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Swaption: Swap Option Definition – Explanation – Example

What is a Swaption – Swap Option?

SwaptionA swaption, also known as a swap option, is an option to engage in a swap, such as an interest rate swap or another sort of swap. The buyer receives the right, but not the obligation, to enter into a specified swap agreement with the issuer on a specified future date in exchange for the option’s premium.

A swap option is simply a kind of options contract.  Like other options, it gives the holder the right but not the obligation to participate in a predefined swap contract. The holder of the swaption must pay a premium to the contract’s issuer in exchange for that right. A swaption typically refers to the right to engage in interest rate swaps.  However, the term is also used with other sorts of swaps.

Swap options, unlike stock options and futures contracts, are not standardized.  They are customized over-the-counter products. As a result, the buyer and seller must negotiate and agree on the specific details.  For instance, the price of the swaption, the duration until the swaption expires, the notional amount, and the fixed or floating rates.

Elements of a Swaption – Swap Option

Swaptions come in two main types: a payer swaption and a receiver swaption.

  • Payer swaption – The buyer has the option, but not the requirement, to engage in a swap arrangement in which they become the fixed-rate payer and the floating-rate receiver.
  • Receiver swaption – the opposite of a payer swaption. The purchaser may sign into a swap arrangement in which they get the fixed rate and pay the fluctuating rate.

In addition to these requirements, the buyer and seller must agree on whether the swaption will be Bermudan, European, or American. These labels have nothing to do with location. They instead outline the way by which the swaption will be carried out. Because swaptions are bespoke contracts, more imaginative, customized, and one-of-a-kind clauses may be inserted.

Swaption styles explained

A swaption is similar to an option in that it has an expiry date, a strike price, and an expiration style.  The buyer pays the seller for the opportunity. The strike price is a strike rate – the fixed rate that will be exchanged (swapped) for the floating rate.  In terms of expiration, there are three commonly used standards:

  1. Bermuda style – Establishes a series of dates that the option can be exercised.
  2. American style – The option can be exercised at any time prior to the expiration.
  3. European style – Allows the holder to exercise the option only on one specified date.  This is either the option’s expiration date or just before the expiration date, which is also the start of the swap.

A Swaption allows you to lock in an interest rate on future borrowings. This is accomplished via an interest rate swap option. By purchasing the Swaption, you have ensured that if interest rates rise over the agreed-upon amount before the rollover or drawdown date, you will be protected from these increases. If interest rates do not climb beyond the agreed-upon Swaption rate, you will not continue with the Swap and will instead borrow at the market rate.

Example

Consider a corporation wanting protection from rising interest rates.  In this case, they might choose to buy a payer swaption. For example. Acme Corporation has a facility maturing in six months’ time that will require refinancing. The annual budget process for Acme has factored in a maximum interest rate. Management is concerned that, prior to the rollover date, rates may rise above this rate. Acme elects to take out a Swaption. If interest rates rise above the agreed Swap rate when the re-financing is due, Acme would proceed with the Swap. If interest rates on the rollover date are below the Swap rate, Acme would not proceed with the Swap.  Instead, they would borrow at the prevailing lower interest rate.

How Does the Swaption – Swap Option Market Work?

Swaptions are often used to hedge bond option holdings, assist in the restructuring of present positions, restructure a portfolio, or adjust a party’s aggregate payment profile. Market participants are often large financial institutions, banks, and/or hedge funds.  Due to the nature of swaptions, they assist in controlling interest rate risk. Swap contracts are available in the majority of the world’s main currencies, including the US dollar (USD), Euro, and British Pound. Swaptions require an enormous amount of technology and human resources to monitor and manage a portfolio.  As a result, swaptions are often beyond of reach of smaller-sized enterprises.  Commercial banks are typically the primary market makers.

What is an Interest Rate Swaption?

