Consider a swaption with option term of 15 years, swap tenor of 5 years and swap strike rate of 4%. To calculate whether the option is in the money, at time 2 say, would we compare the current 5 year swap rate with 4% or would we compare the 5 year forward swap rate starting at time 15, as seen at time 2??
Thanks for the reply! I would appreciate if you could explain it in a bit more detail. I thought that to determine whether the option in the money one would check its value assuming it were exercised immediately. However, if you excercise the swaption immediately wouldn't you receive the current 5 year swap rate?
The comparison should be with the forward swap rate ar time 15. This is the rate expected to be realized when the option becomes due for exercise(time 15). This should be obvious in case of the European style option, as exercise is possible only at time 15, and not before. For American style option, where immediate exercise is possible, the comparison again with Forward rate is more sensible. The argument that American equity call option shouldnt be exercised early carries here as well. If the option is in the money, it is better to sell the option rather than exercise it, as it will give higher cashflow (due to remaining time value of the option at the tine off exercise).
More so, comparison with current rate isnt valid when the swap kicks in at time 15. The rate againt which strike rate should be compared then is the expected spot rate at time 15 for 5 years. This , under forward risk neutral expectation is the current 5 year forward rate at time 15. QUOTE=manish.rex;38720]The comparison should be with the forward swap rate ar time 15. This is the rate expected to be realized when the option becomes due for exercise(time 15). This should be obvious in case of the European style option, as exercise is possible only at time 15, and not before. For American style option, where immediate exercise is possible, the comparison again with Forward rate is more sensible. The argument that American equity call option shouldnt be exercised early carries here as well. If the option is in the money, it is better to sell the option rather than exercise it, as it will give higher cashflow (due to remaining time value of the option at the tine off exercise).[/QUOTE]
