Derivatives

CHAPTER 39Swaptions, Forward Swaps, and MBS

Aims

• To demonstrate how a payer swaption can be used to set an effective maximum swap rate that begins at expiration of the swaption but also allows the holder of the swaption to take advantage of lower (cash market) swap rates, should they occur in the future.
• To show how a long position in a forward swap locks in a known swap rate which will begin at expiration of the forward swap but the holder of the forward swap cannot take advantage of lower cash-market swap rates in the future should they occur.
• To analyse the use of various forms of mortgage-backed securities (MBS) and the interaction between interest rate changes, prepayment options, and the change in value of the MBS.
• To show how the Greeks can be used to hedge fixed income derivatives.

39.1 SWAPTIONS

Suppose you are thinking of taking out a 3-year pay-fixed (receive-float) vanilla interest rate swap in 2 years' time. You are worried that swap rates in 2 years' time will be high, implying you will pay a high fixed swap rate. If swap rates turn out to be low in 2 years' time then you will be happy to take advantage of this outcome. But you cannot know today what cash market swap rates will be in 2 years' time.

However, today, you would like to be able to fix the maximum swap rate you will pay in 2 years' time, whilst also being able to take advantage of low swap rates should they occur.

You can achieve this desired outcome if today you buy a 3-year payer swaption which ...