Bermudan Swaption is one of three types of swaption on the basis of execution. The other two are – European swaption and American swaption. In this article, we will mainly talk about Bermudan Swaption.
What is Bermudan Swaption?
Like any other swaption, a Bermudan Swaption gives the holder the right but not obligation to enter into an interest rate swap. However, the holder can enter into a swap only on a predetermined date or dates in such an option. Or, we can say it gives the buyer the facility to exercise the swap on one of the pre-specified dates, provided that date has not been used before. This is unlike other swaptions where the rights can be exercised by the holder of the option until the expiry of the option.
Bermuda swaption is similar to the Bermuda option. This is because, like the Bermuda option, the dates for executing the swaption are mentioned in the contract. It is up to the buyer and sellers to decide on the expiration dates of the Bermudan swaption.
Pricing of Bermuda Swaptions
In comparison to a simple swaption, the pricing of a Bermuda Swaption is a bit complex. This is because of the presence of the number of dates on which a holder can exercise such an option. Thus, parties (buyer and seller) do not commonly use popular or traditional swaption and option-pricing models for pricing the Bermuda Swaption. Instead, analysts and parties prefer using the Monte Carlo Simulation pricing method for pricing this option.
Bermudan vs. American vs. European Swaption
As said above, there are three types of swaptions on the basis of their execution strategy or rights. These are Bermudan, American, and European swaptions. We can say that Bermudan swaption is a mix of the other two types of the swaption.
In American swaption, a buyer can enter into a swap on any date between the start and termination (or expiration) of the contract. On the other hand, one can exercise European style swaptions only at maturity. However, with Bermudan swaption, one can enter the swap on pre-decided specific dates.
Bermudan swaption is better than American and European swaptions in many ways. For instance, a Bermuda Swaption gives the ability to parties to develop a hybrid contract. This capability is not there with the American and European swaptions.
Another advantage is that the Bermudan swaption gives the holder more control over when to execute the swaption.
How do Bermuda Swaptions Work?
A plain swaption allows the holder to execute the swap on the expiration date. However, with Bermuda Swaptions, the buyer can enter the swap on any of the different dates that the buyer and seller decide.
Generally, a Bermuda swaption is less costly than an American swaption. Also, it is less restrictive than European swaption. Also, European and Bermuda swaptions are usually less costly than the American option.
The American swaption attracts a bigger premium because of the flexibility it gives the holder in exercising the swap. Also, with American swaption, the probability of the swaption hitting the strike price is more. This, in turn, raises the chances of the holder exercising the swap, and this also makes this option relatively more costly.
Terms of Bermudan Swaption
Like with any other type of swaption, Bermudan swaption is also traded over-the-counter (OTC). This means they do not trade in an exchange; instead, the buyer and seller enter and agree to the contract privately. To enter a Bermudan swaption, the buyer and seller need to agree on the following points:
This is the duration during which period the swaption is valid and viable. Usually, the duration is a day or two prior to the start of the underlying swap.
It is nothing but the cost of the swaption. Or, we can also call it the swaption premium.
To enter into a contract, the buyer and seller need to reach a consensus on many other terms as well, such as the Notional amount, fixed rate, and frequency of payment.