Swap Rates Fallback and Term Structure Modelling

Abstract

The ISDA designed fallback for cash-settled swaptions with collateral discounting generates swap rate and term structure dependent exotics. To analyse precisely the fallback impact a full term structure of rates and volatility modelling is required. A recent paper Bang and Daboussi (2022) developed such an approach for swap rate based products like CMS. In this paper we apply those techniques to the valuation and risk management of the instruments resulting from the cash-settled and physical delivery swaption fallback. In doing so, we provide some model validation for the approximations previously proposed in this context.

Keywords: Swap rates, term structure modelling, LIBOR fallback, swaption

JEL Classification: G13, G15, G23, K12