FM2 Themes: Antonio Mannolini, PH.D

Swaps
Cap and Floors

Alternative methods for valuing Cap and Floors
Swaptions
How Traders use Caps&Floors, and Swaptions in Practice
FM2 Themes
Antonio Mannolini, Ph.D
Siena, Winter 2015
FM2 Themes
Swaps
Cap and Floors
Swaptions
Introduction
1
Swaps
Basic facts
Basis Swaps
Bond and Swaps
Asset Swaps
Cap and Floors

The market Standard
Fixing Black Model: the Shifted Lognormal Model

Cap replica via a portfolio of Put Options on ZCB
Swaptions
Bermudan Swaptions and Callable Bonds
Pricing Swaptions with short rate models

FM2 Themes
Swaps
Cap and Floors
Swaptions
Swap rates
An Interest Rate Swap is a contract that exchanges payments
between two differently indexed legs, starting from a future
time instant. At every pre-specified instant Ti the fixed leg pays
the amount
N (Ti1 , Ti )K
while the variable leg pays the amount
N (Ti1 , Ti )L(Ti1 , Ti )
When the fixed leg is paid, the IRS is termed Payer IRS. If the
opposite holds, we have a Receiver IRS.
The discounted payoff of a Payer IRS can be expressed as:
X
i=+1
D(t, Ti )N
i
[L(Ti1 , Ti ) K]
|{z}
(Ti1 ,Ti )
FM2 Themes
Swaps
Cap and Floors
Swaptions
IRS and FRA I
The last (stochastic) expression is indeed the sum payoff FRAs

payoffs. Consider a Receiver forward start IRS ([K L(Ti1 , Ti )
replaces [L(Ti1 , Ti ) K]). We have:
RF S(t, T, , N, K)
= N
i P (t, Ti )(K F (t; Ti1 , Ti ))
i=+1
= N P (t, T ) + N P (t, T )
+N
i KP (t, Ti )
i=+1
FM2 Themes
Swaps
Cap and Floors
Swaptions
IRS and FRA II

An IRS can then be also seen as en exchange of a coupon-bearing
bond with a floating rate one
The rate K which makes the swap payout zero at inception is
called forward Swap rate:
P (0, T ) P (0, T )
S, (0) = P
i=+1 i P (0, Ti )
In case it it spot start T = 0 the above reads
1 P (0, T )
S, (0) = P
i=+1 i P (0, Ti )
o
In market practice is used as the strike for ATM Caps and
Swaptions. For swap in intuitive; for caps we will see later on
FM2 Themes
Swaps
Cap and Floors
Swaptions
Playing with the swap payoff

Take a Payer IRS with N = 1:
P (t, T ) P (t, T )
i KP (t, Ti )
i=+1
By multiplying and dividing by:
i P (t, Ti )
i=+1
we get
P
i=+1 i P (t, Ti )
P
i=+1 i P (t, Ti )

P (t, T ) P (t, T )

i KP (t, Ti )
i=+1
It follows
P (t, Ti )(S, (t) K)
i=+1
Antoniowill
Mannolini,
Ph.D when
FM2 Themes
This expression
be useful
pricing swaptions.
Swaps
Cap and Floors
Swaptions
The Theory in the One Curve Setting I

A basis swap is defined as a contract in which two floating legs
of a swap are exchanged.
The two legs can differ both in the tenor of the underlying rate
and in the frequency of payments.
For instance a typical basis swap is one in which a floating leg
indexed to Euribor6M is exchanged against one indexed to
Euribor3M
In theory there should be no basis as the value of the floating leg
is given by the following for the Forward Start case
P (0, T ) P (0, T )
and the following for the Spot Start case
1 P (0, T )
FM2 Themes
Swaps
Cap and Floors
Swaptions
The Theory in the One Curve Setting II
To verify the claim note that in both cases (spot and forward
start) what matters to determine the value of the floating leg is
the first reset date and the last payment date; hence if two
swap have the same first reset date and the same maturity,
whichever the reset frequency dates and the tenor of the index,
the basis should be zero according to this single curve theory
Exercise: write in detail the above argument, and provide an
example for both a 10Y spot start basis swap and a 1Y forward
10Y Swap. Which condition you need to derive the result?
FM2 Themes
Swaps
Cap and Floors
Swaptions
Bond-Swap relationship
Consider a Payer Forward Swap
P F S(t, T , T , , N, K) = N (P (t, T )P (t, T ))N
i P (t, Ti )
i=+1
(1)
which is the floating leg?
with
T = t,
i.e., spot trading. We thus get
P S(t, T ) = N N P (t, T ) KN
i P (t, Ti )
i=+1
= N CBP (t, T , K, N )
FM2 Themes
(2)
Swaps
Cap and Floors
Swaptions
Fixed Rate Side Continued
which rearranged gives

