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

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