Cash-Settled Swaptions - A Review of Cash-Settled Swaption Pricing

Abstract

In this paper we provide an outline of interest rate swaptions and how to price swaptions with different payoff or settlement types. Firstly we review the different settlement styles commonplace in financial markets. Secondly we review the swaption pricing formulae corresponding to each settlement type and review pricing considerations associated with each payoff. Thirdly we review the pricing of swaptions with different choices of settlement style. We outline swaption par-yield pricing considerations and review the cash-annuity factor. We note that par-yield cash-settlement is not arbitrage-free, yet despite this par-yield settlement is a standard swaption payoff in European markets. We emphasize par-yield settlement, since his method can be provide significant benefits and yet be quite opaque and often misunderstood. Par-yield settlement provides a simplified representation of the cash payoff of a swap, which is convenient for swaption payoff standardization, trade netting and the exchange clearing of swaptions. Trade netting can significantly reduce counterparty credit risk, associated XVA and capital charges, which can be substantial. Finally we review how to extend the par-yield and cash-annuity definitions to allow the pricing of swaptions with stubs and irregular coupons.