What it means
An interest rate swap is an agreement to exchange one kind of interest payment for another, typically a fixed rate for a floating rate, on an agreed notional amount. A swaption is simply an option on such a swap: the buyer pays a premium today for the right to start that swap later.
If the right is never worth using, it expires and the premium is the only loss. The call or receiver version gives the holder the right to receive the fixed rate and pay the floating rate.
That position gains value when market rates fall, because the holder has locked in the higher fixed rate while paying the lower floating one. It is bought by anyone whose income falls when rates fall, such as a fund that must reinvest maturing bonds.
The commercial attraction is the asymmetry. A premium is paid up front and that is the worst case, while the benefit if rates move the right way is open-ended, which is the opposite of entering the swap directly and being exposed in both directions.
Non-finance colleagues usually recognise the shape once it is described as a deposit paid to secure a price you may decide not to use. Pricing and quotation follow a standard shorthand.
The premium is expressed in basis points of the notional amount, and the contract is described by two periods, for instance a swaption with three years to expiry on a ten year swap. Settlement can be physical, meaning the swap actually starts, or cash, meaning the parties simply exchange the market value of the swap at expiry.
The nuance worth knowing is that the mirror image exists and is easy to confuse. A payer swaption gives the right to pay fixed and receive floating, and it gains when rates rise, so the two instruments protect against opposite risks.
Because the naming conventions vary between markets, careful treasurers write out which side of the swap they would be taking rather than relying on the label.
In practice
Real-world examples.
Example
An insurer with a large book of fixed annuity promises worries that falling rates will make its guarantees expensive to meet. It buys a receiver swaption covering part of the book, so that if rates fall the swaption gains enough to offset the extra cost of the promises.
Example
A charitable endowment holds $80,000,000 of bonds maturing in two years and fears it will have to reinvest at much lower rates. A call swaption on a notional amount of $40,000,000 costs 1% up front and protects half the reinvestment, which the trustees judge a reasonable balance between cost and cover.
Example
A corporate treasurer who has already fixed the group's borrowing costs for five years uses a small call swaption as a partial reversal. If rates fall sharply he can exercise it and effectively reduce the fixed rate he pays, without unwinding the original swap and paying a break cost.
Formula
Calculation
Premium = notional amount x premium rate; value at expiry if exercised = notional x (fixed rate received - market swap rate) x annuity factor for the swap period
A pension fund buys a call swaption on a notional amount of $50,000,000 at a premium of 1.20%, so it pays 50,000,000 x 0.0120 = $600,000 up front. The contract gives it the right to receive a fixed rate of 4.00% for ten years. At expiry the market rate for a ten year swap has fallen to 3.20%, so the fund exercises and gains 4.00% - 3.20% = 0.80% a year on the notional, which is 50,000,000 x 0.0080 = $400,000 a year. Applying an annuity factor of 8.2 to allow for the time value of ten yearly amounts gives a value of 400,000 x 8.2 = $3,280,000, so the net gain is 3,280,000 - 600,000 = $2,680,000. Had rates instead risen to 4.60%, the option would simply have been left to expire and the loss would have been the $600,000 premium and nothing more.Case study
Seen in the real world.
Marlowe Infrastructure Trust is an illustrative, fictional investor in toll roads and water assets, with income that is partly linked to short-term interest rates. Its board was comfortable with rising rates, which would increase income, but a sustained fall would leave a hole in the distribution it had promised investors.
Rather than entering a swap and giving up the upside, the finance team bought a call swaption on a notional amount of $30,000,000 for a premium of 0.95%, which is $285,000. The trust kept the benefit of any rise in rates, and in the fictional scenario where rates fell by one percentage point, the swaption gained several times its cost and the distribution was maintained.
The illustrative lesson recorded in the board minutes was about the trade-off rather than the forecast. The premium was a known, budgeted cost that protected a promise to investors, and the directors agreed that was a better use of money than guessing the direction of interest rates.
Watch out
Common mistakes.
- Confusing a call or receiver swaption with a payer swaption, which protects against rates rising rather than falling.
- Thinking the premium is only the start of the cost, when the premium is in fact the maximum loss for the buyer of the option.
- Quoting the notional amount as if it were the money at risk, when no principal is ever exchanged under the underlying swap.
Questions
People also ask.
Who sells these options?
Banks and other dealers, which take the premium as income and manage the resulting exposure across a whole book of trades rather than one at a time.
Does the swap have to start if the option is exercised?
Not always, because many contracts are cash settled, meaning the parties exchange the market value of the swap instead of putting the swap in place.
How is the premium accounted for?
It is normally carried as an asset and remeasured to market value, with hedge accounting available if the documentation and effectiveness tests are met.
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