CBP (t, T , K, N ) = N P S(t, T )
The meaning is straightforward: a fixed rate bond can be
replicated using the N P V of a payer swap whose fixed leg
coincides with the fixed leg of the swap. The floating leg
represents the funding of the Bond: i.e. the interest the issuer
must pay to raise funds in the interbank market
FM2 Themes
(3)
Swaps
Cap and Floors
Swaptions
Swaps as an exchange of bonds

A swap can be considered as an exchange between two bonds. In
fact, the fixed leg of the swap can be viewed as a fixed coupon,
while the variable can be considered a floating rate note. In
detail, consider a coupon bond that pays the following cash flow
C = [c+1 , ..., c ]
(4)
T = [T+1 , ..., T ]
(5)
on the schedule
with
ci = N K,
i<
(6)
and
c = N K + N,
i=
(7)
The Coupon Bond price can be written as
CBP (t, C, T) =
ci P (t, Ti )
i=+1
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(8)
Swaps
Cap and Floors
Swaptions
A Floating Rate Note
Next consider a floating rate note that pays coupons at dates

T = [T+1 , ..., T ]
(9)
coupons calculated as the Libor rate fixed in the previous period

T = [T , ..., T1 ]
At maturity T notional is reimbursed.
FM2 Themes
(10)
Swaps
Cap and Floors
Swaptions
Floating Rate Side Continued

To value the price of this note we change sign to the RF S. Then
we impose K = 0, i.e., no fixed rate payments, and finally we
insert the present value of the notional at maturity N P (0, T ).
Hence
RF S(t, , N, 0) + N P (t, T ) = N P (t, T )
(11)
The intuition behind this formula is straightforward if we put

T = t. At the date of the first reset, the bond price equals par.
This result also holds for all the dates equal to the reset of the
floating rates. This is an alternative proof that to avoid arbitrage
opportunities, floating rate notes must trade at par
Provide an example of Italian government floating rate notes.
Did they trade at par in recent times? Provide an explanation
FM2 Themes
Swaps
Cap and Floors
Swaptions
Definition of the Asset Swap Package
An asset swap can be defined as a Syntetic floating-rate note

In fact, the Asset Swap transform a fixed rate in a floating rate,
leaving the credit risk profile unchanged
In the following we consider Par Asset Swaps. The package is
composed of a position in a Bond and a Position in a swap.
In case of default, the Asset swap buyer must pay the Fixed Leg
and the principal in the swap but does not receive the coupon of
the defaulted bond
FM2 Themes
Swaps
Cap and Floors
Swaptions
Valuation of the Asset Swap Package I

At valuation time t the three following facts are observed:
1
The asset swap buyer in t buys a generic risky coupon bond

CB(t, T, K, 1) at the market price CBP (t, T, K, N ) from the
asset swap seller
The asset swap seller pays/receives to/from the asset swap buyer
the diference CBP (t, T, K, N ) 1 in such a way that the net sum
paid from the asset swap Buyer is 1; hence if the Bond trades
above par the difference CBP (t, T, K, N ) 1 is paid to the asset
swap buyer by the asset swap seller; conversely if the bond trades
below par the difference 1 CBP is paid to the asset swap seller
by the asset swap buyer
A swap is started between the two counterparties such that the

asset swap seller receives a fixed leg equal to the coupon stream
of the bond and the asset swap buyer receives the floating leg
given by the euribor rate plus a spread AS
FM2 Themes
Swaps
Cap and Floors
Swaptions
Valuation of the Asset Swap Package II: Valuation

