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**Cap and Floors
**

Alternative methods for valuing Cap and Floors

Swaptions

How Traders use Caps&Floors, and Swaptions in Practice

FM2 Themes

Antonio Mannolini, Ph.D

Siena, Winter 2015

Antonio Mannolini, Ph.D

FM2 Themes

Swaps

Cap and Floors

Alternative methods for valuing Cap and Floors

Swaptions

How Traders use Caps&Floors, and Swaptions in Practice

Introduction

1

Swaps

Basic facts

Basis Swaps

Bond and Swaps

Asset Swaps

2

**Cap and Floors
**

The market Standard

Fixing Black Model: the Shifted Lognormal Model

3

**Alternative methods for valuing Cap and Floors
**

Cap replica via a portfolio of Put Options on ZCB

4

Swaptions

Bermudan Swaptions and Callable Bonds

Pricing Swaptions with short rate models

5

**How Traders use Caps&Floors, and Swaptions in Practice
**

Antonio Mannolini, Ph.D

FM2 Themes

Swaps

Cap and Floors

Alternative methods for valuing Cap and Floors

Swaptions

How Traders use Caps&Floors, and Swaptions in Practice

Swap rates

An Interest Rate Swap is a contract that exchanges payments

between two differently indexed ”legs”, starting from a future

time instant. At every pre-specified instant Ti the fixed leg pays

the amount

N τ (Ti−1 , Ti )K

while the variable leg pays the amount

N τ (Ti−1 , Ti )L(Ti−1 , Ti )

When the fixed leg is paid, the IRS is termed Payer IRS. If the

opposite holds, we have a Receiver IRS.

The discounted payoff of a Payer IRS can be expressed as:

β

X

i=α+1

D(t, Ti )N

τi

[L(Ti−1 , Ti ) − K]

|{z}

τ (Ti−1 ,Ti )

Antonio Mannolini, Ph.D

FM2 Themes

Swaps

Cap and Floors

Alternative methods for valuing Cap and Floors

Swaptions

How Traders use Caps&Floors, and Swaptions in Practice

IRS and FRA I

**The last (stochastic) expression is indeed the sum payoff FRAs
**

payoffs. Consider a Receiver forward start IRS ([K − L(Ti−1 , Ti )

replaces [L(Ti−1 , Ti ) − K]). We have:

RF S(t, T, τ, N, K)

= N

β

X

τi P (t, Ti )(K − F (t; Ti−1 , Ti ))

i=α+1

= −N P (t, Tα ) + N P (t, Tβ )

+N

β

X

τi KP (t, Ti )

i=α+1

Antonio Mannolini, Ph.D

FM2 Themes

Cap and Floors

Alternative methods for valuing Cap and Floors

Swaptions

How Traders use Caps&Floors, and Swaptions in Practice

**IRS and FRA II
**

An IRS can then be also seen as en exchange of a coupon-bearing

bond with a floating rate one

The rate K which makes the swap payout zero at inception is

called forward Swap rate:

P (0, Tα ) − P (0, Tβ )

Sα,β (0) = Pβ

i=α+1 τi P (0, Ti )

In case it it spot start Tα = 0 the above reads

1 − P (0, Tβ )

Sα,β (0) = Pβ

i=α+1 τi P (0, Ti )

o

In market practice is used as the strike for ATM Caps and

Swaptions. For swap in intuitive; for caps we will see later on

Antonio Mannolini, Ph.D

FM2 Themes

Ti ) i=α+1 By multiplying and dividing by: β X τi P (t. . Ti ) i=α+1 It follows β X τ P (t. and Swaptions in Practice Playing with the swap payoff Take a Payer IRS with N = 1: P (t. Ti )(Sα. Ph. Ti ) P (t. Tα ) − P (t. Ti ) i=α+1 we get Pβ i=α+1 τi P (t. Tα ) − P (t. Ti ) Pβ i=α+1 τi P (t. Tβ ) − β X τi KP (t.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors.β (t) − K) i=α+1 Antoniowill Mannolini.D when FM2 Themes This expression be useful pricing swaptions. Tβ ) − β X τi KP (t.

