A Payer Swaption or Put Swaption gives the buyer a right but not an obligation to agree on an Interest Rate Swap. Here the buyer pays the fixed interest rate and gets the floating interest rate. This option is beneficial for the buyer if they expect the interest rate to move up going ahead.
Usually, payer swaption participants are big firms or financial institutions. Such financial institutions enter this swaption to manage some of their interest rate risk for the debt they have on their balance sheet.
Before we detail more about Payer Swaption, let’s take a quick look at what are Swaption and Interest Rate Swap.
What is Swaption and Interest Rate Swap?
A swaption is a right, but not an obligation to enter into a swap with another party. The swap could be of anything, but generally, it is of the interest rate. These are OTC (over-the-counter) contracts. This means they are private contracts with information only to the buyer and seller.
Before entering into a swaption, a buyer and seller must agree on the price (or premium) of the swaption, the time period, and other specific terms. These terms are the fixed rate, the floating rate, the strike rate, and more.
Though individual investors can enter into swaptions, generally, the companies use them. They use this financial tool to save themselves from the volatility in the interest rate.
Talking about interest rate swap, it involves swapping a fixed rate with the floating interest. For example, Company A has a huge debt on its balance sheet. It has a floating rate debt and believes the interest rate to move up in the near term. To overcome this risk, it enters into an interest rate swap with Company B and swaps floating with a fixed rate. The difference of interest in such a swap is paid in cash on every date when the debt is due.
Understanding Payer Swaption
As said above, such a swaption gives the buyer the right (not obligation) to pay the seller a fixed rate. In exchange, the buyer gets a floating rate. This type of option is extremely handy in case of big debt as it enables the buyer to trade fixed interest on the debt with floating. The buyer of the put swaption believes the interest rate to move up in the near term. Thus, it uses the swaption to lower its risk due to interest rate volatility.
For example, assume Company A has a massive amount of floating-rate debt on its balance sheet. To hedge the risk of a rise in the interest rate, Company A enters into payer swaption to convert its floating rate debt into a fixed rate one. Now, if the interest rate rises, the buyer can exercise the option and pay the fixed interest. If the interest rate doesn’t rise, the buyer can just pay the premium and cancel the option.
When to Use Swaption
As we discussed, swaption and interest rate swap both are the financial tools that large institutions and companies use. And this is to take care of the risk of fluctuations in the interest rates over the term of the debt. These give an entity two-sided protection or a sort of insurance – against fluctuation of interest rate that may increase the cost of operations and margins may go haywire. Another benefit is the cash flow does not have any stress because of these swings, and smooth operations can continue.
However, when the company is quite confident about the interest rate movement and its trend, i.e., whether it will move up or down, the company uses the interest rate swap. But when the company is not so sure about the interest rate movements, then swaption is the most preferred way.
Because swaption, like stock derivatives, at a nominal premium, gives a right to the swaption holder to exercise it in case his estimation or anticipation turns right and get the same benefit what the swap could have given. However, in case the estimation turns out wrong or not on the expected lines, then the entity can avoid all the formalities and associated costs of the Swap contract. The nominal cost of the option premium is only there for the entire transaction.
Price of Payer Swaption
The price of a payer swaption depends upon three things:
- More the volatility in the interest, the higher will be the price.
- A swaption with more tenor would mean more price.
- If the strike interest rate is closer to the prevailing interest rate, the price will be more.
A swaption is a derivative terminology. It is basically an option or extension of any swap agreement. Normally it is linked with interest rate swaps; however, there are many other types of swaps that are also traded in the market. These are like stock swaps, commodity swaps, currency swaps, etc. And swaption is used when the company or the institution is unsure about the anticipated movements in the interest rates (or, for that matter, underline asset or security). Moreover, when the entity would like to avoid a long drawn process of a proper swap contract and at the same time like to enjoy the benefit thereof by paying a small premium for buying the option.
Quiz on Payer Swaption
This quiz will help you to take a quick test of what you have read here.