Equation
From the perspective of the asset swap seller the value of the
package is give by
n
X
1 CBP (t, T, K, 1) + K
i P (0, Ti )
i=1
n
X
(12)
i P (0, Ti )(L(T i 1, Ti ) + AS) = 0
i=1
Pn
Split in two parts i=1 i P (0, Ti )(L(T i 1, Ti ) + AS)
Observe that, as floating rate notes trade at par, we can write
n
X
1=
i P (0, Ti )(L(T i 1, Ti ) + P (0, Tn )
(13)
i=1
Pn
hence i=1 i P (0, Ti )(L(T i 1, Ti ) is equal to 1 P (0, Tn )

substitute in 12 and get a simpler equation
FM2 Themes
Swaps
Cap and Floors
Swaptions
Valuation of the Asset Swap Package III: result and

financial meaning
So we can write
1CBP (t, T, K, 1)+K
n
X
n
X
i P (0, Ti )(1P (0, Tn )+
i P (0, Ti )AS = 0
i=1
i=1
(14)
from which we can derive
n
n
X
X
CBP (t, T, K, 1) + K
i P (0, Ti ) + P (0, Tn ) =
i P (0, Ti )AS
i=1
i=1
(15)
Pn
We know then that K i=1 i P (0, Ti ) + P (0, Tn ) is the CBP
without credit risk. Indeed, as seen before, is the sum of coupons
and bond principal priced off the LIBOR curve, which, for the
moment, we have assumed risk free, (but remember, is not in real
life; it is just a benchmark curve!)
and finally we get
FM2 Themes
Swaps
Cap and Floors
Swaptions
The Result
AS =
CBP (t, T, K, 1) CBP (t, T, K, 1)

Pn
i=1 i P (0, Ti )
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(16)
Swaps
Cap and Floors
Swaptions
The market Standard

Caps and floors

A Cap is a Payer IRS in which the payment is done only if
positive. Its value is the expectation under the risk neutral
measure of:

D(t, Ti )N i max L(Ti1 , Ti ) K, 0
i=+1
A Floor is the same thing with the Receiver IRS:

D(t, Ti )N i max K L(Ti1 , Ti ), 0
i=+1
The cap allows investors which have a debt at variable rate to

buy insurance against high rates in the future.
In the following we will see how to evaluate this expectation
FM2 Themes
Swaps
Cap and Floors
Swaptions
The market Standard

The Black model

The Black model extends the Black-Scholes formulas for caplets,
swaptions and Bond Option prices. It uses the forward
coordinates, not the spot ones; this last is not a minor issue
indeed.
The main assumption is that relevant forward rates are
lognormally distributed.
It is the model widely used in practice. A formal justification of
this model is provided later in the course (Libor market model)
Black formula was indeed the metric by which traders translated
volatilities into prices until rates became too lows and the model
collapsed under the assumption of positive rates.
Alert: if the LIBOR/EURIBOR simple rates are lognormal, swap
rates can not be. This theoretical inconsistency is negligible in
real world situations
LIBOR/EURIBOR: they are both simple rates, look in the
internet for the difference (institutional feature)
FM2 Themes
Swaps
Cap and Floors
Swaptions
The market Standard

Pricing caps with the Black-76 formula
CapBl (0, , N, K, , ) = N
P (0, Ti ) Bl(K, F (0, Ti1 , Ti ), vi , 1)
i=+1
(17)
where
Bl(K, F, v, w) = F w(wd1 (K, F, v)) Kw(wd2 (K, F, v)
with
ln(F/K) + v 2 /2
v
ln(F/K) v 2 /2
d2 =
v
d1 =
(18)
(19)
(20)
and
vi = ,
Ti1
In the market , is quoted (CAP volatility!)

