Swaps & Swaptions

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
1
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
2
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
3
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)
4
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
5
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
6
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
7
& Bonds
Float side:
A single floating leg & the replicating portfolio
Period τ $1+
LIBRO LIBRO $ 1
τ τ
= =
Ti-τ Ti
$1
$1
8
& Bonds
Float side: PV fl (t ) = 1 − Z (t ; TN )
All floating legs
=
t
t
$1
9
& 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
10
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
11
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 )
12
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
13
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))
14
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
15
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
16
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!
17
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
18
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
19
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
20
Thank You!
21

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Swaps & Swaptions

Interest rate swaps.

 Swaps- agreements between two companies

The parties to an interest rate swap

Pays fixed Receives fixed

Receives floating Floating interest Pays floating

•Notional principal will not be exchanged

Diagram of cash payments-2-y, semi-annual, $1, r*, r

Z(t, Ti); rs-fixed rate; principal= 1.

Obtain the (par) swap rate by

Obtain Z(t, T1) by

 At initiation: swap has value of 0

Suppose- A: paying floating B: receive fixed

 Receiver swaption: option to a swap receiving

Decision of a payer swaption holder Tom

Year 0: Year 5: Exercise date Year 15

Tom buys a Exercise! if 10-year swap

The underlying is a forward on a swap

 Swaps can be decomposed into zero-coupon

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Interest rate swaps.

Swaps- agreements between two companies

At initiation: swap has value of 0

Receiver swaption: option to a swap receiving

Swaps can be decomposed into zero-coupon