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I am following through the book "An Introduction to Financial Derivatives" by Salih Neftci. According to the book, a swap can be decomposed into cash flows from forwards and options.

I am thinking about this, and whether swaptions, which are options on swaps, can also be analogously decomposed into payoffs from forward options and options on options.

I am relatively new to derivative pricing, so I am seeing if this is (a) theoretically feasible and sound as well as (b) practical.

My underlying intuition tells me this can be done, but I am not sure if this is correct and if it has any practical usage (even if theoretically sound in logic).

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  • $\begingroup$ You may have been misled. A swap is a portfolio of forward contracts, but does not typically have any option content. $\endgroup$
    – dm63
    Nov 25, 2020 at 22:50
  • $\begingroup$ @dm63: see my answer below, I believe we could still interpret a swap as a strip of caplets and floorlets. Although obviously there is no vega exposure in a swap (I believe though that the strip of long caplets and short floorlets struck on the same strikes quite possibly nenutralize the vega: it would only make sense, because the caplets & floorlets "replicate" the swap pay-off). $\endgroup$
    – Jan Stuller
    Nov 26, 2020 at 9:21

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A long forward can be decomposed into a long call and a short put. This is also true for forward contracts on interest rates: these can be expressed as a long caplet and a short floorlet.

An interest rate swap can be understood as a series of (off-market) interest rate forwards (but with miss-matched cashflows, if i.e. the floating coupons settle semiannually and the fixed annually): each of the off-market forwards could be expressed as a caplet and a floorlet.

A payer swaption could then be understood as an option on a strip of long caplets and short floorlets.

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    $\begingroup$ Thanks for the answer. This makes a lot of sense and jumping ahead in the textbook, it seems that this works analogously. $\endgroup$
    – qxzsilver
    Nov 26, 2020 at 18:31

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