FM2 Themes
(21)
Swaps
Cap and Floors
Swaptions
The market Standard

Flat vols and Spot Vols

The market quotes caps volatilities for atm options and several
strikes (the smile)
Cap volatilities are known as flat vol, while caplet volatilities
must be boostrapped and are known as spot vols.
Caplet volatilities are logically tied to forward rate volatility as
measure of uncertainty
There is a sort of inconsistency in this market practice. The same
caplet belonging to two different caps, even if refers to the same
time period, is being valued using different volatilities....
and the different caplets of the same cap share the same volatility.
Bootstrapping is the way to solve the puzzle.
FM2 Themes
Swaps
Cap and Floors
Swaptions
The market Standard

The Volatility Hump
Market implied volatilities often dispay an hump in the front end

When the hump does not appear it is regarded as stressed market
There is a financial explanation for this feature.
Uncertainty is bigger in the intermediate region and lower in the
front of the maturity spectrum.
For long maturities volatility tends to decay. Think to an
economic explanation please!
FM2 Themes
Swaps
Cap and Floors
Swaptions
The market Standard

Problems with the Black model

In Black model negative rates are not allowed. Hence a zero
strike floor can not be priced
When rates where at 5% level this was not an issue.
But now in the interbank market it is not so unusual to find
prices for 1% strike floors
Remember that in the standard Black formula d1 is not defined
when the forward rate is negative
Moreover in the Black model the empirical fact of the smile is not
accounted for
Two caps identical but for the strike need a different volatility to
recover two different market prices if one uses Black Formula
And this is clear if one looks at the distribution and at the
process of F (t, T, S); the volatility does not depend on the strike
of the option. It is a characteristic of the forward rate.
FM2 Themes
Swaps
Cap and Floors
Swaptions
The market Standard

The Practitioner solutions
To face the smile, the model is used with different input

volatilities for different strikes.
In practice the model is a mapping of implied volatilities into
prices and viceversa
It is used to boostrap caplet volatilities
To face the non negativity of rates, Black model has been shifted
The tecqnique was already known, but was used in order to
account for a (bit) smile
Now it is used to shift the lower bound of prices admitted by the
model.
FM2 Themes
Swaps
Cap and Floors
Swaptions
The market Standard

The Shifted Lof Normal Model for Caplets I
Rewrite the Black -76 SDE for the (T,S) caplet as follows
dF (t, T, S) = shif ted (F (t, T, S) )dW (t)QS
(22)
It easy to see that the price for a (T,S) caplet with strike K is
given by
Cpl(t, T, S, , K, vT , ) =
P (t, S)Bl(K , F (t, T, S) , vT )
FM2 Themes
(23)
Swaps
Cap and Floors
Swaptions
The market Standard

The Shifted Log Normal Model for Caplets II
where 18,d1 and d2 read as before and instead vi is now given by
shif ted
T
(24)
vT = ,
shif ted
In the market ,
is quoted (with = 3 in the current rate
environment)
What is the relationship between shif ted and vT ?
FM2 Themes
Swaps
Cap and Floors
Swaptions
Caplets as ZCB put options

A caplet is defined as:

D(t, Ti )N i max L(Ti1 , Ti ) K, 0

and its value is given by:
R

Ti
N E Q max e t rs ds N (L(Ti1 , Ti ) K), 0
This can also be written:
R

T
t i1 r(s)ds
+
NE e
P (Ti1 , Ti ) (L(Ti1 , Ti ) K) | Ft
FM2 Themes
(25)
Swaps
Cap and Floors
Swaptions
continues
Using the definition of Libor rates we get:
R

Ti1 r(s)ds
N E e t
P (Ti1 , Ti )

NE e
Multiplying by
R Ti1
t
r(s)ds
1
1+K
1
P (Ti1 , Ti )
+
1 K
+

| Ft
[1 (1 + X )P (Ti1 , Ti )] | Ft
we finally get:
R
Ti1
r(s)ds
N (1 + K )E e t
[
1
P (Ti1 , Ti )]+ | Ft
1 + K
Caplets can then be seen as put options on ZCBs. In the same

way, floorlets can be seen as call options on ZCBs.
FM2 Themes
Swaps
Cap and Floors
Swaptions
Uses of this result
With this replica we can price Cap and Floors every time we use
a model which admits a closed formula for ZCB Options.
As we will see the most used short rate models admit closed
formulas for these options
Rememeber that a closed formula connects parameters of the
model with a price of an option
So with this replica we can directly price Caps and Floors with
many short rate models we will see later
Short rate models always need a bridge that connects a market
price with their parameters.
FM2 Themes
Swaps
Cap and Floors
Swaptions

