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Topic Title: Pricing an Amortizing Interest Rate Swap Topic View:

Created On Tue Jan 28, 03 09:11 PM

Tue Jan 28, 03 09:11 PM

Can anyone tell me how I might come up with the current swap rate on a semi annual, 11 year interest rate swap whose
wkung notional decreases at each period without any set pattern. Does not need to be exact - maybe to 10bps accuracy??
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Posts: 5 Thanks.
Joined: Jul 2002

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Thu Jan 30, 03 02:41 AM

Non deterministic amortising interest rate swaps are quite straight forward to price.
RooBoy
Junior Member Given a swap zero curve, and a zero margin to floating on the other side is simply a matter of initially modelling the
Posts: 5 amortisation profile of the deal on a spreadsheet, setting out the structure of the deal paydown profile by dates.
Joined: Jan 2003
From there all floating dollar coupons are modelled by combining the forward rates derived from the zero curve with
principal outstanding relevant to each of the cash flow payment dates to generate the floating leg cash flows. These are
then discounted back to spot via the zero curve. This will give you the PV of the floating leg.

From there the swap is prices by solving for that fixed rate of interest which sets the NPV of the deal to zero. It is critical
however to set up all day count basis and roll conventions correctly. Watch out also for the terms the traders expect the
result to be quoted in. Once the amortisation profile has been set up it really is as simple as pricing a standard swap.

Hope this helps !

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Thu Feb 06, 03 01:36 PM

The answer below what the exact method. A quick interpolation is to view the swap as series of annual swaps from 1y to
11y, of notional 1/11. Then simply take the average of each annual swap quote in the correct DCB. Probably within 10bp
j20056
I would reckon.
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Mon Feb 24, 03 09:24 AM

Both the solutions are simplistic.The swap amortisation must be linked to some market movement or some constraints.eg
pareshgokhale the swap has to last for 11 years whatever the amortisation schedule.Unless these things are included , priccing in my
Junior Member opinion is not possible.
Posts: 13
Joined: Nov 2002 Regards.

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Mon Feb 24, 03 12:54 PM

I missed the "without any set pattern" below. The only thing we know is that a 11y non-call 6m bermudan callable swap is
the upper barrier of that price as it assumes optimal exercise. Any index amortizer or balance guaranteed swap has a
j20056
lower BE because of sub-optimal exercise. By experience, the difference in price between a bermudan and an index am
Member
can certainly be in excess of 10bp depending on the amortization scheme. So I agree, if there is nothing known about the
Posts: 95 amortization schedule, then there is no price within 10bp, the only price I would quote is the bermudan, the most
Joined: Nov 2002
expensive.

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Mon Feb 24, 03 03:10 PM

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Wilmott Forums - Pricing an Amortizing Interest Rate Swap http://www.wilmott.com/messageview.cfm?catid=4&threadid=4891

I think we need a clearer picture of the deal:

Case A: The swap's amortization schedule is set in advance, regardless of movements in interest rates
Case B: The swap's amortization schedule is stochastic, but determined by events uncorrelated with interest rates
Case C: The swap's amortization schedule depends only on interest rates (the yield curve & it's movements)
Case D: The swap's amortizatin schedule depends on events not unrelated to interest rates.
?
Pat
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Mon Feb 24, 03 07:57 PM

I am a postgraduate student. I study "MSc RISK MANAGEMENT & FINANCIAL SERVICES", I have some strong
educational background in the trading and use of financial derivatives.
VJOHNNY
I need some good idea for a dissertation that will combine financial risk management techniques, with the uses in
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financial institutions, banks, intermediaries, hedge funds etc.
Posts: 18 I am particullary interested in the uptodate key sector aspects.
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Tue Feb 25, 03 03:05 AM

My earlier response assumes that the swap posesses no optionality and that the structure of the amortisation profile is a
RooBoy given to the pricing process. For example a roller coaster swap whose schedule may run up and down with no set pattern
Junior Member at all but remains fixed for the life of the transaction.
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Thu Feb 27, 03 05:52 AM

Edited: Mon May 03, 04 at 04:49 PM by slevin

slevin
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Thu Feb 27, 03 12:11 PM

In this case, there's 2 options:

1. Use historical data and find the most correlated interest rate benchmark with the principal balance. Then create a
j20056
deterministic table of amortization as a function of this benchmark (usually 3M Libor or 10Y treasury). Then use an
Member
interest rate model (2 factor recommended if benchmark is long tenor, in fact, 2 factor recommended in general) to price
Posts: 95 the swap with stochastic amortization (given that amortization = F(stochastic benchmark) becomes stochastic). This is
Joined: Nov 2002
usually called an index amortizing swap
2. Explicitely model the sinking bond, with a correlated interest rate process. This is called a balance guaranteed swap,
where the notional follows the actual principal balance of a reference asset. This gets done usually to swap fixed rate
CDOs into floating.

Having said all this, the client may want #2, but you may want to model it as #1, and you'll take the basis risk between
your amortization assumptions versus the real thing. Even in the case of #2, you still have basis/model risk on your
correlation assumptions between rates and the factors driving the principal balance.
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Wed Jun 30, 04 03:25 AM

Hi,

hw0531
I was trying to price a balance guaranteed swap and I used the "simplistic method". Basically I justed used the projected
Junior Member
mortgage pool cashflows. The dealer's price is 3 times of mine. Does anyone have the insight as what might have caused
Posts: 1 such a huge difference.
Joined: Sep 2003

Thank you very much in advance.

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Wed Jun 30, 04 09:28 PM

Sounds like you're pricing a mortgage-backed cash flow... if so, you may have to consider optionalities embedded in the
mortgage pool. Prepayment is a big factor there. In other words, there is substantial uncertainty in the projected cash flow
JackInTheBox
and that's likely why your price is way off from dealers' quotes.
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Posts: 57
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Wed Jun 10, 09 01:41 PM

Is it worth publishing a paper on closed-form pricing of balance guaranteed swaps? Or has it been done to death?

hongjiren2000
Edited: Wed Jun 10, 09 at 01:42 PM by hongjiren2000
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Thu Mar 04, 10 01:29 PM

wkung, I have the exact samen problem. Have you implemented a solution yet?

stefanvdp82
I have to value a balance guaranteed total return swap.
Junior Member
Posts: 1 Company A has about fifty types of mortgages on its balance sheets. Those mortgages might prepay, people could
Joined: Mar 2010
default, those mortgages also have embedded options etc. Company A has swapped the cash flows from the mortgages
against 1M euribor + spread with Company B. Problem: how to price this swap. I was thinking about bucketing the
mortgages and selecting a benchmark for each bucket (i.e. the most correlated interest rate). Then use e.g. Hull White
model and determine mortgage cash flows in each scenario. Then determine expected cash flows for each bucket.

Does this make sense or are there better solutions to value this type of swap? All help is appreciated.
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