Interest Rate Swaptions (Swaption)

As an important instrument in the interest rate derivatives market, interest rate swaptions provide market participants with effective tools for managing interest rate risk and flexibly adjusting asset-liability structures.

1. Core Product Concepts

1.1 Basic Definition

An interest rate swaption (Swaption) is a European-style option that grants the holder the right, but not the obligation, to enter into an interest rate swap agreement on a specific future date. Based on the direction of the right, they can be divided into:

• Payer Swaption: Grants the right to pay fixed rate and receive floating rate
• Receiver Swaption: Grants the right to receive fixed rate and pay floating rate

1.2 Key Elements

Element	Description
Underlying Swap	Typically plain vanilla interest rate swap
Strike Rate	Fixed rate level in the swap agreement
Expiry Date	Option exercise date
Swap Tenor	Duration of underlying swap (e.g., 5Y, 10Y)
Pricing Benchmark	Mainly linked to SHIBOR3M or FR007 in RMB market

2. Pricing Models and Technical Analysis

2.1 Black-76 Model

The market standard pricing model assumes forward swap rates follow lognormal distribution:

Payer Swaption Pricing Formula:

$$V_{payer} = A(0,T_{start},T_{end})[FΦ(d_1) - KΦ(d_2)]$$

Receiver Swaption Pricing Formula:

$$V_{receiver} = A(0,T_{start},T_{end})[KΦ(-d_2) - FΦ(-d_1)]$$

Where:

$$d_1 = \frac{\ln(F/K) + σ^2T/2}{σ\sqrt{T}}, \quad d_2 = d_1 - σ\sqrt{T}$$

Parameter Explanation:

• $A$: Annuity Factor
• $F$: Forward swap rate
• $K$: Strike rate
• $σ$: Implied volatility
• $T$: Option tenor

2.2 RMB Market Characteristics

1. Volatility Surface:

   • Short-term (1Y) implied volatility: 18-25%
   • Long-term (10Y) implied volatility: 15-20%
   • Displays "smile" feature - volatility increases when strike deviates from ATM

2. Liquidity Distribution:

   • Most active tenors: 1Y and 5Y
   • Most active strikes: ATM±50bp

3. Basis Impact:

   • 10-15bp basis between SHIBOR3M and FR007 swaps
   • Benchmark conversion adjustments needed in pricing

3. Application Scenarios and Strategies

3.1 Typical Application Case

Case: Bank Asset-Liability Management

• Background: A joint-stock bank needs to convert 2B RMB floating-rate liabilities to fixed-rate in 6 months
• Operation: Buy 6M expiry, 5Y tenor Receiver Swaption at 3.2% strike
• Effect:
  • If 5Y swap rate < 3.2% after 6M: Exercise to lock favorable rate
  • If market rate >3.2%: Let expire and enter swap at market rate
  • Maximum loss: Premium paid

Cash Flow Analysis:

Scenario	Market Rate	Decision	Actual Funding Cost
Rate Decline	2.8%	Exercise	3.2%
Rate Rise	3.5%	Let expire	3.5%

3.2 Advanced Trading Strategies

1. Straddle Strategy:

   • Simultaneously buy Payer and Receiver Swaptions at same strike
   • Bet on volatility increase

2. Spread Strategy:

   • Buy short-term Receiver + Sell long-term Payer
   • Hedge against yield curve steepening

3. Bermudan Swaption:

   • American-style with multiple exercise dates
   • Suitable for mortgage prepayment risk hedging

4. Risk Management Highlights

1. Greek Letters Management:

   Risk Metric	Management Approach
   Delta	Hedge with underlying IRS
   Gamma	Dynamic hedge ratio adjustment
   Vega	Control volatility exposure

2. Stress Testing:

   • Extreme scenario: 50bp single-day rate move
   • Sustained shock: 100bp cumulative move over 5 days

3. Margin Monitoring:

   • Daily mark-to-market (MtM)
   • Periodic collateral quality assessment

5. Interest Rate Swap Basis

In China's interest rate derivatives market, systematic spreads exist between different benchmark rates, known as Basis. Specifically for the two main benchmarks SHIBOR3M and FR007:

1. SHIBOR3M (3-month Shanghai Interbank Offered Rate)

   • Reflects unsecured interbank lending rate
   • Contains bank credit risk premium
   • Relatively higher volatility
   • Typically 10-15bp higher than FR007 long-term

2. FR007 (7-day Repo Fixing Rate)

   • Collateralized short-term rate using government bonds
   • Lower credit risk
   • Better market liquidity
   • Considered RMB market's "risk-free" benchmark

Although some swaption contracts reference SHIBOR3M, market practice generally uses FR007 curve for pricing due to:

(A) Market Liquidity Differences

• FR007 market: Daily trading volume exceeds 2 trillion RMB with diverse participants (banks, non-banks etc.), accounting for over 70% of RMB IRS market
• SHIBOR3M market: Relatively lower trading volume, lack of reliable long-term (e.g., 5Y+) quotes, and typically 3-5bp wider bid-ask spreads than FR007

(B) Curve Construction Quality

1. FR007 Curve Advantages

   • Supported by active cash (repo) and futures (government bond futures) markets
   • Forward rates can be precisely derived through no-arbitrage principle
   • Continuous and transparent data

2. SHIBOR3M Curve Limitations

   • Lacks directly corresponding cash instruments
   • Forward rates rely on bank quotes
   • Long-end data requires model filling, introducing material errors

(C) Risk Management Considerations

• Hedging Instrument Availability
  • FR007 has abundant hedging tools (government bond futures, IRS etc.)
  • SHIBOR3M hedging tools are relatively limited
• Capital Efficiency
  • FR007 products typically have lower risk weights
  • Using FR007 curve optimizes capital usage

In practice, when using FR007 curve to price SHIBOR3M-linked swaptions, basis adjustments are required:

(A) Basic Adjustment Formula

SHIBOR3M forward rate = FR007 forward rate + Basis (typically 10-15bp)

(B) Strike Rate Adjustment
For Receiver Swaption:

Adjusted strike rate = Nominal strike rate - Basis

Example:

• Nominal strike: 3.5%
• Basis: 12bp
• Adjusted strike: 3.38%

Practical Recommendations

1. Pricing Advice

   • Prioritize FR007 curve as pricing benchmark
   • Apply basis adjustments for SHIBOR3M products
   • Update basis parameters regularly (recommended quarterly)

2. Risk Management

   • Establish basis risk monitoring mechanism
   • Set limits for cross-benchmark positions
   • Conduct regular basis stress tests

3. System Construction

   • Build basis adjustment modules into pricing systems
   • Develop multi-curve management framework

This approach of FR007-based pricing supplemented with basis adjustments ensures both pricing accuracy/reliability and compliance with market liquidity/regulatory requirements, representing current best practice in RMB interest rate derivatives markets.