Swaptions
There are two main types of swaptions (as the underlying swaps),
a payer version and a receiver version
An European payer swaption is an option giving the right to
enter a payer IRS at a given future time, called the swaption
maturity. If you are on the buyer side (you are long payer
swaption) which is your view on rates? Why? And the Receiver?
Usually, the swaption maturity coincides with the first reset date
of the underlying IRS.
The length of the underlying IRS is called the tenor of the
swaption. ATM Swaption are quoted for maturities ranging from
1m 30Y
for tenors ranging from
1Y 30Y
A swaption is ATM when the strike is equal to the Swap Forward
Rate
S, (t)
FM2 Themes
Swaps
Cap and Floors
Swaptions

Swaption Continued
The discounted payoff of a payer swaption (with maturity T is
given, recalling the value of a payer IRS:
N
P (T , Ti )i (F (T ; Ti1 , Ti ) K)
i=+1
by:
N D(t, T )
!+
P (T , Ti )i (F (T ; Ti1 , Ti ) K)
i=+1
This payoff cannot be easily decomposed in elementary parts.

Notiche that it canbBe written also as

+ X
N D(0, T ) ST , (T ) K
i P (0, Ti )
(26)
i=+1
FM2 Themes
Swaps
Cap and Floors
Swaptions

Black Formula for Swaptions

if you substitute F (0, Ti1 , Ti ) with S, (0)
and plug in the quoted swaption volatility (and the right dates)
you get Blacks formula for swaptions
P SBl (0, T, S, N, K, , ) = N
P (0, Ti ) [S, (T )(d1 )K(d2 ]
i=+1
(27)
where
ln(S, /K) + v 2 /2
v
ln(S, /K) v 2 /2
d2 =
v
p
vi = , T
d1 =
and
In the market , is quoted: with respect to caps there one

more dimension: we have in fact quotes for Option Maturity,
Tenor and strike. So we have a surface of volatilities.
FM2 Themes
(28)
(29)
(30)
Swaps
Cap and Floors
Swaptions

Difference between Caps and Swaptions I
Caps can be decomposed into more elementary products: caplets.

You can value simply each caplet at once and then add their
prices.
So you can value them modeling each forward rate at once.
No joint action of forward LIBOR /EURIBOR rates is involved
Instead in a swaption, if you take as foundamental entity the
LIBOR /EURIBOR rates you have to deal with the joint action
of the simple forward LIBOR /EURIBOR rates
So you have to deal with terminal correlation between rates of
different portions of the yield curve. Do you undestand the
point? Can you provide an example?
FM2 Themes
Swaps
Cap and Floors
Swaptions

Difference between Caps and Swaptions II
Swaption volatilities are quoted for different maturities and

tenors (length of the undelying swaps)
Both for ATM and away from ATM in both sides (Swaption
smile)
So swaption have an additional dimension with respect to caps
They have also a different delta effect on you book.
Volatility trade between caps and swaption: WEDGE.
FM2 Themes
Swaps
Cap and Floors
Swaptions

Bermudan Swaptions
A Bermudan Swaption gives the holder the right to enter in
an interest rate swap contract at different dates (usually the swap
reset dates) with some days of notification to the counterparty
The interest rate swap the holder can enter is the same existing
contract, so if the holder does not exercise at the first date in the
call schedule, the option for the following periods is written on
shorter swaps
As an example consider the following: Receiver Bermudan
Swaption written on a 3 year swap with the first call date 2y
from now ( we suppose semiannual payments): if at the end of
the second year she will not excercise, six months later she will
have to decide if enter on not in the same remaining swap which
now has become a 2y6m swap
In this case at the last option exercise date she will decide
whether or not to enter on the 2y6m 3y FRA.
To value this Option Tree methods or the Longstaff Schwartz
methos is to be used
FM2 Themes
Swaps
Cap and Floors
Swaptions

