Swaptions: European Swap Options

12/5/2020
Swaptions
EUROPEAN SWAP OPTIONS

Swap options: Referred to as Swaption.
Option that gives the right (at expiration date) to

enter into a pre-specified swap agreement.
1. For instance, the right may be to enter into a swap

agreement to receive 6 month LIBOR and pay a
specified fixed rate Rk on notional principal L, for a
specified period.
2. Alternatively, the right may be to receive fixed rate
Rk on principal L and pay floating rate, say 6
month LIBOR on L, for specified period.
Swaption is equivalent to a Bond Option:
A swap as in (1) above is equivalent to an agreement

to exchange a fixed-rate bond for a floating rate bond.
At the start of the swap, the value of the floating rate
bond = Notional principal, L. So the Swaption with
swap as in (1) above is equivalent to exchange a fixed
rate bond for L. So it is a put option to sell a fixed rate
bond for L.
The Swaption with swap as in (2) is equivalent to

exchanging a floating rate bond for a fixed rate bond.
Since the value of the floating rate bond is L, the
Swaption is equivalent to a call option to buy the
fixed rate bond for L.
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Valuation of Swaption:
Suppose the swap is as in (1), i.e., receive floating

rate and pay fixed. Swap rate for particular
maturity at a particular time is the fixed rate that
would be exchanged for LIBOR in a newly issued
swap with that maturity.
Assumption: Swap rate at maturity of option has a
log-normal distribution.
RT: Swap rate at maturity T of option.
Suppose fixed rate specified in the Swaption is Rk.
If RT < Rk, Swaption will not be exercised.

If RT > Rk, Swaption will be exercised.
Suppose there are m ( = 2 for 6 month LIBOR)
payments in a year. Then RT and Rk are expressed
with compounding frequency of m times per year.
Note: If RT > Rk, Swaption is exercised and the

series of fixed payments will be (L.Rk/m), instead of
(L.RT/m). The pay off from exercising the option will
be a series of cash flows
L
m
R T  R k .
So the Swaption in this case is a Call option on RT

with series of cash flows
L
m
Max R T  R k , 0 .......... ..( 1 )
Suppose that the life of the swap is n years, we
have series of mn cash flows as in (1) at times T1,
T2, ……., Tmn.
The value of the cash flow received at time Ti is
L
P ( 0 , T i ) R 0 N ( d 1 )  R k N ( d 2 ) 
m
 R  T
ln  0    2
where d1   Rk  2
 T
d 2  d1   T
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12/5/2020
Also,
R0 is the Forward swap rate
P(0, Ti): Value of a zero coupon bond maturing at Ti
Value of Swaption
mn
L
  P ( 0 , T i ) R 0 N ( d 1 )  R k N ( d 2 ) 
m
i 1
 L A R 0 N ( d 1 )  R k N ( d 2 ) 
mn
1
where A 
m

i 1
P ( 0 , Ti )
Note: A is the value of a contract that pays (1/m) at

times Ti, i = 1, 2, …., mn
If the Swaption is as in (2), i.e. Receive Fixed rate

and Pay Floating rate, then the payoff from the
option is L
m
Max R k  RT , 0 
So in this case, Swaption is a Put option on RT
with series of cash flows
L
m
Max R k  RT , 0 
at times Ti, i = 1, 2, …., mn
Value of Swaption is
 L A R k N (  d 2 )  R 0 N (  d 1 ) 
where A, d1, d2 and R0 are as defined before.
Swaption Example
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LIBOR yield curve is flat: 6% per annum with

continuous compounding
Swaption: Holder gets the right to pay 6.2% in a 3
year swap starting 5 years from now
Payments are semi-annual
Principal: 100
Volatility of swap rate: 20%
A = (1/2)[e-0.06(5.5) + e-0.06(6) + e-0.06(6.5) + e-0.06(7)
+ e-0.06(7.5) + e-0.06(8)] = 2.0035
Rate of 6% with continuous compounding is
equivalent to 6.09% with semi annual compounding.
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So,
R0 = 0.0609; Rk = 0.062; T = 5;  = 0.2
 0.0609  2 5 
ln   0.2   
 0.062   2   0.1836
d1 
0 .2 5
d2 = 0.1836 – 0.25 = -0.2636
Value of Swaption is
100 (2.0035) [0.0609 N(0.1836) – 0.062 N(-0.2636)]
= 2.07
11
Thank You!
Indian Institute of Management Bangalore

Bannerghatta Road, Bangalore – 560 076, INDIA
www.iimb.ernet.in
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12/5/2020

EUROPEAN SWAP OPTIONS

Option that gives the right (at expiration date) to

1. For instance, the right may be to enter into a swap

Swaption is equivalent to a Bond Option:

A swap as in (1) above is equivalent to an agreement

The Swaption with swap as in (2) is equivalent to

Suppose the swap is as in (1), i.e., receive floating

If RT < Rk, Swaption will not be exercised.

Note: If RT > Rk, Swaption is exercised and the

So the Swaption in this case is a Call option on RT

Note: A is the value of a contract that pays (1/m) at

If the Swaption is as in (2), i.e. Receive Fixed rate

where A, d1, d2 and R0 are as defined before.

LIBOR yield curve is flat: 6% per annum with

Indian Institute of Management Bangalore

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