Swap Rate Fallback: Unreasonable Effectiveness of Approximations and Alternatives

13 Pages Posted: 14 Jun 2022

See all articles by Marc P. A. Henrard

Marc P. A. Henrard

muRisQ Advisory; OpenGamma; University College London - Department of Mathematics

Date Written: May 1, 2022

Abstract

Cash-settled swaptions with collateral discounting are impacted by the Swap Rate fallback mechanisms decided by working groups/ISDA. The legacy vanilla swaptions are becoming exotic products, as the mechanism is based on a non-linear transformation of the OIS swap rate, and generate convexity adjustments. It turns out that those two effects almost cancel each other and lead to almost vanilla products. We analyse those cancelling effects and the risk management impacts. Based on those insights, we propose an adjusted fallback mechanism that reduces further the exotic features and simplify further the risk management of the legacy book.

Keywords: swaption, LIBOR transition, fallback, vanilla options, convexity adjustment

JEL Classification: G13, G15, G23, K12

Suggested Citation

Henrard, Marc P. A., Swap Rate Fallback: Unreasonable Effectiveness of Approximations and Alternatives (May 1, 2022). Available at SSRN: https://ssrn.com/abstract=4130090 or http://dx.doi.org/10.2139/ssrn.4130090

Marc P. A. Henrard (Contact Author)

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