Swap and Swaptions

Swaps & Swaptions
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 t1,5)
½ r* (at t0,5) ½ r* (at t1)
½ r* (at t0)
½r ½r ½r ½r
t0 t1 t2
t0.5 t1,5
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-fixedN rate; principal= 1.
PVfix (t)  rs 
i Z
1
(t;Ti ).
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)
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 
i1 Z (t;Ti ) 1 Z (t;TN ) 
0 1 Z (t;TN )
i.e. rs  N
Z
(t;Ti )
i1 11
5. Swap curve & Bootstrapping with Swaps
-Bootstrapping with Swaps
Obtain Z(t, T1) by

1 Z 1
rs (T1 )  1
 Z (t;T1 )
(t;T
Z ) 1 1 rs

M (t;T ) (T1 )
k
1 rs (Tk 1 ) Z
i1
Z (t : Tk 1 ) (t;T
i)
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
P e  rT
(F  N (d )  K  N (d
))
call 1 2
P  erT (F  N (d )  K  N
(d ))
ln(F / K )  (  2
/2
d1 
put ; d 2  d1   T
2)T  T
1
18
8. Valuation of Swaptions-
Value European Swaptions use Black’76
1
1
(1 F / m) m rT
c e F  N (d  K  N (d 2 )
F
1) 
1
1
(1 F / m) m
p e rT K  N ( d  F  N (d1 )
F 
2 ) 
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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Swap and Swaptions

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Swaps & Swaptions

Interest rate swaps.

 Swaps- agreements between two

The parties to an interest rate swap

Pays fixed Receives fixed

•Notional principal will not be exchanged

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

Z(t, Ti); rs-fixedN 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

 Receiver swaption: option to a swap receiving

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-

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