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How are swaptions priced?

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A

The pricing of swaptions relies on the development of models that are on the cutting edge of options theory. Dealers differ greatly in the models they use to price such options, and the analytical tools range from modified Black-Scholes to binomial lattice versions to systems based on Monte Carlo simulations. As a result, bid/ask spreads vary greatly, particularly from more complicated structures that cannot be easily backed off in the secondary markets. The price of a swaption, known as the premium, depends on several factors: the expected shape of the yield curve, the length of the option and swap periods, the strike yield?s relationship to market interest rates, and expected interest-rate volatility. See Federal Reserve Board Trading and Capital Markets Manual.
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