Saturday, August 20, 2011

What is an "American Swaption?"

Technically speaking, like all options, it has a fixed life in which the underlying swap may be exercised. It differs from its European and Bermudan counterparts in that it allows the user to exercise the swap at any point in its life. The stodgy, rigid European swaptions, on the other hand, permit the swap only on the maturity date, while the Bermudan swaptions grant the user only a handful of additional predetermined dates in which the user may enter the swap.
There is obviously a parallel here to be made. The easiest political point to score here is that the American swaption is the free-est of his kind: unburdened by contracts, the user has complete control over the execution of the swap. There’s no way around it: ceteris paribus, you would take the American Swaption any day of the week.
But ceteris paribus exists only in the offices of our favorite economics professors and in the halls of Congress. The reality is that European swaptions are a lot less messy and a little more predictable: there is a consensus formula analysts use to value the European variety (the Black model, which is essentially the Black-Scholes model), while there are no closed form solutions for the American swaption. The value American swaptions add can be masked by the complexity of the arrangement, and there are more confused message board posts from analysts and traders on the topic than there are solutions. At the end of the day, sometimes (though not always) traders prefer the relative simplicity of the already complicated European design.
You may be disappointed to learn that my anonymous handle is simply a metaphor. It goes like this: although I believe that the American choice (if you will) is the better choice overall, I also think that many of our governing and social institutions are overwrought with so much complexity that it’s often hard to trace value back to the source. Our corporate tax code is a disgrace and seemingly sucks more money out of the system than it adds, via K-Street lobbyists and an army of accountants. Our healthcare system is an inequitable, costly mess. Our political institutions seem frozen in time. It isn’t hard to look across the pond, halfway envious of the simplicity of the Eurozone’s crisis, which appears to be caused by too much action, too soon, with the goal of making things too simple. Even though people are rioting in the streets over there, the wisdom holds, at least it looks like they’re trying to do something about it.
Take the recent debt-ceiling debacle. Is there a better example of “what hath we wrought!” in the world? We just had the closest episode of government default in our nation’s history, and our response was “we’ll figure it out in four months, just leave us alone.” Why, exactly, are lawmakers in this country permitted to spend money before figuring out where to get that money? I’m not talking about raising debt; that’s a necessary function of a federal government, particularly in times of dire need (read as: right now). I’m talking about passing massive omnibus bills without coming clean to citizens about how much money we’d have to raise simultaneously. That’s shameful, and simultaneously so overwrought that it reduces the amount of time and value we can get out of our congressmen and senators, who constantly have to waste valuable political capital on a majority dominated debt ceiling vote. 
The metaphor is very simple. We have one of the largest, most fertile, best educated, healthiest, and most diverse populations on the planet. Just like the American swaption, we have a civil society which is based on the principle of freedom. Yet for all our dynamism, our complexity comes at great risk of alienation of investors and creditors. Let the S&P’s downgrade act as a warning shot: if we don’t clean up our act, there are a whole lot of other markets for the world’s money. 

No comments:

Post a Comment