possible swaption mispricing...

Posted by Toyin Akin on Nov 13, 2005; 8:41am
URL: http://quantlib.414.s1.nabble.com/bug-report-negative-price-for-an-American-put-option-using-Bjerksund-and-Stensland-approximation-tp4195p4197.html

Hi all,

Let's say we have the following situation.

A 10 year swap starting from spot (ValueDate+SettleDays).

Let's also have a swaption structure where we want to have the option
(European let's say) of
cancelling this swap at year 5.

It looks like if you were simply to pass in the 10 year swap object created
above to the swaption() class, the swaption class (along with all it's
various pricing engines) assumes that the swap starts after the exercise
date and simply uses all the cashflows within the swap, even those before
the first exercise date. Thus mispricing the option.

(At least that is what I think is happening!)

Looks like under the above specification, to price the swap and the swaption
together, you would have to build 2 swaps and a swaption object. A 10 year
swap, the forward starting 5 year into 5 year swap and a swaption object on
this forward starting swap.

If what I have presented above is true, could you either put in a check to
detect whether there are flows that are after the ValueDate but before the
first exercise date and throw an error if true.

Even sexier exclude these flows during the pricing of the swaption (European
and Bermudan.)
The latter approach might be a little tricky if the first exercise date lies
in the middle of one of the valid legs accural period.

Best Regards,
Toyin Akin.