Callable Coupon Bond

A callable bond is a bond which allow the issueer to call the bond
(usually at par) during the life of the bond
There can be one callability date or more callability dates
It is easy to guess that a replica for the callable bond price can
be obtained by simply adding a Swaption to the swap used to
price a bond in the bond swap replica seen above
If there are multiple callability dates is clear that the swaption
we need is a bermudan one.
With a receiver bermudan swaption with the same contractual
conventions of the Swap (so the strike of the swaption is equal to
the coupon of the bond) we can offset the swap; which represents
the economic equivalent of calling the bond at par.
So max(CCBP (T, S, K, ) 100, 0) can be represented as
max(K S(Tj , )(T ), 0)
Intuition: Long on the bond, short on the rates
FM2 Themes
Swaps
Cap and Floors
Swaptions

Callable Coupon Bonds vs Non callable coupon Bonds I

Ceteris Paribus a non callable Coupon Bond has an higher price
than a callable one
At inception both must be worth 100 (a part from other costs
and fees which we wil neglect)
A Typical cooupon bond, once credit risk is isolated and
remunerated will pay the average market rates prevailing at the
time of the issue. These are related to the swap rate prevailing in
that moment
Suppose credit risk is zero: in this ideal case the coupon bond
will pay the corresponding swap rate prevailing on the market.
Suppose we price a 5Y bullet bond. At inception the following
must hold
CBP (0, 5, K, ) = 100 N P V5ySwap(0) = 100
FM2 Themes
(31)
Swaps
Cap and Floors
Swaptions

Callable Coupon Bonds vs Non callable coupon Bonds

II
which implies N P V5ySwap(0) = 0; Hence K = K5ySwap(0) . This

means that credit consideration apart, a bank must pay the
market prevailing rate when it issues a bond. And this should
not surpirise anyone
If the same bond were callable after two years each six months,
we will have the following facts
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Swaps
Cap and Floors
Swaptions

Callable Coupon Bonds vs Non callable coupon Bonds

III
Let us denote RBS(t, 6m, T1c , T , K, N ) the bermudan receiver
swaption with first call date T 1c and subsequent ones each six
months. The last payment date is equal to the one of the swap.
In this case the call dates vector is [2y, 2y6, 3y, 3y6m, 4y, 4y6m]
Suppose RBS(0, 6m, T2y , T5y , K1 , N ) > 0
CBP (0, 5, K, ) = 100 (N P V5ySwap(0) + N P VRBS ) = 100 (32)
implies
N P V5ySwap(0) = N P VRBS < 0
(33)
K1 > K5ySwap(0)
(34)
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Cap and Floors
Swaptions

Risk Analysis of a Callable Bond Recap

It can not go much above PAR. The Price-Yield relation is
broken at a certain level
Investor sells an option to the Bank for higher (initial) coupons.
Customer is long bond, short rates, short Option (Receiver
Swaption)
Coupons are better than market prevailing rates would have
allowed for a fixed rate note
After the issue if rates go down the Bank will call the bond
(because, ceteribus paribius, it will have a price above 100) as it
will not want to pay an higher than market level remuneration
for the money it has borrowed from customers: conversely if rates
goes down it will not buy back the bond as is financing itself at a
lower that market implied rates
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Swaps
Cap and Floors
Swaptions

Callable Coupon Bonds vs Non callable coupon Bonds:

Concluding remarks
A very wide spread generalization of this bond is the step up

bond callable bond (coupons increase with time)
Which is the relation between the callable and non callable bond
duration?
How volatility affects the Bond holders in the two cases?
Which is the effect of the moneyness of the option on the
duration of a callable bond?
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Swaps
Cap and Floors
Swaptions

Swaptions with short rate models
We have seen that a Swap can be also seen as an exchange of

bonds
Hence a Swaption an option to exchanage fixed for floating
Floaters trade at par at coupon dates
So to price a swaption we need an expression for a Coupon Bond
Option
If we could express a Coupon Bond Option as a Portfolio of Zero
Coupon Bond Options life would be simpler as shorte rate models
admit closed form solution for that
We can do that thanks to the Jamshidian Trick
FM2 Themes
Swaps
Cap and Floors
Swaptions

