A swaption is an over-the-counter contract that allows but does not obligate the buyer to enter into an interest rate swap deal at a predetermined strike rate and future date. The phrase is a portmanteau of swap and option, enabling traders to reduce interest rate risk by swapping cash flows or liabilities.
This contract, also called the swap option, permits investors to perform different swaps in exchange for premiums. However, it does not obligate buyers to enter into a pre-decided swap agreement. Aside from being non-standardized, this option guarantees a maximum fixed interest rate and gives the customer flexibility and protection.
Table of contents
- A swaption contract gives buyers the right to enter into an interest rate swap in exchange for a premium, but it is not obligatory.
- It is traded outside the stock exchange at a predetermined strike rate and future date, and the buyer pays a premium upfront to the issuer of the swap agreement.
- A swap option agreement is non-standardized and provides the buyer with freedom and protection while guaranteeing a maximum fixed interest rate.
- The interest rate swap is categorized as Payer and Receiver. It can be executed in three ways – European, American, and Bermudan and physically resolved or cash-paid at expiry.
How Swaption Works?
A swaption is an interest rate swapInterest Rate SwapAn interest rate swap is a deal between two parties on interest payments. The most common interest rate swap arrangement is when Party A agrees to make payments to Party B on a fixed interest rate, and Party B pays Party A on a floating interest rate. contract between a buyer and a seller (issuer). It is one of the best backup strategies for traders who want protection against risks of market interest rate swings that could occur at any moment in the future.
It also implies that the buyer will be offered a maximum fixed interest rateInterest RateAn interest rate formula is used to calculate loan repayment amounts as well as interest earned on fixed deposits, mutual funds, and other investments. It is also used to calculate credit card interest. on future borrowings. As a result, if the rate rises above the predetermined terms at the contract expiry, the buyer can exercise the swap and stay protected from losses. On the other hand, if the rate does not increase in the future, the buyer can borrow at lower market rates, avoid exercising the swap and sell it for monetary gains.
Features Of Swaption
- A swaption is traded outside the stock exchangeStock ExchangeStock exchange refers to a market that facilitates the buying and selling of listed securities such as public company stocks, exchange-traded funds, debt instruments, options, etc., as per the standard regulations and guidelines—for instance, NYSE and NASDAQ. or open market.
- It usually occurs in the U.S. dollar, sterling, euro, and Japanese yen.
- The buyer and the seller must predetermine the swap option price (premium) and expiry date.
- The premium allows the trader to execute the swap option at a fixed or floating rate and notional amounts.
- The buyer must pay a premium to the issuer of the swap deal.
- Large corporations, investment and commercial banksCommercial BanksA commercial bank refers to a financial institution that provides various financial solutions to the individual customers or small business clients. It facilitates bank deposits, locker service, loans, checking accounts, and different financial products like savings accounts, bank overdrafts, and certificates of deposits., financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. , and hedge fundsHedge FundsA hedge fund is an aggressively invested portfolio made through pooling of various investors and institutional investor’s fund. It supports various assets providing high returns in exchange for higher risk through multiple risk management and hedging techniques. are the main participants in the swap option.
- Investors use the contract as a backup plan if their main operations and financial arrangements are exposed to interest rate riskInterest Rate RiskThe risk of an asset's value changing due to interest rate volatility is known as interest rate risk. It either makes the security non-competitive or makes it more valuable. .
- The options contractOptions ContractAn option contract provides the option holder the right to buy or sell the underlying asset on a specific date at a prespecified price. In contrast, the seller or writer of the option has no choice but obligated to deliver or buy the underlying asset if the option is exercised. can be settled in two ways:
- Cash Settlement – When the seller pays the buyer the current market priceMarket PriceMarket price refers to the current price prevailing in the market at which goods, services, or assets are purchased or sold. The price point at which the supply of a commodity matches its demand in the market becomes its market price. for the underlying swap
- Swap Settlement – Two parties swap according to the agreement’s predetermined terms when choosing a swap option.
The terms and conditions of different swaption contracts vary. Hence, there are three categories in which they can be executed:
- European Swaption: The buyer can enter and exercise the swap option at expiry.
- American Swaption: The buyer can exercise the swap option at any time between the originationOriginationOrigination in finance refers to the borrower applying for a loan or mortgage and getting it approved by the lender. and expiration periods.
- Bermudan Swaption: The buyer can enter and exercise the swap option on multiple specified dates.
The European swaption form of execution is generally favored due to its simple terms and one exercise date. The other two are more complicated in terms of execution.
Types Of Swaptions
The two common types of swaption are:
#1 – Put or Payer Swaption
This form of swap option gives purchasers the option of entering into a swap agreement in which they pay a fixed swap or strike rate (non-changeable) while receiving a floating (variable) swap rateSwap RateSwap rate refers to the fixed exchange rate of a swap contract as ascertained by the parties or the market. The rate is inclusive or exclusive of the spread and determined on the benchmark rates such as LIBOR or MIBOR.. Firms frequently choose this option to protect themselves from interest rate risk if interest rates rise in the future.
