual LIBOR ( = 1/2), while swaps
    pay annual coupons ( = 1).

    Interest Rate Models


    Example of Swaption Quotes - Black ATM volatilities

    Blacks implied volatilities (in %) of EUR ATM swaptions on August 30, 2013.
    Maturities are 1,2,3,4,5,7,10 years, swaps lengths from 1 to 10 years:
    100

    Lenghts
    80
    1YR 2YR 3YR 4YR 5YR 6YR 7YR 8YR 9YR 10YR

    ATM Vol (%)


    Maturities
    1YR 83.56 66.6 59.1 53 48.82 44.02 40.42 37.61 35.34 33.53 60
    2YR 67.95 53.7 47.89 43.7 40.8 37.86 35.48 33.53 31.92 30.65
    3YR 52.12 44.2 40.85 38.01 35.72 33.72 32.03 30.62 29.48 28.53 40
    4YR 43.26 38.03 35.61 33.59 31.86 30.52 29.38 28.51 27.78 27.16
    5YR 37.37 33.45 31.75 30.29 29.03 28.11 27.41 26.87 26.46 26.09
    20
    7YR 29.64 27.44 26.44 25.6 24.99 24.63 24.37 24.24 24.23 24.17
    1y
    10YR 23.76 22.86 22.58 22.39 22.27 22.39 22.52 22.69 22.9 23.01 2y
    3y
    4y 10y
    5y 7y
    6y 5y
    7y 4y
    8y 3y
    9y 2y
    10y 1y
    Length Maturity

    An interest rate model for swaptions valuation must fit given volatility surface.

    Interest Rate Models


    Example of Swaption Quotes - Normal ATM volatilities

    Normal implied volatilities (in bps) of EUR ATM swaptions on August 30, 2013.
    Maturities are 1,2,3,4,5,7,10 years, swaps lengths from 1 to 10 years:
    100

    90
    Lenghts

    ATM Vol (bps)


    1YR 2YR 3YR 4YR 5YR 6YR 7YR 8YR 9YR 10YR 80
    Maturities
    1YR 53.7 69.76 78.5 83.79 87.32 86.59 85.79 85.02 84.22 83.48 70
    2YR 76.91 85.01 87.9 88.9 89.8 88.84 87.83 86.85 85.86 84.9
    3YR 89.26 92.79 92.98 92.21 91.36 90.24 89.08 87.95 86.8 85.7 60
    4YR 94.31 94.1 92.89 91.68 90.43 89.6 88.74 87.95 87.15 86.25
    5YR 92.94 91.83 90.82 89.81 88.79 88.23 87.64 87.15 86.64 85.95 50
    7YR 88.22 87.2 86.29 85.4 84.49 84.08 83.66 83.36 83.04 82.47 1y
    10YR 82.41 81.13 80.35 79.6 78.84 78.46 78.07 77.79 77.52 76.97 2y
    3y 10y
    4y 7y
    5y 5y
    6y 4y
    7y
    8y 3y
    9y 2y
    10y 1y
    Length Maturity

    An interest rate model for swaptions valuation must fit given volatility surface.

    Interest Rate Models

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