A Technical Guide For Pricing Interest Rate Swaption

Swaption Product and
Vaulation
Alan White
FinPricing
Swaption
Summary
◆ Interest Rate Swaption Introduction
◆ The Use of Swaption
◆ Swaption Payoff
◆ Valuation
◆ Practical Guide
◆ A real world example
Swaption
Swaption Introduction
◆ An interest rate (European) swaption is an OTC option that grants its owner the
right but not the obligation to enter the underlying swap.
◆ There are two types of swaptions: a payer swaption and a receiver swaption.
◆ A payer swaption is also called a right-to-pay swaption that allows its holder to
exercise into a swap where the holder pays fixed rates and receives floating
rates
◆ A receiver swaption is also called right-to-receive swaption that allows its
holders to exercise into a swap where the holder receives fixed rates and pays
floating rates.
◆ Swaptions provide clients with a guarantee that the fixed rate of interest they
will pay or receive at some of future time will not exceed certain level.
Swaption
The Use of Swaption

◆ Market participants use swaptions to manage interest rate risk arising
from their business.
◆ A firm might buy a payer swaption if it wants protection from rising
interest rates.
◆ A corporation holding a mortgage portfolio might buy a receiver swaption
to protect against decreasing interest rates that might lead to mortgage
prepayment.
◆ A company believing that interest rates will not increase much might sell
a payer swaption to earn the premium.
◆ An institution believing that interest rates will not decrease much might
sell a receiver swaption to earn the premium.
Swaption
Swaption Payoff
◆ For a payer swaption, the payoff at payment date T is given by
𝑃𝑎𝑦𝑓𝑓𝑝𝑎𝑦𝑒𝑟 = max(0, 𝑁𝐴(𝑆𝑇 − 𝑆0 )
where
N- the notional;
A – the annuity or forward basis point value
𝑆0 – the fixed rate or contract swap rate at inception
𝑆𝑇 – the swap rate at time T
◆ From a receiver swaption, the payoff at payment date T is given by

𝑃𝑎𝑦𝑓𝑓𝑝𝑎𝑦𝑒𝑟 = max(0, 𝑁𝐴(𝑆0 − 𝑆𝑇 )
Swaption
Valuation
◆ The present value of a payer swaption is given by
𝑃𝑉𝑝𝑎𝑦𝑒𝑟 𝑡 = 𝑁𝐴 𝑆Φ 𝑑1 − 𝐾Φ(𝑑2)
where
t – the valuation date
N – the notational principal amount
𝑛
𝐴= 𝑖=1 𝜏𝑖 𝐷𝑖 – the annuity factor or forward basis point value
𝑆 = 𝐷1 − 𝐷𝑛 𝐴 - the forward swap rate
Φ - the cumulative standard normal distribution function
i – the ith cash flow (swaplet) of the underlying swap from 1 to n
𝜏𝑖 = 𝜏(𝑇𝑖−1 , 𝑇𝑖 ) – the accrual period ( , ) of the ith cash flow.
𝐷𝑖 = 𝐷(𝑡, 𝑇𝑖 ) – the discount factor
Swaption
Valuation (Cont)
◆ The present value of a receiver swaption can be expressed as
𝑃𝑉𝑝𝑎𝑦𝑒𝑟 𝑡 = 𝑁𝐴 𝐾Φ −𝑑2 − 𝑆Φ −𝑑1
where all notations are the same as (1)

Swaption
Practical Guide
◆ A swaption contract contains terms and conditions of the swaption and the
underlying swap. For example, it specifies two maturities: swaption
maturity and underlying swap maturity.
◆ The valuation model for pricing a swaption is the Black formula that
assumes the underlying swap rate follows a log-normal process.
◆ First, one needs to generate the cash flows of the underlying swap. The
generation is based on the start time, end time and payment frequency of
each leg, plus calendar (holidays), business convention (e.g., modified
following, following, etc.) and whether sticky month end.
Swaption
Practical Guide
◆ The accrual period is calculated according to the start date and end date of
a cash flow plus day count convention
◆ Any compounded interest zero rate curves can be used to compute discount
factor, of course the formulas will be slightly different. The most common
used one is continuously compounded zero rates.
◆ The other key for accurately pricing an outstanding swaption is to construct
an arbitrage-free volatility surface. Unlike a cap/floor volatility surface that
is 3 dimensional (maturity – strike – volatility), a swaption volatility surface
is 4 dimensional (swaption maturity – underlying swap tenor – strike –
volatility).
Swaption
A Real World Example

Swaption Specification Underlying Swap Specification
Buy Sell Buy Leg 1 Specification Leg 2 Specification
Pay Receive Pay Currency USD Currency USD
Notification Lag 2 Day Count dc30360 Day Count dcAct360
Settlement Cash Leg Type Fixed Leg Type Float
2500000
Exercise Type Call Notional Notional 25000000
0
Notification Date 4/30/2020 Pay Receive Pay Pay Receive Receive
Settlement Date 5/5/2020 Payment Freq 6 Payment Freq 3
Forward Premium Amount 3375000 Start Date 5/5/2020 Start Date 5/5/2020
Premium Pay Receive Pay End Date 5/5/2030 End Date 5/5/2030
Forward Premium Date 5/5/2020 Fixed Rate 0.02855 Spread 0
Index Specification
Type LIBOR
Tenor 3M
Day Count dcAct360
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What are the two types of swaptions?

What are some uses of swaptions?

Swaption Product and

The Use of Swaption

◆ From a receiver swaption, the payoff at payment date T is given by

where all notations are the same as (1)

A Real World Example

You can find more details at

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