What it means
Think of a swaption as insurance on a swap. If rates move in your favour you can walk away and lose only the premium, and if they move against you, you can exercise the option and lock in the rate you agreed earlier.
The swap itself would run for a set number of years after the option is exercised. There are two main types.
A payer swaption gives the right to pay a fixed rate and receive a floating one, which suits borrowers worried about rising rates. A receiver swaption gives the right to receive the fixed rate, which suits investors who want to protect income if rates fall.
The agreed fixed rate in the option is called the strike. If the market swap rate at expiry is above the strike on a payer swaption, the option is worth exercising because the holder can pay less than the going rate.
The premium depends on the strike, how long until expiry, the length of the underlying swap and how volatile (changeable) rates are expected to be. Companies use swaptions when they are not certain they will need a hedge.
Examples include a business bidding for a contract that would require new borrowing, or a developer waiting for planning approval. If the project falls through, they let the option lapse and lose only the premium instead of being locked into a swap they no longer need.
Swaptions can also be American, exercisable at any time up to expiry, or Bermudan, exercisable on a set list of dates. Cancellable swaps and callable bonds often contain swaptions embedded inside them, so people sometimes hold one without realising.
In practice
Real-world examples.
Example
A property fund is bidding for a shopping centre and will need an $80,000,000 floating-rate loan if it wins. It buys a payer swaption so that, if the bid succeeds and rates have risen, it can fix its borrowing cost at the agreed strike.
Example
An insurer expects to receive large premium inflows next year that it will invest in long-dated bonds. It buys a receiver swaption to protect its reinvestment income in case interest rates fall before the cash arrives.
Example
A shipping company's treasurer is unsure whether an order for new vessels will be confirmed. A swaption lets her hedge the financing cost without committing to a swap that she would have to unwind at a loss if the order is cancelled.
Formula
Calculation
At expiry, payoff of a payer swaption per year = (Market swap rate - Strike) x Notional, if positive, otherwise zero.
Suppose a company buys a one-year payer swaption on a five-year swap with a notional of $50,000,000, a strike of 4.00% and a premium of $400,000.
If the market swap rate at expiry is 5.00%:
Annual saving = (5.00% - 4.00%) x $50,000,000 = 0.01 x $50,000,000 = $500,000
Over five years the saving is $500,000 x 5 = $2,500,000 (before discounting to present value).
Net benefit = $2,500,000 - $400,000 = $2,100,000.
If the market swap rate is 3.50%, the option is worth nothing, the company lets it expire and its loss is limited to the $400,000 premium.Case study
Seen in the real world.
Lumen Healthcare is an illustrative, fictional hospital operator planning a $60,000,000 expansion that depended on a regulatory licence expected in nine months. A fixed-rate swap booked today would have been unwound at a cost if the licence were refused.
The treasurer bought a nine-month payer swaption with a strike of 4.2% for a premium of 0.6% of the notional, which came to $360,000. The board accepted that the premium was a sunk cost in exchange for flexibility.
In the illustrative outcome the licence was approved, rates had risen to 5.1% and the swaption was exercised. Lumen fixed its borrowing at 4.2%, and the saving over the life of the loan was many times the premium.
Watch out
Common mistakes.
- Treating the premium as refundable if the option is not exercised, when it is paid up front and lost if the option expires worthless.
- Confusing a payer swaption with a receiver swaption, which have opposite exposures to a rise in rates.
- Assuming a swaption is the same as a swap, when a swap is a binding commitment and a swaption is only a right.
Questions
People also ask.
What is the difference between a swap and a swaption?
A swap commits both sides to exchange payments, while a swaption gives one side the choice of whether to enter the swap at all.
Why is the premium higher when rates are volatile?
Because bigger expected swings make it more likely that the option will end up valuable, so sellers charge more to take that risk.
Can a swaption be sold before expiry?
Yes, in most cases it can be sold or closed out in the market at its then-current value.
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