Publication Type
Journal Article
Version
submittedVersion
Publication Date
7-2021
Abstract
Internal-rate-of-return (IRR) settled swaptions are the main interest rate volatility instruments in the European interest rate markets. Industry practice is to use an approximation formula to price IRR swaptions based on Black model, which is not arbitrage-free. We formulate a unified market model to incorporate both swaptions and constant maturity swaps (CMS) pricing under a single, self-consistent framework. We demonstrate that the model is able to calibrate to market quotes well, and is also able to efficiently price both IRR-settled and swap-settled swaptions, along with CMS products. We use the model to illustrate the difference in implied volatilities for IRR-settled payer and receiver swaptions, the pricing of zero-wide collars and in-the-money (ITM) swaptions, the implication on put-call parity, and the issue of negative vega. These findings offer important insights to the ongoing reform in the European swaption market.
Keywords
Interest rate marketswaptionsconstant maturity swapsderivative valuationstochastic volatility modelsfixed income marketinterest rate models
Discipline
Finance | Finance and Financial Management
Research Areas
Finance
Publication
International Journal of Theoretical and Applied Finance
Volume
24
Issue
4
First Page
1
Last Page
31
ISSN
0219-0249
Identifier
10.1142/S0219024921500266
Publisher
World Scientific Publishing
Citation
TEE, Chyng Wen and KERKHOF, Jeroen.
A unified market model for swaptions and constant maturity swaps. (2021). International Journal of Theoretical and Applied Finance. 24, (4), 1-31.
Available at: https://ink.library.smu.edu.sg/lkcsb_research/6868
Creative Commons License
This work is licensed under a Creative Commons Attribution-NonCommercial-No Derivative Works 4.0 International License.
External URL
https://doi.org/10.1142/S0219024921500266