Swaption, as the word suggests, is a combination of the words Swap and Option. It is an option to avail of a swap, such as interest rate swap, going ahead. Or, we can say it gives buyers’ a right but not the obligation to enter into a swap at a specified future date. In exchange for the option, the buyer needs to pay a premium to the issuer/seller. Another name for such an option is the swap option.
Unlike futures, these tools are not standardized, instead are OTC (over-the-counter) contracts. It means that the parties need to agree on the terms of the agreement, including price, fixed and floating rates, expiration, and the notional amount.
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Following are the features of swaptions:
- They are not standardized contracts. Or, we can say that these contracts enjoy more flexibility when it comes to deciding on the terms of the agreement.
- Usually, big financial organizations, banks, or hedge funds make use of this option.
- Big companies use it as well to manage interest rate risk.
- Since there is a need for massive resources to manage the swaptions portfolio, they are out of reach of smaller firms. Commercial banks are the primary market players.
- Swap contracts support major world currencies, such as USD, Euro, and more.
Following are the benefits of swaptions:
- They allow an investor to hedge options position on bonds, or the interest rate risk.
- Swap options also help financial companies to alter their payoff profile.
- They also allow investors to restructure current positions.
- One may also use the swap option to alter the tenor of an underlying swap.
How does it work?
To understand how the swap options work, we will consider the interest rate swap. If you have a swaption for the interest rate, and if the interest rate rises above the agreed level before the expiration date, you remain unaffected from the rise. On the other hand, if the rate remains the same or goes below, you won’t exercise the swap and borrow at the current rate.
For example, Company ABC has a borrowing facility, which will expire in six months, if they do not refinance it. However, the finance manager of the company expects the interest rate to rise above the current rate. Thus, to eliminate the risk, the manager takes a Swaption. So if the interest rate increases above the swap rate when the refinancing is due, ABC would exercise the swap. And, if the interest rate remains below the swap rate, ABC won’t use the option and refinance with the prevailing rate.
Types of Swaption
Based on rights and obligations, swaption can be of two types:
Under this, the buyer has the right (not obligation) to enter into a swap contract. The buyer here becomes the fixed-rate payer and the receiver of the floating-rate. For example, a company that seeks to save itself from a rise in the interest rate may go for a payer swaption.
It is the exact opposite of the payer swaption. Under this, the buyer has the option to seal a swap contract. In this case, the buyer pays the floating rate and receives a fixed rate. For instance, a bank with a mortgage portfolio may purchase a receiver swaption to save itself from lower interest rates in the future.
Since Swaptions are not standardized, the buyer and seller also need to agree on the time to enter the swap option or the execution-style. The buyer and seller have three options to choose from:
Under this, the buyer can avail of the swap option at the predetermined specific dates.
Under this, the buyer can enter into the swap option only after the expiration date.
Under this, the buyer can exercise the swap option on any date between the start date and the expiration date.
The selection of the swap option based on execution-style has an impact on the valuation. Thus, for the Black valuation model, analysts usually go for European style swaptions. On the other hand, analysts go for American and Bermudian swaptions when using Black-Derman-Toy or Hull-White models. Analysts often consider American and Bermudian swaptions as more complex than the European options.
Cost of a Swaption
The buyer of a swap option pays a premium, and this is the cost of a swaption. The amount of premium depends on the structure of the swap, especially on the difference between the swap interest rate and the current interest rate. Moreover, the premium also depends upon the rollover frequency and how the buyer makes the premium payment and the time horizon of the swap.
The premium an investor pay becomes your loss if the interest rate does not go above the swap rate on the expiration date. It means you got no benefit by paying the premium. However, you can see the premium as an insurance against any potential rise in the interest rate.1–3