Principles of Financial Engineering, 2nd Edition

CHAPTER 21

Caps/Floors and Swaptions with an Application to Mortgages

1. Introduction

Swap markets rank among the world’s largest in notional amount and are among the most liquid. The same is true for swaption markets. Why is this so?

There are many uses for swaps. Borrowers “arbitrage” credit spreads and borrow in currencies that yield the lowest all-in-cost. This, in general, implies borrowing in a currency other than the one the borrower needs. The proceeds, therefore, need to be swapped into the needed currency. Theoretically, this operation can be done by using a single currency swap where floating rates in different currencies are exchanged. Currency swaps discussed in Chapter 5 are not interest rate swaps, but the operation would involve ...