Chapter 45. Valuing Swaptions


Professor in the Practice of Finance, Yale School of Management


President Founder of BFRC Services, LLC

Abstract: An interest rate swap is a derivative instrument wherein the counterparties agree to exchange periodic interest payments. In the generic interest rate swap, also referred to as the plain vanilla swap, one party (the fixed-rate payer) agrees to pay the other party fixed interest payments at designated dates for the life of the contract. The fixed rate that the fixed-rate payer must make is called the swap fixed rate or swap rate. The other party agrees to make payments that float with some reference rate (the fixed-rate receiver). There are options on interest rate swaps, referred to as swaptions. There are two types of swaps: a pay fixed swaption and a received fixed swaption. As the name implies, the former swaption entitles the option buyer to enter into an interest rate swap in which the buyer of the option pays a fixed rate and receives a floating rate; the latter swaption grants the buyer the right to enter into an interest rate swap that requires paying a floating rate and receiving a fixed rate. While the valuation of a plain vanilla interest rate swaps is straightforward, the valuation of swaptions is more complex.

Keyword: interest rate swap, plain vanilla swap, swaptions, pay fixed swaption, pay floating swaption, lattice model, interest rate models, backward induction

The valuation ...

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