How do I determine moneyness for payer versus receiver swaptions?

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AcadiFi · Accepted Answer

Swaption moneyness depends on the relationship between the strike rate and the prevailing forward swap rate for the underlying swap tenor. **Payer swaption** — right to PAY fixed (receive floating). Holder benefits when rates RISE above strike. - ITM: forward swap rate > strike - ATM: forward swap rate = strike - OTM: forward swap rate < strike **Receiver swaption** — right to RECEIVE fixed (pay floating). Holder benefits when rates FALL below strike. - ITM: forward swap rate < strike - ATM: forward swap rate = strike - OTM: forward swap rate > strike Example: Marsfield Bank sells both a 1Y × 5Y payer swaption struck at 4.50% and a 1Y × 5Y receiver swaption struck at 4.50% to Coventry Pension. The 1Y forward 5Y swap rate is currently 4.75%. - Payer (strike 4.50%, forward 4.75%): ITM by 25bp — Coventry would exercise to pay 4.50% fixed on a swap where market requires 4.75%. - Receiver (strike 4.50%, forward 4.75%): OTM by 25bp — exercising would mean receiving below-market 4.50%. ```mermaid flowchart TD A[Forward swap rate] --> B{vs Strike?} B -->|Fwd > K| C[Payer ITM
Receiver OTM] B -->|Fwd = K| D[Both ATM] B -->|Fwd < K| E[Payer OTM
Receiver ITM] ``` Mnemonic: 'Payers love rate rises, Receivers love rate falls.' Buyers pay premium based on volatility (normal or Black vol), time to expiry, and distance to strike. Swaption volatility surface has strike and expiry-tenor dimensions (the 'cube'), making it more complex than equity vol surfaces.

How do I determine moneyness for payer versus receiver swaptions?

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