Tα ) − P (0. For instance a typical basis swap is one in which a floating leg indexed to Euribor6M is exchanged against one indexed to Euribor3M In theory there should be no basis as the value of the floating leg is given by the following for the Forward Start case P (0. Ph. Tβ ) Antonio Mannolini. Tβ ) and the following for the Spot Start case 1 − P (0.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. and Swaptions in Practice The Theory in the One Curve Setting I A basis swap is defined as a contract in which two floating legs of a swap are exchanged.D FM2 Themes . The two legs can differ both in the tenor of the underlying rate and in the frequency of payments.

and Swaptions in Practice The Theory in the One Curve Setting II To verify the claim note that in both cases (spot and forward start) what matters to determine the value of the floating leg is the first reset date and the last payment date. whichever the reset frequency dates and the tenor of the index. Ph. and provide an example for both a 10Y spot start basis swap and a 1Y forward 10Y Swap.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. Which condition you need to derive the result? Antonio Mannolini. the basis should be zero according to this single curve theory Exercise: write in detail the above argument.D FM2 Themes . hence if two swap have the same first reset date and the same maturity.

Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. K) = N (P (t. Tβ ))−N β X τi P (t.e. Ti ) i=α+1 (1) which is the floating leg? with Tα = t. Tβ . Tβ . K. and Swaptions in Practice Bond-Swap relationship Consider a Payer Forward Swap P F S(t. Tα . N ) Antonio Mannolini. τ. N. Tβ ) − KN β X τi P (t. i. Tβ ) = N − N P (t. Ph. Ti ) i=α+1 = N − CBP (t.. We thus get P S(t.D FM2 Themes (2) . spot trading. Tα )−P (t.

The floating leg represents the funding of the Bond: i.e. and Swaptions in Practice Fixed Rate Side Continued which rearranged gives CBP (t. Tβ ) The meaning is straightforward: a fixed rate bond can be replicated using the N P V of a payer swap whose fixed leg coincides with the fixed leg of the swap.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. Tβ . the interest the issuer must pay to raise funds in the interbank market Antonio Mannolini. K.D FM2 Themes (3) . N ) = N − P S(t. Ph.

Ti ) i=α+1 Antonio Mannolini.. consider a coupon bond that pays the following cash flow C = [cα+1 ..Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors.. i<β (6) and cβ = N τ K + N. while the variable can be considered a floating rate note.. . the fixed leg of the swap can be viewed as a fixed coupon.D FM2 Themes (8) . Ph. cβ ] (4) T = [Tα+1 . Tβ ] (5) on the schedule with ci = N τ K. T) = ci P (t. In detail. i=β (7) The Coupon Bond price can be written as β X CBP (t. In fact. .. and Swaptions in Practice Swaps as an exchange of bonds A swap can be considered as an exchange between two bonds. C..

. .. Antonio Mannolini. and Swaptions in Practice A Floating Rate Note Next consider a floating rate note that pays coupons at dates T = [Tα+1 .Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors.D FM2 Themes (10) ... Ph. Tβ−1 ] At maturity Tβ notional is reimbursed... . Tβ ] (9) coupons calculated as the Libor rate fixed in the previous period T = [Tα .

Tβ ) = N P (t. Tβ ). floating rate notes must trade at par Provide an example of Italian government floating rate notes. the bond price equals par. and finally we insert the present value of the notional at maturity N P (0. This result also holds for all the dates equal to the reset of the floating rates. Ph. and Swaptions in Practice Floating Rate Side Continued To value the price of this note we change sign to the RF S.e. Did they trade at par in recent times? Provide an explanation Antonio Mannolini. N. τ. i. no fixed rate payments.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. Then we impose K = 0. 0) + N P (t.. At the date of the first reset.D FM2 Themes . Tα ) (11) The intuition behind this formula is straightforward if we put Tα = t. This is an alternative proof that to avoid arbitrage opportunities. Hence −RF S(t.

The package is composed of a position in a Bond and a Position in a swap. the Asset swap buyer must pay the Fixed Leg and the principal in the swap but does not receive the coupon of the defaulted bond Antonio Mannolini. Ph.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. In case of default. and Swaptions in Practice Definition of the Asset Swap Package An asset swap can be defined as a Syntetic floating-rate note In fact. the Asset Swap transform a fixed rate in a floating rate. leaving the credit risk profile unchanged In the following we consider Par Asset Swaps.D FM2 Themes .