#2 – Call or Receiver Swaption
Here, buyers have the opportunity, but not the obligation, to participate in a swap option contract in which they obtain a fixed swap rate while paying the variable swap rate. Mortgage lenders typically choose this option to protect themselves from decreased interest rates, which would result in early mortgage prepayment.
Let us consider the following swaption examples to understand the concept better:
Mary entered into a swap option contract to make sure she does not face any interest rate risk in the future. The issuer, John, prepared the agreement and specified a predetermined rate of 8% with the expiration date mentioned. Contrary to what Mary expected, the interest rate fluctuated but remained in her favor on the date of contract expiry.
As a result, Mary did not bother to execute the swap option anymore. However, she could do so as the contract gave her the right to enter into an agreement if needed but did not make it an obligation in any manner.
Dynex Capital, an American real estate investment trust, released its fourth-quarter financial report for 2020, announcing a total economic return of 15.2% and total shareholder returns of 17%. However, the corporation invested $750 million in interest rate swaption to get greater returns and ensure that interest rate risk does not impair the entity’s financial success over time. Additionally, this aided the corporation in replacing US Treasury options that had expired or been terminated.
Swaption finds relevance in different financial decisions that traders make to maximize the return on their investments. SpeculatorsSpeculatorsA speculator is an individual or financial institution that places short-term bets on securities based on speculations. For example, rather than focusing on the long-term growth prospects of a particular company, they would take calculated risks on a stock with the potential of yielding a higher return. and hedgers, in particular, benefit the most from such contracts.
Speculators anticipate the interest rate riskInterest Rate RiskThe risk of an asset's value changing due to interest rate volatility is known as interest rate risk. It either makes the security non-competitive or makes it more valuable. and seek to protect themselves with a swap option if required in the future.
On the other hand, hedgers pay a premium for the swap option and use it as a backup plan to cover their losses in the event of significant market changes. For example, the interest rate risk on bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period..
For instance, Jed takes up two loans, accounting for $100 million, maturing in two years. But he is unsure how the market will turn out in the next couple of years. Thus, he enters a swap option to hedge his expected refinancingRefinancingRefinancing is defined as taking a new debt obligation in exchange for an ongoing debt obligation. In other words, it is merely an act of replacing an ongoing debt obligation with a further debt obligation concerning specific terms and conditions like interest rates tenure. plans against an adverse increase in the 10-year rates.
Besides, there are other reasons to execute a swap option deal, such as:
- RestructuringRestructuringRestructuring is defined as actions an organization takes when facing difficulties due to wrong management decisions or changes in demographic conditions. Therefore, tries to align its business with the current profitable trend by a) restructuring its finances by debt issuance/closures, issuance of new equities, selling assets, or b) organizational restructuring, which includes shifting locations, layoffs, etc. existing financial positions
- Altering an investment portfolioInvestment PortfolioPortfolio investments are investments made in a group of assets (equity, debt, mutual funds, derivatives or even bitcoins) instead of a single asset with the objective of earning returns that are proportional to the investor's risk profile.
- Covering losses on a rollover of an existing loan agreement
- Facing uncertainty regarding the borrowing timing or need
- Getting protection from unpredictable interest rate movements
- Having future funding requirements that demand flexibility
Pros and Cons
Let us look at the benefits and drawbacks of swaption through the below-mentioned table:
|The maximum interest rate is guaranteed
|Requires a premium upfront
|No additional fees on terminating the contract early
|No value in case the market rate goes below the predetermined swap rate
|Not necessary to enter into the swap if interest rates fall instead of rising
|Can be sold
|Low floating swap rates can benefit before exercising the contract
Frequently Asked Questions (FAQs)
A swaption is a type of options contract that allows buyers to enter into a swap agreement at a specified interest rate for a specific period. It is not traded on a stock exchange, and the buyer must pay a premium to the swap deal’s issuer. The participants are large corporations, banks, financial institutions, and hedge funds. They use it as a backup plan for perceived interest rate risk arising from their business activities and financial arrangements.
Swap and swaption both provide similar benefits to traders, but they differ in one way. The former is an actual contract to trade in derivatives, while the latter is a non-binding contract to enter into a swap agreement with a predetermined interest rate valid for a set future date.
This has been a Guide to Swaption and its meaning. Here we discuss how swap options work along with features, types, examples and uses. You may also learn more about financing from the following articles –
- Options in FinanceOptions In FinanceOptions are financial contracts which allow the buyer a right, but not an obligation to execute the contract. The right is to buy or sell an asset on a specific date at a specific price which is predetermined at the contract date.
- Credit Default SwapCredit Default SwapA Credit Default Swap (CDS) is a financial agreement between the CDS seller and buyer. The CDS seller agrees to compensate the buyer in case the payment defaults. In return, the CDS buyer makes periodic payments to the CDS seller till maturity.
- Currency SwapCurrency SwapCurrency Swap is an agreement between the two parties for exchanging notional amount in one currency with that of another currency. It's interest rate can be fixed or floating rates denominated in two currencies.