An interest rate swaption gives the borrower the right, but not the responsibility, to engage in an interest rate swap. It includes an agreed-upon date in the future under the conditions mutually negotiated. The price, expiry date, amount, and fixed and floating rates are all agreed upon by the buyer/borrower and seller. A swaption protects a borrower by ensuring a maximum fixed interest rate due in the future. It also provides the borrower with flexibility. If the rate does not climb to the swaption strike rate at expiration, the borrower might opt not to exercise it and benefit from lower market rates.

What is a Call Swaption?

A call swaption is also known as a receiver swaption.  It is a kind of option that enables the holder to participate in a private tax rate swap. Swaptions are all traded over-the-counter (OTC), which means they are not standardized contracts. To engage in a call swaption – or any swaption – both the buyer and seller must agree to all of the swaption contract’s provisions.

What Is a Put Swaption?

A put swap option is an interest rate swap position also known as a payer swaption.  It gives a company the right to pay a fixed rate of interest while receiving a variable rate of interest from the swap counterparty. Put swaptions are utilized by organizations looking to earn floating rate interest payments in an interest rate swap contract while anticipating increasing rates.

Who Trades Swaptions?

As stated above, the swap option market is dominated by financial institutions or huge, multinational corporations. Swaptions are primarily used to control interest rate risk. For example, a bank or other financial institution that owns a large number of mortgages.  They may desire to hedge against lowering interest rates.  The result of which might result in many mortgages being paid off early. For financial protection, the bank would be interested in purchasing a receiver or call option.

In the swaption market, investment banks function as market makers. They often possess a portfolio of swaption contracts made with a variety of counterparties. In order to limit their rate risk exposure, banks will engage in call swaption or put swaption contracts. The composition of their current swaption portfolio determines whether they are seeking to acquire call or put swaptions.  Ultimately, they look to hold a balanced portfolio with neutral overall exposure.

Advantages

  • Financial security – It provides the borrower with a pre-agreed maximum rate of interest.
  • Flexibility – The borrower has the flexibility to benefit from low floating rates prior to the exercise date. The borrower is not obliged to enter into the swap if interest rates should fall instead of rising.
  • No hidden costs – There are no additional costs arising on early termination. The borrower will be entitled to receive any residual value attributable to the swaption.
  • Transferable – The borrower can sell the swaption to a third party.

Disadvantages

  • Upfront premiums – The borrower will incur a premium cost usually paid upfront.
  • Limited value in a stagnant market – If the market rate fails to rise above the swaption rate, the borrower may feel they received no value.  (Source: chathamfinancial.com)

Federal Oversight on Swaptions

In 2010, Congress enacted legislation tasking the SEC and CFTC with developing a regulatory framework to manage this multitrillion-dollar industry. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 charged the CFTC with “swaps”.  The SEC was tasked with security-based swaps.  This includes swaps based on a security, such as a stock or a bond, or a credit default swap. As a result, the market is more transparent, efficient, and accessible under the new administration. The SEC is in charge of the following under the new regime:

  • Dealers and major players in the security-based swap market
  • Trading platforms and exchanges on which certain security-based swaps would be transacted
  • Clearing agencies that generally step in the place of the original counterparties and effectively assume the risk should there be a default
  • Data repositories which would collect data on security-based swaps as they are transacted by counterparties, make that information available to regulators, and disseminate data, such as the prices of security-based swap transactions, to the public.

Up Next: What Is New Growth Theory?

New Growth TheoryThe New Growth Theory is an economic concept.  It holds that humans’ unlimited desires foster ever-increasing productivity and economic growth. It contends that because of people’s insatiable desire for profit, real GDP per person will continue to rise indefinitely. The New Growth Theory, sometimes known as the NGT, is a modern view of the forces that drive economic success and growth.

According to the NGT, economic productivity and growth are intimately related to human factors. Particularly, what humans desire and need. The primary underlying logic is that people’s desires are nearly limitless or infinite.  As a result, these needs drive their buying and investment choices.  In turn, these purchases and investments drive the economy. According to the theory, the actual GDP per person grows indefinitely as a result of people’s desire to make money. When earnings in a particular area fall, people will continue to look for better ways to solve the problem in order to maximize profits.

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