conversely if the bond trades below par the difference 1 − CBP is paid to the asset swap seller by the asset swap buyer 3 A swap is started between the two counterparties such that the asset swap seller receives a fixed leg equal to the coupon stream of the bond and the asset swap buyer receives the floating leg given by the euribor rate plus a spread AS Antonio Mannolini. K. K. N ) − 1 is paid to the asset swap buyer by the asset swap seller. T. T. T. Ph. N ) from the asset swap seller 2 The asset swap seller pays/receives to/from the asset swap buyer the diference CBP (t. hence if the Bond trades above par the difference CBP (t. K. N ) − 1 in such a way that the net sum paid from the asset swap Buyer is 1.D FM2 Themes . T. 1) at the market price CBP (t. and Swaptions in Practice Valuation of the Asset Swap Package I At valuation time t the three following facts are observed: 1 The asset swap buyer in t buys a generic risky coupon bond CB(t. K.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors.

D FM2 Themes . Tn ) (13) i=1 Pn hence i=1 τi P (0. we can write n X 1= τi P (0. Ti ) + P (0.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. K. Ph. Ti )(L(T − i − 1. 1) + K τi P (0. Ti )(L(T − i − 1. Ti ) is equal to 1 − P (0. Ti )(L(T − i − 1. Ti )(L(T − i − 1. Ti )− i=1 n X (12) τi P (0. as floating rate notes trade at par. T. Ti ) + AS) Observe that. and Swaptions in Practice Valuation of the Asset Swap Package II: Valuation Equation From the perspective of the asset swap seller the value of the package is give by n X 1 − CBP (t. Ti ) + AS) = 0 i=1 Pn Split in two parts i=1 τi P (0. Tn ) substitute in 12 and get a simpler equation Antonio Mannolini.

D FM2 Themes . 1)+K n X n X τi P (0. as seen before. and Swaptions in Practice Valuation of the Asset Swap Package III: result and financial meaning So we can write 1−CBP (t. T. which. Tn ) is the CBP without credit risk. T. we have assumed risk free. 1) + K τi P (0. Ti )AS = 0 i=1 i=1 (14) from which we can derive n n X X −CBP (t. K. K. it is just a benchmark curve!) and finally we get Antonio Mannolini. (but remember. Ti ) + P (0. is the sum of coupons and bond principal priced off the LIBOR curve. Tn )+ τi P (0. for the moment. Ti )−(1−P (0. Ti ) + P (0. Tn ) = τi P (0. Indeed.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. is not in real life. Ph. Ti )AS i=1 i=1 (15) Pn We know then that K i=1 τi P (0.

1) Pn i=1 τi P (0. T.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. 1) − CBP (t. K. and Swaptions in Practice The Result AS = CBP (t.D FM2 Themes (16) . Ti ) Antonio Mannolini. Ph. T. K.

D FM2 Themes . Ti )N τi max K − L(Ti−1 . Ti ) − K. 0 i=α+1 The cap allows investors which have a debt at variable rate to buy insurance against high rates in the future. Ph.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. Its value is the expectation under the risk neutral measure of: β X D(t. In the following we will see how to evaluate this expectation Antonio Mannolini. 0 i=α+1 A Floor is the same thing with the Receiver IRS: β X D(t. Ti )N τi max L(Ti−1 . and Swaptions in Practice The market Standard Fixing Black Model: the Shifted Lognormal Model Caps and floors A Cap is a Payer IRS in which the payment is done only if positive. Ti ).

swap rates can not be. and Swaptions in Practice The market Standard Fixing Black Model: the Shifted Lognormal Model The Black model The Black model extends the Black-Scholes formulas for caplets. It is the model widely used in practice.D FM2 Themes . Alert: if the LIBOR/EURIBOR simple rates are lognormal. not the spot ones. The main assumption is that relevant forward rates are lognormally distributed. Ph. this last is not a minor issue indeed. A formal justification of this model is provided later in the course (Libor market model) Black formula was indeed the metric by which traders translated volatilities into prices until rates became too lows and the model collapsed under the assumption of positive rates. It uses the forward coordinates. look in the internet for the difference (institutional feature) Antonio Mannolini. This theoretical inconsistency is negligible in real world situations LIBOR/EURIBOR: they are both simple rates.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. swaptions and Bond Option prices.