Jamshidians Trick I
Consider a coupon bond which pays the folowing cash flow
C = [c1 , ..., cn ] at dates T = {T1 , ...Tn }.
Let t T1 . The bond price is given by:
CB(t, C, T) =
n
X
ci P (t, Ti ) =
i=1
n
X
ci (t, Ti , r(T ))
(35)
i=1
suppose we want to calculate the price of a put option with strike

K on a Coupon Bond. The payoff reads:

+
K CB(t, C, T)
(36)
The first step consists in finding R? , solution of the following
n
X
ci (t, Ti , r? ) = K
i=1
FM2 Themes
(37)
Swaps
Cap and Floors
Swaptions

Jamshidians Trick II
which allows us to rewrite the payoff as

X
n
+
ci ((T, Ti , r? ) (T, Ti , r(T )))
i=1
FM2 Themes
(38)
Swaps
Cap and Floors
Swaptions

Jamshidians trick III

If the model satisfies this condition
(t, T, r(t))
< 0, 0 < t < s
r
We can write
n
X
ci [((t, Ti , r? ) (t, Ti , r(T ))]+
(39)
(40)
i=1
This equation tell us that we can price a coupon bond option as a

portfolios of options on ZCBs.
The strike of these option is calculated as the value of a ZCB
given a particular value of the short rate.
This particular value is calculated with a root finding procedure
In formulas the CBO with maturity T , strike K reads
n
X
CBP (t, T, T, C, K) =
ci ZBP (t, T, Ti , (T, Ti , r? ))
(41)
i=1
The same relation

holds for the call
option
FM2 Themes
Swaps
Cap and Floors
Swaptions

Adapting the procedure to Swaptions
Denote as usual i the year fraction between ti1 e ti , i = 1, .., n,

fix ci = Xi for i = 1, ..., n 1 and cn = 1 + Xi
Let the swap notional be equal to N = N 1,
Thus for the price of a payer swaption we have to calculate the
following payoff

+
1 CB(t, C, T)
(42)
We can calculate this payoff via the procedure outlined before
FM2 Themes
Swaps
Cap and Floors
Swaptions

Swaption Pricing via Affine Short rate Models

Let r? the value of the short rate at time T , solution of the
following
n
X
?
ci A(t, ti )eB(t,ti )r = 1
(43)
i=1
Given the affine structure of the model, we get

Ki = A(T, ti )eB(T,ti )r
.
The payer swaption price is thus given by
n
X
P S(t, T, T, N ) = N
ci ZBP (t, T, ti , Ki )
(44)
(45)
i=1
while the receicer swaption price reads

n
X
RS(t, T, T, N ) = N
ci ZBC(t, T, ti , Ki )
i=1
FM2 Themes
(46)
Swaps
Cap and Floors
Swaptions

Review of Results
Caps and Floors can be priced as Options on ZCBs
Jamshidians Trick for Swaptions allows us to estend the use of
ZCBO
If the model admits a closed form expression for ZCBs option,
then it admits a closed for solutions for Caps, Floors Swaptions
(great!)
Also becuase it can be (easily?) calibrated to market instruments
It can be used to price al least everything coherent with the main
liquid instruments in IRD option markets
But how effective can they be? Are we forcing the wrong model
to replicate a too complicated market?
FM2 Themes
Swaps
Cap and Floors
Swaptions

Pros and Cons of Short Rate Models
Pros: easy to implement, Can do any payout....

Often appealing economic interpretation of the parameters
Cons: often they have too few parameters to account for enough
liquid instruments
Cons: the market speaks a different language. Volatilities are
quoted in percentage, annualized
Traders do not quote model parameters.
FM2 Themes
Swaps
Cap and Floors
Swaptions
Basic tricks I
Rule 1
max(F (T ), K) = K + max(F (T ) K, 0)
(47)
Rule 2
max(F (T ) K, 0) = F (T ) K + max(K F (T ), 0)
Rule 3
max(F (T ), K) = max(F (T ),
FM2 Themes
K
)
(48)
(49)
Swaps
Cap and Floors
Swaptions
Basic tricks II
Rule 4
max(F (T ), K) = K + max(F (T )
K
, 0)
(50)
Rule 5
max(F (T ), 0) = min(F (T ), 0)
(51)
Rule 6
min(max(F (T ) Kmax , 0), Kmin ) =
max[F (T ) Kmax , 0] max[F (T ) Kmax Kmin , 0]
FM2 Themes
(52)
Swaps
Cap and Floors
Swaptions
Analysis of a Reverse Floater Bond

