Swaptions Valuation: Why you need to understand the different settlement types and how this will help you not fall victim to arbitrage
Plain vanilla interest rate swaptions are among the most basic interest rate derivatives around. They are widely used by many market participants. Their pricing, however, is far from trivial! Strictly speaking, European cash-settled swaptions - the market standard for EUR and GBP swaptions - are not vanilla options and their valuation is model dependent. The flaws of the simplified market standard formula were exposed in 2015 when interest rates hit their historical lows leading to large valuation discrepancies and arbitrage opportunities.
The introduction of a new settlement valuation standard by ISDA in November 2018 was an answer to some issues. Legacy trades however will remain under older conventions, further complicating pricing and valuation of swaptions portfolios.
Even more importantly, European swaptions form the basis for all volatility-sensitive interest rate product valuations such as constant maturity swaps (CMS), Bermudan swaptions and callable Libor exotics. Therefore, mispricing them impacts the whole spectrum of interest rate volatility products.
Follow us on an exciting journey through the world of swaptions and interest rate volatility, and learn how to get things right for your own interest rate derivatives portfolio!