w) = F wΦ(wd1 (K. Ti−1 . Ti )τ Bl(K.β ) = N P (0. v)) − KwΦ(wd2 (K.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. F.D FM2 Themes (21) . 1) i=α+1 (17) where Bl(K. K. F. σα. v. N. τ.β is quoted (CAP volatility!) Antonio Mannolini. Ph. v) with ln(F/K) + v 2 /2 v ln(F/K) − v 2 /2 d2 = v d1 = (18) (19) (20) and vi = σα.β p Ti−1 In the market σα. Ti ). vi . and Swaptions in Practice The market Standard Fixing Black Model: the Shifted Lognormal Model Pricing caps with the Black-76 formula β X CapBl (0. F (0. F.

while caplet volatilities must be boostrapped and are known as spot vols. and the different caplets of the same cap share the same volatility. Caplet volatilities are logically tied to forward rate volatility as measure of uncertainty There is a sort of inconsistency in this market practice.. is being valued using different volatilities. even if refers to the same time period. and Swaptions in Practice The market Standard Fixing Black Model: the Shifted Lognormal Model Flat vols and Spot Vols The market quotes caps volatilities for atm options and several strikes (the smile) Cap volatilities are known as flat vol. The same caplet belonging to two different caps. Ph.. Bootstrapping is the way to solve the puzzle.D FM2 Themes .Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. Antonio Mannolini..

For long maturities volatility tends to decay.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. Think to an economic explanation please! Antonio Mannolini. Ph. and Swaptions in Practice The market Standard Fixing Black Model: the Shifted Lognormal Model The Volatility Hump Market implied volatilities often dispay an hump in the front end When the hump does not appear it is regarded as stressed market There is a financial explanation for this feature. Uncertainty is bigger in the intermediate region and lower in the front of the maturity spectrum.D FM2 Themes .

S). T.D FM2 Themes . Ph. the volatility does not depend on the strike of the option. Hence a zero strike floor can not be priced When rates where at 5% level this was not an issue. Antonio Mannolini. and Swaptions in Practice The market Standard Fixing Black Model: the Shifted Lognormal Model Problems with the Black model In Black model negative rates are not allowed. But now in the interbank market it is not so unusual to find prices for −1% strike floors Remember that in the standard Black formula d1 is not defined when the forward rate is negative Moreover in the Black model the empirical fact of the smile is not accounted for Two caps identical but for the strike need a different volatility to recover two different market prices if one uses Black Formula And this is clear if one looks at the distribution and at the process of F (t. It is a characteristic of the forward rate.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors.

Ph. but was used in order to account for a (bit) smile Now it is used to shift the lower bound of prices admitted by the model. and Swaptions in Practice The market Standard Fixing Black Model: the Shifted Lognormal Model The Practitioner solutions To face the smile.D FM2 Themes . Black model has been shifted The tecqnique was already known. the model is used with different input volatilities for different strikes. Antonio Mannolini. In practice the model is a mapping of implied volatilities into prices and viceversa It is used to boostrap caplet volatilities To face the non negativity of rates.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors.

S) caplet as follows dF (t. S) = σ shif ted (F (t. vT ) Antonio Mannolini.S) caplet with strike K is given by Cpl(t. T. S) − α. S) − α)dW (t)QS (22) It easy to see that the price for a (T. S. S)Bl(K − α. T. K. τ. T.D FM2 Themes (23) . α) = P (t. and Swaptions in Practice The market Standard Fixing Black Model: the Shifted Lognormal Model The Shifted Lof Normal Model for Caplets I Rewrite the Black -76 SDE for the (T. F (t. vT . T. Ph.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors.

β is quoted (with α = −3 in the current rate environment) What is the relationship between σ shif ted and vT ? Antonio Mannolini. and Swaptions in Practice The market Standard Fixing Black Model: the Shifted Lognormal Model The Shifted Log Normal Model for Caplets II where 18.d1 and d2 read as before and instead vi is now given by √ shif ted T (24) vT = σα.D FM2 Themes .Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. Ph.β shif ted In the market σα.

D FM2 Themes (25) . Ph. Ti )τ (L(Ti−1 .Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. 0 and its value is given by: R Ti N E Q max e− t rs ds N τ (L(Ti−1 . and Swaptions in Practice Cap replica via a portfolio of Put Options on ZCB Caplets as ZCB put options A caplet is defined as: D(t. Ti ) − K) | Ft Antonio Mannolini. 0 This can also be written: R T − t i−1 r(s)ds + NE e P (Ti−1 . Ti ) − K. Ti )N τi max L(Ti−1 . Ti ) − K).