Denote F(T) the Euribor 6m observed at date T. We write the
coupon in general form as:
C = max[0, K F (T )]
(53)
which, adding and subtracting K, we can rewrite as

max[K, F (T )] + K = K min[K, F (T )]
(54)
which reads, after having added and subtracted F (T )

K min[0, K F (T )]+F (T ) = K F (T )+max[F (T )K, 0]
(55)
FM2 Themes
Swaps
Cap and Floors
Swaptions
Analysis of a Reverse Floater Bond II
Which gives the payoff as the sum of a fixed leg of an irs which
pays K F (T ) and a Cap written on F (T ) with strike K.
Investor is long vega. If K is close to the forwad rates, Vega is
much higher.
What happens if F (T ) collapses? How the vega affects the bond
holder?
FM2 Themes
Swaps
Cap and Floors
Swaptions
Liability Management: Vertigine della lista
Collars
Floor down and in. Example: Floor with strike 4 down and in at
3. It is replicated by means of two floors: one digital, the other
plain vanilla. In this case the digital floor has a lower strike (i.e 3
and a payout equal to the difference between higher and lower
strike (i.e 4 3 = 1. Then there is a vanilla floor with strike 3 (
the lower one).
Collar Down and In. In a collar down and in the Floor is down
and in. In this way the customer can pay a lower rate but if the
digital bites the strike then he pays as the floor would have been
higher.
FM2 Themes

FM2 Themes: Antonio Mannolini, PH.D

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Swaps

Cap and Floors

Siena, Winter 2015

Antonio Mannolini, Ph.D

Cap and Floors

Alternative methods for valuing Cap and Floors

How Traders use Caps&Floors, and Swaptions in Practice

Antonio Mannolini, Ph.D

IRS and FRA I

The last (stochastic) expression is indeed the sum payoff FRAs

i P (t, Ti )(K F (t; Ti1 , Ti ))

Antonio Mannolini, Ph.D

IRS and FRA II

Playing with the swap payoff

By multiplying and dividing by:

P (t, Ti )(S, (t) K)

The Theory in the One Curve Setting I

The Theory in the One Curve Setting II

Antonio Mannolini, Ph.D

Fixed Rate Side Continued

which rearranged gives

Antonio Mannolini, Ph.D

Swaps as an exchange of bonds

The Coupon Bond price can be written as

A Floating Rate Note

Next consider a floating rate note that pays coupons at dates

coupons calculated as the Libor rate fixed in the previous period

Antonio Mannolini, Ph.D

Floating Rate Side Continued

The intuition behind this formula is straightforward if we put

Antonio Mannolini, Ph.D

Definition of the Asset Swap Package

An asset swap can be defined as a Syntetic floating-rate note

Antonio Mannolini, Ph.D

Valuation of the Asset Swap Package I

The asset swap buyer in t buys a generic risky coupon bond

A swap is started between the two counterparties such that the

Valuation of the Asset Swap Package II: Valuation

i P (0, Ti )(L(T i 1, Ti ) + AS) = 0

hence i=1 i P (0, Ti )(L(T i 1, Ti ) is equal to 1 P (0, Tn )

Valuation of the Asset Swap Package III: result and

CBP (t, T, K, 1) CBP (t, T, K, 1)

Antonio Mannolini, Ph.D

The market Standard

Caps and floors

A Floor is the same thing with the Receiver IRS:

The cap allows investors which have a debt at variable rate to

The market Standard

The Black model

The market Standard

Pricing caps with the Black-76 formula

P (0, Ti ) Bl(K, F (0, Ti1 , Ti ), vi , 1)

In the market , is quoted (CAP volatility!)

The market Standard

Flat vols and Spot Vols

Antonio Mannolini, Ph.D

The market Standard

The Volatility Hump

Market implied volatilities often dispay an hump in the front end

Antonio Mannolini, Ph.D

The market Standard

Problems with the Black model

The market Standard