Interest Rate Derivatives 2: Options

Interest Rate Options are an essential part of the derivatives marketplace. This course will equip you to use, price, manage and evaluate interest rate options and related instruments.

The course starts with a detailed review of option theory, from a practitioner’s viewpoint. Then we cover the key products in the rates world (caps/floors, swaptions, Bermudans) and their applications, plus the related products (such as CMS) that contain significant ’hidden’ optionality. We finish with a detailed look at the volatility surface in rates, and how we model vol dynamics (including a detailed examination of SABR).

The course includes extensive practical exercises using Excel spreadsheets for valuation and risk-management, which participants can take away for immediate implementation.

This course is designed for anyone who wishes to be able to price, use, market, manage or evaluate interest rate derivatives.

• Interest-rate sales / traders / structurers / quants and relevant IT personnel
• Bank Treasury and other Asset Liability Management executives
• Central Bank and Government Treasury / Funding managers
• Insurance Company investment managers
• Fixed Income portfolio managers
• Company finance executives and Investment Bankers

• Gain familiarity with option products traded in the rates world
• Understand how (and why) to delta-hedge an option position
• Know the classic option combinations and strategies employed by practitioners and customers
• Understand the vol surface and how to trade it
• Appreciate the reasons behind the choice of Normal vs Lognormal vol
• Understand the significance of stochastic vol
• Understand how SABR works
• Understand the mechanics of Constant Maturity swaps, and the origin of the convexity adjustment
• Know how to price and hedge a CMS with a replicating swaption portfolio

Basic knowledge of Microsoft Excel, a broad understanding of fixed-income markets and basic knowledge of Interest Rate Swaps and Futures is assumed.

Comprehensive teaching on fixed income markets and bond maths takes place in the Fixed Income Markets & Analytics course; comprehensive teaching on Interest Rate Swaps and Futures takes place in Interest Rate Derivatives and Swaps.

Option Fundamentals

• Terminology, basic payoff diagrams
• Cash vs physical, European/American/Bermudan settlement
• Key drivers of the premium – the forward and the implied vol
• Put-call parity, intrinsic and time value

Option Strategies

• Spreads, ratio spreads
• Buy-side strategies – protective puts, buy-writes
• Collars and risk-reversals
• Straddles and strangles, and the de=levered cousins (flies and condors)

Option Pricing and the Greeks

• Introduction to SDEs and modelling asset dynamics
• The fundamental BS equation and its motivation
• Solving the BS equation – the Black-Scholes formula
• Pricing options on a lattice
• Monte Carlo approaches

Option Hedging and the Greeks

• The key first-order risks
• Delta-hedging an option position
• The fundamental importance of gamma
• Gamma versus theta
• Quantifying vol risk (vega)
• Hedging at the portfolio level

Interest Rate Options: Caps, Floors

• Definitions and mechanics
• Applications
• Zero cost collars, participating caps
• Delta-hedging caps and floors

Interest Rate Options: Swaptions

• Definitions and mechanics
• Cash versus physical settlement – why it matters
• Bermudan swaptions
• Hedging swaption risk, and why Bermudans are so much harder
• Applications (in corporate interest-rate risk management, in structuring callable bonds)

Interest Rate Options: Bermudans

• Mechanics of the most common varieties
• The key pricing and risk-management issues

Trading Volatility

• Straddles and strangles
• The vol surface – smile and skew and their drivers
• Hedging smile and skew with RRs and Flys
• The role of stochastic vol
• Second-order vol risks (vanna and volgamma)
• The needs for a better model, introduction to SABR

The Vol Surface for Rates

• Defining interest rate dynamics – Normal, Lognormal or CEV?
• Quoting vols – Lognormal (Black) or absolute (Normal)
• Understanding the shape of IRD vol surface

Constant Maturity Swaps

• Mechanics of constant maturity swaps
• Applications of CMS
• Intuitive pricing – why do we get the wrong answer?
• Understanding the convexity adjustment
• Pricing and hedging CMS – the replicating swaption portfolio
• What CMS flows have done to the IRD vol surface