Ti ) + − 1 − Kτ + | Ft [1 − (1 + Xτ )P (Ti−1 . Antonio Mannolini. and Swaptions in Practice Cap replica via a portfolio of Put Options on ZCB continues Using the definition of Libor rates we get: R Ti−1 r(s)ds N E e− t P (Ti−1 . Ti )] | Ft we finally get: R Ti−1 r(s)ds N (1 + Kτ )E e− t [ 1 − P (Ti−1 . In the same way.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. Ti ) − NE e Multiplying by R Ti−1 t r(s)ds 1 1+Kτ 1 P (Ti−1 . floorlets can be seen as call options on ZCBs. Ph. Ti )]+ | Ft 1 + Kτ Caplets can then be seen as put options on ZCBs.D FM2 Themes .

As we will see the most used short rate models admit closed formulas for these options Rememeber that a closed formula connects parameters of the model with a price of an option So with this replica we can directly price Caps and Floors with many short rate models we will see later Short rate models always need a bridge that connects a market price with their parameters. Ph. and Swaptions in Practice Cap replica via a portfolio of Put Options on ZCB Uses of this result With this replica we can price Cap and Floors every time we use a model which admits a closed formula for ZCB Options.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. Antonio Mannolini.D FM2 Themes .

If you are on the buyer side (you are long payer swaption) which is your view on rates? Why? And the Receiver? Usually. The length of the underlying IRS is called the tenor of the swaption.D FM2 Themes .β (t) Antonio Mannolini. the swaption maturity coincides with the first reset date of the underlying IRS.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. a payer version and a receiver version An European payer swaption is an option giving the right to enter a payer IRS at a given future time. Ph. and Swaptions in Practice Bermudan Swaptions and Callable Bonds Pricing Swaptions with short rate models Swaptions There are two main types of swaptions (as the underlying swaps). ATM Swaption are quoted for maturities ranging from 1m − 30Y for tenors ranging from 1Y − 30Y A swaption is ATM when the strike is equal to the Swap Forward Rate Sα. called the swaption maturity.

Ti ) (26) i=α+1 Antonio Mannolini. Ti−1 . Ti ) − K) i=α+1 This payoff cannot be easily decomposed in elementary parts. Ti )τi (F (Tα . and Swaptions in Practice Bermudan Swaptions and Callable Bonds Pricing Swaptions with short rate models Swaption Continued The discounted payoff of a payer swaption (with maturity Tα is given. Notiche that it canbBe written also as + X β N D(0.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. Ti ) − K) i=α+1 by: N D(t. Ti )τi (F (Tα .β (Tα ) − K τi P (0. Tα ) β X !+ P (Tα . Tα ) STα . Ti−1 . recalling the value of a payer IRS: N β X P (Tα . Ph.D FM2 Themes .

β ) = N β X P (0. K. Antonio Mannolini. and Swaptions in Practice Bermudan Swaptions and Callable Bonds Pricing Swaptions with short rate models Black Formula for Swaptions if you substitute F (0. σα. Ti )τ [Sα.β is quoted: with respect to caps there one more dimension: we have in fact quotes for Option Maturity. So we have a surface of volatilities.β Tα d1 = and In the market σα.β /K) + v 2 /2 v ln(Sα.β /K) − v 2 /2 d2 = v p vi = σα.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. Ph. Ti−1 . T. N.D FM2 Themes (28) (29) (30) .β (T )Φ(d1 )−KΦ(d2 ] i=α+1 (27) where ln(Sα. S. Ti ) with Sα. Tenor and strike.β (0) and plug in the quoted swaption volatility (and the right dates) you get Black’s formula for swaptions P SBl (0.

and Swaptions in Practice Bermudan Swaptions and Callable Bonds Pricing Swaptions with short rate models Difference between Caps and Swaptions I Caps can be decomposed into more elementary products: caplets. Do you undestand the point? Can you provide an example? Antonio Mannolini. No joint action of forward LIBOR /EURIBOR rates is involved Instead in a swaption.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. Ph. if you take as foundamental entity the LIBOR /EURIBOR rates you have to deal with the joint action of the simple forward LIBOR /EURIBOR rates So you have to deal with terminal correlation between rates of different portions of the yield curve. You can value simply each caplet at once and then add their prices. So you can value them modeling each forward rate at once.D FM2 Themes .

