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Can someone explain, in layman's terms, the mechanics behind Bermudan Swapttions ( without having recourse to pricing models )?

Why are they popular? when are they used ?

How are they hedged i.e exercise strategy, main risk factors ( forward rates correlation, volatility ...etc.) ?

Any intuition / rule of thumb / approximation of pricing (e.g. wrt to its European swaption equivalent , weighted sum of European swaptions )

Now, and that is my main question, consider a strategy with a long bermudan swaption payer combined with a short European swaption payer ( with the same parameters ) i.e this captures only the optionality-feature. Any intuition about the price ? What would be the main risk in this case ? How to hedge it? Any approximation ?

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  • $\begingroup$ You should think about the equity case, in BS where in no dividends case the both options are equal, and try to workout what happening in the dividend case. $\endgroup$
    – Olórin
    May 19, 2018 at 16:41

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Those are all very deep questions. Bermudan swaptions are very complicated products despite that they are one of the most actively traded rates vol products. Below are a few thoughts from my experience.

  1. Why are they popular?

Corporate clients of banks issue callable bonds but they might not know the good timing of exercising the call option. After issuing the bonds, they consequently do OTC swap trades with investment banks to exchange fixed coupon with floating coupon. The net effect is banks long callable swaps which are essentially Bermudan swaption + plain vanilla swap. Then the clients can exercise the call option should the bank exercise the Bermudan.

  1. What would be the main risk？

The diff btw Euro and Bermudan swaption prices is called as switch value in practice. The drivers behind the switch value include but are not limited to forward volatility, forward skew, volatility of volatility, etc. However, rates vol market is generally illiquid: even the spot vol risk cannot be hedged perfectly by trading vanilla swaptions, not to mention the forward vol and forward skew. And the most challenging part is to appropriately handle/hedge/risk-manage the valuation adjustment for the diff btw market quote and model price.

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See Blyth "An Introduction to Quantitative Finance" which has a whole chapter on the elementary properties of Bermudian swaptions and answers pretty much all of your questions.

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