CASH-SETTLED SWAPTIONS: A NEW PRICING MODEL

Raoul Pietersz, Frank Sengers () and Matteo Michielon ()
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Raoul Pietersz: ABN AMRO Bank N.V., Gustav Mahlerlaan 10, 1082 PP Amsterdam, The Netherlands
Frank Sengers: ABN AMRO Bank N.V., Gustav Mahlerlaan 10, 1082 PP Amsterdam, The Netherlands
Matteo Michielon: ABN AMRO Bank N.V., Gustav Mahlerlaan 10, 1082 PP Amsterdam, The Netherlands

International Journal of Theoretical and Applied Finance (IJTAF), 2020, vol. 23, issue 04, 1-16

Abstract: The market for cash-settled swaptions has changed its quotation conventions. Cash-settled zero-wide collars struck at the swap-settled forward have started trading at nonzero prices. Apart from full-fledged term-structure models, a simple arbitrage-free model to consistently value both cash-settled and swap-settled swaptions has been lacking so far. We propose a straightforward arbitrage-free model that consistently values cash-settled and swap-settled swaptions, and that also allows one to match zero-wide collar premiums. The defining characteristic of the model is to explicitly specify the swap-settled annuity as a function of a discount swap rate under the swap-settled annuity measure. The new methodology has many desirable features, and we show via a numerical example how the model performs in realistic market scenarios.

Keywords: Cash-settled swaption; zero-wide collar; Black model; Bachelier model; SABR; shifted log-normal (search for similar items in EconPapers)
Date: 2020
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DOI: 10.1142/S0219024920500284

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