Antonio Mannolini. Volatility trade between caps and swaption: WEDGE. Ph.D FM2 Themes .Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. and Swaptions in Practice Bermudan Swaptions and Callable Bonds Pricing Swaptions with short rate models Difference between Caps and Swaptions II Swaption volatilities are quoted for different maturities and tenors (length of the undelying swaps) Both for ATM and away from ATM in both sides (Swaption smile) So swaption have an additional dimension with respect to caps They have also a different delta effect on you book.

To value this Option Tree methods or the Longstaff Schwartz methos is to be used Antonio Mannolini. the option for the following periods is written on shorter swaps As an example consider the following: Receiver Bermudan Swaption written on a 3 year swap with the first call date 2y from now ( we suppose semiannual payments): if at the end of the second year she will not excercise. so if the holder does not exercise at the first date in the call schedule. six months later she will have to decide if enter on not in the same remaining swap which now has become a 2y6m swap In this case at the last option exercise date she will decide whether or not to enter on the 2y6m − 3y FRA.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors.D FM2 Themes . and Swaptions in Practice Bermudan Swaptions and Callable Bonds Pricing Swaptions with short rate models Bermudan Swaptions A Bermudan Swaption gives the holder the right to enter in an interest rate swap contract at different dates (usually the swap reset dates) with some days of notification to the counterparty The interest rate swap the holder can enter is the same existing contract. Ph.

and Swaptions in Practice Bermudan Swaptions and Callable Bonds Pricing Swaptions with short rate models Callable Coupon Bond A callable bond is a bond which allow the issueer to call the bond (usually at par) during the life of the bond There can be one callability date or more callability dates It is easy to guess that a replica for the callable bond price can be obtained by simply adding a Swaption to the swap used to price a bond in the bond swap replica seen above If there are multiple callability dates is clear that the swaption we need is a bermudan one.D FM2 Themes .Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. S. Ph. β)(T ). With a receiver bermudan swaption with the same contractual conventions of the Swap (so the strike of the swaption is equal to the coupon of the bond) we can offset the swap. 0) can be represented as max(K − S(Tj . 0) Intuition: Long on the bond. τ ) − 100. So max(CCBP (T. short on the rates Antonio Mannolini. K. which represents the economic equivalent of calling the bond at par.

K. and Swaptions in Practice Bermudan Swaptions and Callable Bonds Pricing Swaptions with short rate models Callable Coupon Bonds vs Non callable coupon Bonds I Ceteris Paribus a non callable Coupon Bond has an higher price than a callable one At inception both must be worth 100 (a part from other costs and fees which we wil neglect) A Typical cooupon bond. Ph. At inception the following must hold CBP (0.D FM2 Themes (31) . τ ) = 100 − N P V5ySwap(0) = 100 Antonio Mannolini. once credit risk is isolated and remunerated will pay the average market rates prevailing at the time of the issue. Suppose we price a 5Y bullet bond.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. 5. These are related to the swap rate prevailing in that moment Suppose credit risk is zero: in this ideal case the coupon bond will pay the corresponding swap rate prevailing on the market.

and Swaptions in Practice Bermudan Swaptions and Callable Bonds Pricing Swaptions with short rate models Callable Coupon Bonds vs Non callable coupon Bonds II which implies N P V5ySwap(0) = 0. we will have the following facts Antonio Mannolini.D FM2 Themes .Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. Hence K = K5ySwap(0) . This means that credit consideration apart. a bank must pay the market prevailing rate when it issues a bond. Ph. And this should not surpirise anyone If the same bond were callable after two years each six months.

K1 . T2y . τ ) = 100 − (N P V5ySwap(0) + N P VRBS ) = 100 (32) implies N P V5ySwap(0) = −N P VRBS < 0 (33) K1 > K5ySwap(0) (34) Antonio Mannolini. In this case the call dates vector is [2y.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. T1c . K. 3y. N ) the bermudan receiver swaption with first call date T 1c and subsequent ones each six months.D FM2 Themes . 3y6m. 5. K. T5y . Ph. 4y6m] Suppose RBS(0. Tβ . 6m. and Swaptions in Practice Bermudan Swaptions and Callable Bonds Pricing Swaptions with short rate models Callable Coupon Bonds vs Non callable coupon Bonds III Let us denote RBS(t. N ) > 0 CBP (0. The last payment date is equal to the one of the swap. 4y. 6m. 2y6.

