Swaps & Swaptions
by Ying Ni
Interest rate swaps.
Valuation techniques
Relation between swaps and bonds
Bootstrapping from swap curve
Swaptions
Value swaption by the Black’76 model
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1. Introduction
Swaps- agreements between two companies
to exchange cash flows in the future
according to a predetermined formula.
Currency
Interest rate
Swaptions- options to enter into a swap
Usually an interest rate swap
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2. Interest Rate Swaps
The parties to an interest rate swap
Fixed interest rate
Party A Party B
Pays fixed Receives fixed
Receives floating Floating interest Pays floating
rate
•Notional principal will not be exchanged
•Floating-rate - Linked to i.e. 6-month LIBOR rates
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2.Interest Rate Swaps-
components of an Interest rate swap
1. Notional principal
2. Interest rates for the parties
Fixed rate
Floating rate
3. Payment frequency
Semi-annual
Quarterly…
4. Duration of the swap (or tenor, maturity)
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2. Interest Rate Swaps-
Example 1: Cash payments in a swap
Diagram of cash payments-2-y, semi-annual, $1, r*, r
½ r* (at t1)
½ r* (at t1,5)
½ r* (at t0,5)
½ r* (at t0)
½r ½r ½r ½r
t0 t0.5 t1 t1,5 t2 Time
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3. Comparative advantage
argument
Two companies want to borrow money
They are quoted fixed and floating rates such
that:
by exchanging payments between themselves
they benefit,
at the same time benefiting the intermediary who
puts the deal together
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4. The Relation between Swaps
& Bonds
Fixed-side= sum of zero-coupon bonds
Z(t, Ti); rs-fixed rate; principal= 1.
N
PV fix (t ) = rs ∑ Z (t ; Ti ).
i =1
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4. The Relation between Swaps
& Bonds
Float side:
A single floating leg & the replicating portfolio
Period τ $1+
LIBRO LIBRO $ 1
τ τ
= =
Ti-τ Ti
$1
$1
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4. The Relation between Swaps
& Bonds
Float side: PV fl (t ) = 1 − Z (t ; TN )
All floating legs
=
t
t
$1
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4. The Relation between Swaps
& Bonds
Value of the swap at initiation:
(receiver of the fixed side)
N
Vs (t ) = rs ∑ Z (t ;Ti ) − 1 + Z (t ;TN )
i =1
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5. Swap curve & Bootstrapping with Swaps
-Swap curve
Obtain the (par) swap rate by
N
Vs (t ) = rs ∑ Z (t ; Ti ) − 1 + Z (t ; TN ) = 0
i =1
1 − Z (t ; TN )
i.e. rs = N
∑ Z (t; T )
i =1
i
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5. Swap curve & Bootstrapping with Swaps
-Bootstrapping with Swaps
Obtain Z(t, T1) by
1 − Z (t ; T1 ) 1
rs (T1 ) = ⇒ Z (t ; T1 ) =
Z (t ; T1 ) 1 + rs (T1 )
M
k
1 − rs (Tk +1 )∑ Z (t ; Ti )
Z (t : Tk +1 ) = i =1
1 + rs (Tk +1 )
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6. Valuation of swaps
At initiation: swap has value of 0
Some time after initiation: swap may have
positive or negative value.
Suppose- A: paying floating B: receive fixed
The swap for A = a long position in a fixed-rate
bond + a short position in a floating-rate bond
Vs = B fix − B fl
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6. Valuation of swaps
value the floating-rate bond:
Suppose:
Notional principal = L,
Next payments at time Ti
Ki: Floating payment at time Ti
Immediately after the payment Bfl= L
Immediately before the payment Bfl= L+Ki
floating-rate bond =
an instrument providing a single cash flow of at time Ti.
value of the floating-rate bond today = (L+ki)exp(-r(Ti))
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7. Swaptions
Swaption: right to enter into a swap
at a specific date in the future
at a particular fixed rate
for a specified term
Components:
1. Maturity of the option
2. Strike rate
3. Payer or receiver
4. Type: American, European or Bermudan
5. All components of a swap
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7. Swaptions
Payer swaptions: option to enter into a swap
paying fixed and receiving floating
Benefit of the pre-set strike rate if the market rates are
higher, expires worthless if they are lower.
Receiver swaption: option to a swap receiving
fixed & pay floating
The opposite is true
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7. Swaptions-
Example 3: In-5-for-10 payer swaption-strike rate 7%
Decision of a payer swaption holder Tom
Year 0: Year 5: Exercise date Year 15
Tom buys a Exercise! if 10-year swap
swaption rate is above 7%, Tom
pays fixed (7%), and
receives floating.
-Otherwise,
do not Exercise!
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8. Valuation of Swaptions-
Black’76 Option Pricing Model
The underlying is a forward on a swap
− rT
Pcall = e ( F ⋅ N (d1 ) − K ⋅ N (d 2 ))
− rT
Pput = e ( F ⋅ N (− d 2 ) − K ⋅ N (− d1 ))
ln( F / K ) + (σ / 2)T 2
d1 = ; d 2= d1 − σ T
σ T
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8. Valuation of Swaptions-
Value European Swaptions use Black’76
1
1− τm
(1 − F / m)
c= e [F ⋅ N (d 1) − K ⋅ N (d 2 )]
− rT
F
1
1− τm
(1 − F / m)
p= e [K ⋅ N (− d 2) − F ⋅ N (− d1 )]
− rT
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9. Conclusion
Swaps can be decomposed into zero-coupon
bonds
Yield curve are often bootstrapped from swap
curve
After initiation, Swaps can be valued in terms of
fixed-rate and floating-rate bond
Swaptions are valued using the Black’76 option
pricing formula
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Thank You!
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