Receiver Swaption or the Call Swaption gives the buyer a right but not an obligation to agree on an Interest Rate Swap Agreement. In this type of option, the buyer pays the floating interest rate and gets the fixed interest rate. We can also call it a right-to-receive swaption. This option is beneficial for the buyer if they expect the interest rate to move down going ahead.
In the receiver swaption, the buyer will gain in case the interest rates drop. Once the two parties enter this swaption, its minimum value can be zero. The maximum loss for the buyer of this option is the cost of swaption or the premium.
For example, suppose Company A believes the 5-year yield on a bond will be less than its one-year implied yield. Thus, to protect themselves from the loss of income, Company A enters into a receiver swaption. It will allow Company A to get a fixed return.
Company A and the other party will have to decide on the strike rate at which the swap would trigger. If the interest rate drops below the strike rate, Company A will have the option to decide whether to enter the swap or not. It can either close the deal at a profit or run a Swap for five years.
If the interest rate goes above the strike rate at maturity, Company A can select to let go of the swaption. In this case, Company A will only lose the premium paid to enter the Swaption, but it can always make up for that by selecting instruments giving a higher interest rate.
Pricing of Call Swaption
Following are the factors determining the pricing of the call swaption:
- The more the volatility, the more the price.
- More the tenor more is the premium.
- If the strike interest rate is close to the real interest rate, then the premium is more.
Receiver Swaption Suitable For?
Receiver Swaption is suitable for investors having investments in floating-rate assets. Thus, to save themselves from the volatility in the interest rate, such investors can go for a call swaption and lock a fixed interest rate.
So, we can say it is suitable for financial organizations or big companies as it enables them to hedge interest rate risk. Suppose a bank has a massive amount of mortgage on its balance sheet. However, the bank is worried that decreasing interest rates could result in borrowers paying in early. Thus, the bank could go for a call swaption to hedge this risk.
Investment banks also commonly use such a swaption. In fact, they may have a portfolio of swaption agreements that they enter into with other parties. In reality, the investment banks make use of call and put swaption depending on their risk exposure.
Along with investment banks, this swaption is suitable for speculators who expect the fixed rates to drop.
Elements of Receiver Swaption
Following are the important element of call swaption:
- The expiration date of the swaption
- Floating rate
- Price of the swaption
The buyer and seller must agree to these elements before entering into a call swaption. The same elements are applicable for put or payer swaption as well.
When and Why to Use Swaption
Swaption and interest rate swap both are financial tools that are used by large institutions and companies. 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 and cash flow stress.
As we discussed in Payer Swaption 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 swaption is the most preferred way when the company is not sure about the interest rate movements.
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. Like Receiver Swaption, there is Payer Swaption also, that are used when the expectation is that the interest rate will move up.
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. Both investors and speculators regularly use such a swaption because it has limited loss potential for the buyer, which means that the maximum loss for the buyer could be the premium it pays to enter the contract. However, one disadvantage is that the buyer needs to pay the premium upfront.
- Payer vs Receiver vs Bermudan vs European vs American Swaption
- Types of Swaps
- Interest Rate Options – Meaning, How it Works, Example and More
- Call Options – Meaning, How it Works, Uses, and More
- Bermudan Swaption – Meaning, Pricing, and More
- Derivatives Market – Types, Features, Participants and More