Cash-settled swaptions and no-arbitrage
Fabio Mercurio derives no-arbitrage conditions that must be satisfied by the pricing function of cash-settled swaptions. He then identifies a strategy leading to an arbitrage when such conditions are not met
Cash-settled swaptions are the most actively traded swaptions in the European market. Their payout is obtained by replacing the classical annuity term with a single-factor one, where discounting is based on a unique interest rate, namely the underlying swap rate set at the option's maturity. This simplification serves the purpose of a swaption payout whose value at maturity can be set with no ambiguity. However, from the modelling point of view, some complications arise, to the extent that cash
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