Swaptions

Chris Dzera
 Outline
 Discuss building blocks of swaptions, including
some we have discussed in class and some I covered
in my previous presentation
 Define swaptions and give a brief history
 Explain the important aspects of swaptions and how
a swaption works
 Outline the different types of swaptions
 Clarify why purchasing swaptions makes sense
 Give examples of swaption contracts
 Briefly touch on ways to value swaptions
 Interest Rate Derivatives
 An interest rate derivative is a derivative
whose payoffs are dependent on future interest
rates
 These are appealing to investors who have
specific cashflow needs that are heavily
influenced by interest rates
 The interest rate derivatives market is the
largest derivatives market in the world
 Swaps
 A swap is an agreement between two
companies to exchange cash flows in the
future, defining the date the cash flows will be
paid and the way they will be calculated
 Swaps are used to hedge certain risks, such as
interest rate risk, or when investors want to
speculate about a certain value
 Interest Rate Swaps
 The most common type of swap and the most common
type of interest rate derivative is a “vanilla” interest rate
swap
 Typically the floating rate in interest rate swap
agreements is a fixed rate such as the London Interbank
Offered Rate (LIBOR)
 These swaps usually involve fixed rates being swapped
for floating rates, but there are many variations
 Interest rate swaps allow for hedging of assets and
liabilities, as well as speculation by investors
 Options
 An option is a derivative contract when a party
can elect whether or not they want to exercise
the contract
 The benefit to this is that there is a limited
downside for this party
 For the right to not exercise the contract, the
party pays a premium
 Swaptions
 A swaption is an option on a swap contract, typically and
almost exclusively an interest rate swap
 The first swaption contract was constructed and executed
by William Lawton in 1983
 The contract was for a period of one year, and his
company sold the right to enter a five year interest rate
swap to pay fixed versus 3-month LIBOR on a notional
amount of $5 million at a premium
 Like the building block derivatives discussed earlier
swaptions are very popular because they can be used to
hedge and they also allow for speculation
 Components of a Swaption
 Premium
 Strike rate (also fixed rate of underlying swap)
 Length of option period
 Length of underlying swap
 Notional amount
 Amortization, if any
 Frequency of settlement of payments on the
underlying swap
 How a swaption works
 Two parties agree to the previously mentioned
components
 The contract holder decides at some date (or
multiple dates, depending on the structure of the
contract) whether or not they would like to enter the
contract before the swap begins or at some point a
certain time period into the swap
 If the holder elects to exercise, a swap contract
begins, and if not then the only exchange of
payments is the premium
 Payer Swaption vs. Receiver Swaption
 Payer swaption – gives the owner of the
swaption the right to enter a swap contract
where they pay the fixed leg and receive the
floating leg
 Receiver swaption – gives the owner of the
swaption the right to enter into a swap contract
where they pay the floating leg and receive the
fixed leg
 Exercise Dates
 There are three different ways the right to exercise the
option in a swaption contract can be scheduled
 European – the owner of the contract can exercise his
right to enter the swap at maturity
 American – the owner of the contract can exercise his
right to enter the swap at any date between the start and
end dates of the option period agreed to
 Bermudan – the owner of the contract can exercise his
right to enter the swap at certain predetermined dates
between the start and end dates of the option period
 A bit more about American swaptions
 There are two types of American swaptions:
• An American swaption with fixed tenor is a when the
length of the underlying swap is a set amount of time
and it begins as soon as the option is exercised, as long
as it is exercised before the option period expires
• An American swaption with fixed end date is when the
predetermined period of time includes the length of the
option period and the underlying swap, so if the day the
swap would begin passes without the swap being
exercised, the length of the underlying swap decreases
 Why enter a swaption contract versus a swap
contract?
 Because the option period can end before the swap
takes place, it may be unclear why it is logical to pay
a premium for the option to enter a swap contract
down the road when the party could just decide
whether or not they want to enter the contract at that
later date
 However, entering a swaption contract assures that
the party that holds the contract has the option to
receive better terms on the swap contract than they
would have if they had waited
 Example of a European receiver swaption
 A company knows that in two years it will
have to enter a 5 year loan on $5 million with a
2% interest rate, and wants to reduce its
interest rate risk by exchanging its payments
on this contract for floating payments
 They enter a swaption contract with a 2 year
option period, where at the end of 2 years on
the expiry date of the option, if they exercise
the option a 5 year swap would be initiated
 Example of a Bermudan payer swaption
 A bond holder knows that in one year they will receive
fixed rates of 3% on $2 million bond for a period of
ten years, and wants to receive a floating rate instead
 They enter a swaption contract that expires in one year
with specific exercise dates afterward that would not
go too far into the swap period
 If they elected to exercise after expiry, the length of
the swap would be reduced by the amount of time
between the end of the option period and the date the
option was exercised
 Example of an American receiver swaption
with fixed tenor
 A company receives a LIBOR -.02% on a 15
year bond it owns and wants to receive a fixed
rate instead
 They enter a swaption with expiry in 2 years
and an underlying swap of length 13 years
 If they elect to exercise the swap at any time in
the option period, a 13 year swap with terms
agreed to begins immediately
 Example of an American payer swaption
with fixed end date
 A company knows it will have to pay a floating
rate of LIBOR + .03% on a 30 year loan and
wants to pay a fixed rate instead
 They enter a swaption contract with expiry in 2
years and an end date in 30 years
 If they elect to exercise the option, a swap that
ends when the loan ends will begin on that date
 Valuation of European swaptions
 The valuation of European swaptions can actually be done
by tweaking Black’s model for valuing futures options
 The swaption model relies on changing the value of the
underlying, the volatility, and the discount factor
 The reason Black’s model benefits us in this calculation is
the option contract and futures contract don’t have to
mature at the same time
 There is also a quick way to value European swaptions that
Hull and White have shown, using an analytic approach
that comes up with results similar to Monte Carlo
simulations for similar material
 Valuation of Bermudan swaptions
 Valuation of Bermudan swaptions is usually done by
using one-factor no arbitrage models that are
controversial because their accuracy has been questioned
 Other methods include a least squares approach where
the value of not exercising on a particular payment date
is assumed to be a polynomial function of the values of
the factors, and an optimal early exercise boundary
approach
 Monte Carlo simulation is an important technique that
can be used to value Bermudan swaptions
 Valuation of American swaptions
 Valuing American swaptions is generally considered
by investors to be a pain, though it is fortunate that
they are not as common as European or Bermudan
swaptions
 There is no set way to value American swaptions,
although there have been certain techniques proposed
including a two factor stochastic model where the
factors are the short-term interest rate and the premium
of the futures rate over the short-term interest rate and
another model that uses trinomial trees
 Summary
 A combination of extremely popular financial
instruments, swaptions are popular for organizations
due to the fact that they are a great way to hedge
interest rate risk with a limited downside, and can be
interesting speculative tools as well
 Because they are so complex, swaptions can be
difficult to price and there is a lot of demand for
quick, effective techniques to price swaption
contracts that improve upon techniques that are
presently used