Ph. ceteribus paribius.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. Customer is long bond. short rates.D FM2 Themes . it will have a price above 100) as it will not want to pay an higher than market level remuneration for the money it has borrowed from customers: conversely if rates goes down it will not buy back the bond as is financing itself at a lower that market implied rates Antonio Mannolini. short Option (Receiver Swaption) Coupons are better than market prevailing rates would have allowed for a fixed rate note After the issue if rates go down the Bank will call the bond (because. and Swaptions in Practice Bermudan Swaptions and Callable Bonds Pricing Swaptions with short rate models Risk Analysis of a Callable Bond Recap It can not go much above PAR. The Price-Yield relation is broken at a certain level Investor sells an option to the Bank for higher (initial) coupons.

Ph. and Swaptions in Practice Bermudan Swaptions and Callable Bonds Pricing Swaptions with short rate models Callable Coupon Bonds vs Non callable coupon Bonds: Concluding remarks A very wide spread generalization of this bond is the step up bond callable bond (coupons increase with time) Which is the relation between the callable and non callable bond duration? How volatility affects the Bond holders in the two cases? Which is the effect of the moneyness of the option on the duration of a callable bond? Antonio Mannolini.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors.D FM2 Themes .

Ph.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors.D FM2 Themes . and Swaptions in Practice Bermudan Swaptions and Callable Bonds Pricing Swaptions with short rate models Swaptions with short rate models We have seen that a Swap can be also seen as an exchange of bonds Hence a Swaption an option to exchanage fixed for floating Floaters trade at par at coupon dates So to price a swaption we need an expression for a Coupon Bond Option If we could express a Coupon Bond Option as a Portfolio of Zero Coupon Bond Options life would be simpler as shorte rate models admit closed form solution for that We can do that thanks to the Jamshidian Trick Antonio Mannolini.

Tn }. .. solution of the following n X ci Π(t.. C. C. cn ] at dates T = {T1 .D FM2 Themes (37) . r? ) = K i=1 Antonio Mannolini. The payoff reads: + K − CB(t. Ti ) = i=1 n X ci Π(t.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors.. r(T )) (35) i=1 suppose we want to calculate the price of a put option with strike K on a Coupon Bond.. Ti . and Swaptions in Practice Bermudan Swaptions and Callable Bonds Pricing Swaptions with short rate models Jamshidian’s Trick I Consider a coupon bond which pays the folowing cash flow C = [c1 . . The bond price is given by: CB(t. T) (36) The first step consists in finding R? . Ti . T) = n X ci P (t. Ph.. Let t ≤ T1 .

and Swaptions in Practice Bermudan Swaptions and Callable Bonds Pricing Swaptions with short rate models Jamshidian’s Trick II which allows us to rewrite the payoff as X n + ci (Π(T. Ti .D FM2 Themes (38) .Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. r(T ))) i=1 Antonio Mannolini. Ti . Ph. r? ) − Π(T.

This particular value is calculated with a root finding procedure In formulas the CBO with maturity T . r(T ))]+ (39) (40) i=1 This equation tell us that we can price a coupon bond option as a portfolios of options on ZCBs. T. Ti . strike K reads n X CBP (t. Ti .D FM2 Themes . K) = ci ZBP (t. r(t)) < 0. The strike of these option is calculated as the value of a ZCB given a particular value of the short rate.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. and Swaptions in Practice Bermudan Swaptions and Callable Bonds Pricing Swaptions with short rate models Jamshidian’s trick III If the model satisfies this condition ∂Π(t. T. r? ) − Π(t. T. ∀0 < t < s ∂r We can write n X ci [(Π(t. C. Ph. T. Ti . r? )) (41) i=1 The same relation holds for the call option Antonio Mannolini. Π(T. Ti .

fix ci = Xτi for i = 1. Thus for the price of a payer swaption we have to calculate the following payoff + 1 − CB(t. C. n − 1 and cn = 1 + Xτi Let the swap notional be equal to N = N ∗ 1. i = 1. Ph... T) (42) We can calculate this payoff via the procedure outlined before Antonio Mannolini.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors..D FM2 Themes . . and Swaptions in Practice Bermudan Swaptions and Callable Bonds Pricing Swaptions with short rate models Adapting the procedure to Swaptions Denote as usual τi the year fraction between ti−1 e ti . n. ...

