Rate derivatives are the most liquid and largest-notional segment of global derivatives markets. The instruments range from the simple — caps and floors that protect against rate moves above or below a threshold — to the structurally complex: Bermudan swaptions where the holder chooses the optimal exercise date, options on CMS spreads that embed cross-tenor correlation, and variance swaps on rates. Pricing all of these requires not just a model for the rate level but a model for rate volatility — its level, term structure, skew, and smile — and for the correlation between rates of different tenors.
This topic bridges the gap between the LIBOR Market Model (Topic 8) and the practical derivatives market. The five lessons cover: the market structure and pricing of caps and floors; swaptions and the annuity measure; pricing rate options in short-rate tree models; the shape and quoting conventions of the implied vol surface; and the post-2008 paradigm shift to OIS discounting, multi-curve frameworks, and SOFR.
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- Lessons in this topic
- Prerequisites
- Key ideas
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