Interest Rate Swaps: A Comparison of Compounded Daily Versus Discrete Reference Rates

Bermudan swaptions are options on interest rate swaps which can be exercised on one or more dates before the final maturity of the swap. Because the exercise boundary between the continuation area and stopping area is inherently complex and multi-dimensional for interest rate products, there is an inherent “tug of war” between the pursuit of calibration and pricing precision, tractability, and implementation efficiency. After reviewing the main ideas and implementation techniques underlying both single- and multi-factor models, we offer our own approach based on dimension reduction via Markovian projection. Specifically, on the theoretical side, we provide a reinterpretation and extension of the classic result due to Gyöngy which covers non-probabilistic, discounted, distributions relevant in option pricing. Thus, we show that for purposes of swaption pricing, a potentially complex and multidimensional process for the underlying swap rate can be collapsed to a one-dimensional one. The empirical contribution of the paper consists in demonstrating that even though we only match the marginal distributions of the two processes, Bermudan swaptions prices calculated using such an approach appear well-behaved and closely aligned to counterparts from more sophisticated models.

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Pricing Interest Rate Swaps in Malaysia

Review of Pacific Basin Financial Markets and Policies ◽

10.1142/s0219091504000251 ◽

2004 ◽

Vol 07 (04) ◽

pp. 493-507 ◽

Cited By ~ 2

Author(s):

Dick Davies ◽

David Hillier ◽

Andrew Marshall ◽

King Fui Cheah

Keyword(s):

Interest Rate ◽

Yield Curve ◽

Capital Controls ◽

Sample Period ◽

Kuala Lumpur ◽

Empirical Results ◽

Illiquid Markets ◽

Interest Rate Swaps ◽

Derivative Markets

This paper compares the theoretical price of interest rate swaps implied from the yield curve with the actual Kuala Lumpur Interbank Offer Rates used for swap resets in the Malaysian swap market for both semi-annual and annual interest rate swaps between 1996 and 2002. As far as we are aware no previous paper has considered pricing swaps in a less established derivative markets. Our empirical results indicate significant and persistent differences between the theoretical implied price and the actual reset price for both swaps over the sample period. This finding has implications for traders and banks in pricing swaps in Malaysia and more generally for pricing swaps in less established or illiquid markets or where capital controls have been introduced.

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