Swaptions

What are Swaptions？

A swap is a contractual agreement between two parties in which one party can exchange floating/ fixed interest rate, currencies of different countries, and even the obligation to repay a loan for the defaulting party, as known as credit default swaps. As for the term swaptions, a conflation of the words “swap” and “option”, are exactly what they imply: they are options contracts that utilize swaps, granting its owners the right rather than the obligation to enter into underlying swaps at a certain price for a fixed period of time. Swaptions are primarily employed by large corporations and financial institutions, including investment banks, commercial banks, and hedge funds, and are mainly used for hedging the fixed or floating rate of interest. If the right is not exercised before the contract is terminated, investors will lose the premium paid for buying the swaption.

The basic mechanism for profiting from swaps and swaptions is the same. The only difference is that a swap contract is an actual agreement to trade a derivative, while a swaption is simply a contract to purchase the right to enter into a swap contract during the specified period of time.

Type of Swaptions

There are different types of swaps. We can categorize swaptions based on what the holder gets and receives, and how it is executed.

On the basis of the legs involved in the anticipating swap contract, swaptions can be divided into payer swaptions or receiver swaptions.

Like plain-vanilla options, swaption contracts come with different execution styles and can be divided into European swaption, American swaption, and Bermudan swaption.

Features of swaptions

• Unlike equity options and futures contracts, swaps are over-the-counter (OTC) contracts and are not standardized.
• Buyers and sellers need to agree on the terms of the agreement such as the premium of the swaption, fixed/floating rates, length of the options contract, and the notional amount.
• The main players in the swaption market are large financial institutions, banks or hedge funds because of the massive resources required to manage swaptions portfolio.

Example

Swaptions have numerous applications in the investment industry and are often used to hedge against various macroeconomic risks such as interest rate risk.

For instance, swaptions are used to hedge risk when it is anticipated that the fixed rate of interest will be higher than LIBOR or vice versa. Assume company A has a borrowing facility maturing in 6 months that will require refinancing. Company A is concerned that the interest rate might rise above the present rate and consequently will take the swaption to mitigate the risk.

In the future, if the interest rate increases beyond the agreed swap rate when the re-financing is due, company A will exercise the option to swap to avoid loss caused by increased rate. On the other hand, if the interest rate does not increase in the market, company A will not exercise the swaption and instead borrow at the prevailing interest rate to enjoy the profits from a decreased rate of interest (LIBOR).

Conclusion

A swaption is basically an option or extension of any swap agreement, usually related to an interest rate swap. Swaption market usually involves two parties, namely receivers and payers, an expiration date, various types of swaptions and a predetermined price. Swaptions allow investors to hedge options position on bonds, or the interest rate risk. Swap options also help financial companies to alter their payoff profile, allow investors to restructure current positions and alter the tenor of an underlying swap. There are two types of swpations based on what the holder gets and receives – payer swaptions or receiver swaptions and three types of swaptions based on how it is executed – European swaption, American swaption, and Bermudan swaption.

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