Skip to content
All library documents

Pricing Swaptions and Caps on Compounded Overnight Rates

Article Quant Q&A · Author: BrownianBread
Read the original

Summary

The document raises a pricing question about swaptions referencing overnight benchmarks such as SONIA, SOFR, and ESTR, in the context of the transition away from LIBOR. It asks how pricing differs from the classical single-curve swaption formula when the underlying OIS swap rate is compounded in arrears. It gives an expression for a forward rate built from overnight fixings over the accrual period and also asks whether the same considerations apply to caps and floors.

The material frames a relevant modeling problem but does not provide a pricing formula, derivation, calibration approach, or answer. It does not specify conventions, volatility treatment, discounting assumptions, or how the compounding structure affects option valuation. The forward-rate expression alone is not enough to determine a swaption or cap/floor price. Readers should treat this as a research question rather than a complete method; the linked market article is cited as context, not presented as evidence or a solution.

Key ideas

  • The question concerns swaptions whose underlying swaps reference compounded overnight rates.
  • The stated forward rate is constructed from overnight fixings compounded across an accrual period.
  • The document asks how this setup changes pricing relative to a classical single-curve formula.
  • Caps and floors are raised as related instruments, but no pricing method or answer is supplied.

Tags

OptionsFixed incomeDerivatives pricing
Full text
# Swaptions on SONIA/SOFR/ESTR


# Swaptions on SONIA/SOFR/ESTR












Given that LIBOR is being decommissioned and we must start building liquidity in swaptions on the OIS swaps, how do we price them? i.e. If I have a swaption on SONIA/SOFR/ESTR etc how does the pricing formula change from the classical single-curve formula? Let us assume we are in a backwards compounded in-arrears forward for the curve.

$$F_j (t)=\frac{1}{τ_j (t)} \left(\prod_{i=1}^n\left(1+τ_i I^{ON} (s_{i-1})\right) -1\right)$$

https://www.risk.net/derivatives/6914531/dealers-dip-toe-into-sonia-swaptions-market

I would also be interested in cap/floors too.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.