Swaption pricing and isolating volatility exposure

Abstract: Starting from basic financial mathematics, we cover the mathematics of pricing swaptions, options on interest rate swaps. We then continue to the topic of obtaining an approximately pure volatility exposure. This exposure to volatility, which in practice enables us to trade volatility according to our perceptions of the market, is obtained by buying or selling swaptions and appropriate amounts of the underlying interest rate swap contract. Taking offsetting positions in the underlying contract is called hedging and is covered in depth. We note that hedging can primarily be done in two ways, and discuss the advantages and disadvantages of each of them. After deriving the value formulas for such a swaption strategy aimed at isolating volatility exposure we end with a discussion on the transition from theory to practice.We find that this way of trading volatility is conceptually simple, but that pre-trade profitability analysis is difficult due to the sometimes poor availability of the sophisticated data needed to simulate such a swaption strategy. Despite the possible limitations in the data necessary to translate this theory into an experimental setup, this thesis serves as a good basis for further research on the profitability of a volatility trading strategy using interest rate swaptions.