Ki ) (44) (45) i=1 while the receicer swaption price reads n X RS(t. N ) = N ci ZBC(t. T. Ki ) i=1 Antonio Mannolini. ti . T.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. T. we get Ki = A(T.ti )r ? . T. ti )e−B(T. T. solution of the following n X ? ci A(t. Ph. N ) = N ci ZBP (t. The payer swaption price is thus given by n X P S(t. ti . ti )e−B(t.ti )r = 1 (43) i=1 Given the affine structure of the model. T. and Swaptions in Practice Bermudan Swaptions and Callable Bonds Pricing Swaptions with short rate models Swaption Pricing via Affine Short rate Models Let r? the value of the short rate at time T .D FM2 Themes (46) .

and Swaptions in Practice Bermudan Swaptions and Callable Bonds Pricing Swaptions with short rate models Review of Results Caps and Floors can be priced as Options on ZCBs Jamshidian’s Trick for Swaptions allows us to estend the use of ZCBO If the model admits a closed form expression for ZCBs option. Floors Swaptions (great!) Also becuase it can be (easily?) calibrated to market instruments It can be used to price al least everything coherent with the main liquid instruments in IRD option markets But how effective can they be? Are we forcing the wrong model to replicate a too complicated market? Antonio Mannolini.D FM2 Themes .Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. Ph. then it admits a closed for solutions for Caps.

. Can do any payout...D FM2 Themes . Antonio Mannolini. annualized Traders do not quote model parameters. and Swaptions in Practice Bermudan Swaptions and Callable Bonds Pricing Swaptions with short rate models Pros and Cons of Short Rate Models Pros: easy to implement.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. Often appealing economic interpretation of the parameters Cons: often they have too few parameters to account for enough liquid instruments Cons: the market speaks a different language. Volatilities are quoted in percentage. Ph.

K) = K + max(F (T ) − K. 0) (47) Rule 2 max(F (T ) − K.D FM2 Themes K ) α (48) (49) . K) = α max(F (T ).Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. Antonio Mannolini. and Swaptions in Practice Basic tricks I Rule 1 max(F (T ). 0) = F (T ) − K + max(K − F (T ). 0) Rule 3 max(αF (T ). Ph.

K) = K + α max(F (T ) − K . 0] − max[F (T ) − Kmax − Kmin . 0) (51) Rule 6 min(max(F (T ) − Kmax . Kmin ) = max[F (T ) − Kmax . Ph. 0] Antonio Mannolini. 0). 0) α (50) Rule 5 max(F (T ).D FM2 Themes (52) . 0) = − min(−F (T ).Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. and Swaptions in Practice Basic tricks II Rule 4 max(αF (T ).

after having added and subtracted αF (T ) K −min[0.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. We write the coupon in general form as: C = max[0. −αF (T )] + K = K − min[K. K − αF (T )] (53) which. 0] (55) Antonio Mannolini. and Swaptions in Practice Analysis of a Reverse Floater Bond Denote F(T) the Euribor 6m observed at date T. Ph.D FM2 Themes . K −αF (T )]+αF (T ) = K −αF (T )+max[αF (T )−K. adding and subtracting K. we can rewrite as max[−K. αF (T )] (54) which reads.

Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors. Ph. If K is close to the forwad rates. and Swaptions in Practice Analysis of a Reverse Floater Bond II Which gives the payoff as the sum of a fixed leg of an irs which pays K − αF (T ) and a Cap written on αF (T ) with strike K. Vega is much higher. What happens if F (T ) collapses? How the vega affects the bond holder? Antonio Mannolini.D FM2 Themes . Investor is long vega.

Antonio Mannolini.D FM2 Themes . In this case the digital floor has a lower strike (i. Then there is a vanilla floor with strike 3 ( the lower one). In this way the customer can pay a lower rate but if the digital bites the strike then he pays as the floor would have been higher. Ph. Collar Down and In. and Swaptions in Practice Liability Management: Vertigine della lista Collars Floor down and in.e 3 and a payout equal to the difference between higher and lower strike (i. It is replicated by means of two floors: one digital. the other plain vanilla. Example: Floor with strike 4 down and in at 3.e 4 − 3 = 1. In a collar down and in the Floor is down and in.Swaps Cap and Floors Alternative methods for valuing Cap and Floors Swaptions How Traders use Caps&Floors.

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