What's the difference between cash-settled and physically-settled swaptions?

Question

AcadiFi · Accepted Answer

At expiry, the holder of an in-the-money swaption chooses (or is forced into) one of two settlement types:

**Physical settlement**: the holder enters the underlying swap with the counterparty at strike K. Ongoing cash flows for the swap's tenor. The swap is then subject to standard ISDA documentation, collateral, and valuation processes. Common in the US dollar market.

**Cash settlement**: the holder receives a one-time lump sum equal to the PV of the in-the-money swap. Two sub-variants exist:

1. *Cash-settled PVBP method* (Euro market standard): Payoff = max(S_T - K, 0) x PVBP*, where PVBP* is computed from a market-agreed yield discounting convention (often flat S_T discounting, a.k.a. IRR method), not the actual DF curve. This creates small but measurable valuation adjustments versus physical.

2. *Cash-settled collateralised* (newer): Payoff = max(S_T - K, 0) x PVBP using actual OIS discount curve. Converges with physical settlement value.

Example: At expiry, 5-year swap rate is 5.40%, strike 4.80%, notional $75M. ITM by 60 bps. Cash-settled PVBP using IRR = (1 - 1/(1.054)^5)/0.054 = 4.319. Payoff = 0.006 x 75M x 4.319 = $1,943,550. If physical, the counterparties exchange cash flows for 5 years instead.

Key risks:
- Cash settlement eliminates ongoing credit and operational risk (clean exit).
- Physical settlement creates a live swap with collateral, funding, and CVA implications.
- Cash-settled IRR convention creates 'cash-physical basis' that dealers hedge explicitly.

For CFA, the key takeaway: swaption value formulas you use in practice assume physical settlement (or OIS-equivalent cash settlement). Exam questions usually don't distinguish unless explicitly asked.

What's the difference between cash-settled and physically-settled swaptions?

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