This article will dive into what a ‘swaption’ is, how it works, and the various facets relating to it.
What is it?
Otherwise known as a ‘call swap option’, a ‘swaption’ refers to an option concerning entrance into an interest rate swap. Alternatively, entrance into any other type of swap. It grants holders the right, though not the obligation, to enter into a swap agreement. They can do so as the floating rate payer and fixed-rate receiver. Another name that call swaptions go by is ‘receiver swaption’.
To provide additional context, a ‘swap’ is a derivative contract through which two parties exchange cash flows or liabilities. These two factors stem from two different financial instruments. A majority of swaps typically involve cash flows that draw from a notional principal amount. Such things include a loan or a bond. However, the instrument can be just about anything. Most of the time, the principal rarely – if ever – changes hands.
Each and every cash flow comprises one leg of the swap. Generally speaking, one cash flow is fixed, while the other is volatile. Moreover, it draws from either a benchmark interest rate, floating currency exchange rate, or index price.
Probably the most common type of swap is an interest rate swap. Swaps are not tradeable on exchanges and retail investors are not usually prone to engaging in swaps. Instead, swaps are over-the-counter contracts that are primarily between businesses or financial institutions. These groups are typically tailored to placate the needs of both parties.
Before we move forward, let’s shed some light on what ‘over-the-counter’ means.
Over-the-counter (OTC) is indicative of the process regarding how securities are traded. Specifically, for companies that are not officially on a formal exchange, such as the New York Stock Exchange (NYSE). Securities that are tradeable over-the-counter are done so by way of a broker-dealer network instead of on a centralized exchange. These securities do not meet the requirements that they need to obtain a listing on a standard market exchange.
OTC securities trade by way of broker-dealers who directly negotiate with each other. They do so through computer networks and by phone using the ‘Over the Counter Bulletin Board’ (OTCBB). The OTCBB is an electronic quotation and trading service that aids in the progress of higher liquidity and information sharing.
Pink Sheets is a private company that works alongside broker-dealers in order to bring small company shares to the market. The dealers operate as market makers utilizing the Pink Sheets and the OTC Bulletin Board, which the National Association of Securities Dealers (NSAD).
To learn more about over-the-counter trading, read “What is OTC Trading and How Does It Relate to Crypto?”
How they work
The main function of swaptions is to operate as the option to swap one specific interest rate payments for another. This effectively supplies a type of risk protection against rates that are rising or falling. This largely depends on the kind of option that is acquired. Swaptions share similarities with other options. Some of these similarities include having two types (receiver or payer), a strike price, expiration date, and expiration style. For the swaption, the buyer needs to pay the seller a premium.
Strike prices for swaptions are, in actuality, interest rate levels. Expiration dates will sometimes appear quarterly or monthly; it depends entirely on the offering institution. Some expiration styles include American, European, and Bermudan. The American style will allow exercise at any time. The European style will only permit exercise at the swaption’s expiration date. The Bermudan style establishes a series of exercise dates. The definition of the style happens at the commencement of the swaption contract.
Swaptions are over-the-counter contracts and are not subject to standardization. This is in stark contrast to equity options or futures contracts. Therefore, the buyer and seller both have to agree on what the price of the swaption will be. Moreover, what will be the time until swaption expiration, the notional amount, and the fixed and floating rates.
‘Notional value’ is a useful term for valuing the underlying asset in a derivatives trade. It can be an array of things. Either the total value of a position, how much value a position is in control of or a pre-established amount in a contract. This term is especially useful when describing derivative contracts in the options, futures, and currency markets.
The different types
Swaptions regularly come in two main types. The type can either be a call (or receiver) swaption or a put (or payer) swaption. Call swaptions provide the buyer with the right to take on the role of the floating ratepayer. Meanwhile, put swaptions give the buyer the right to take on the role of the fixed ratepayer. These constructs authorize call swaption buyers to benefit from floating rate payments in markets with falling interest rates. In addition, it gives put swaption buyers the insurance they need to fight back against such markets.
The buyer and seller of the swaption need to agree on the following:
- The premium of the swaption (i.e. the price).
- The overall length of the option period. This typically wraps up two business days before the start date of the underlying swap.
- The various terms of the underlying swap. These include:
- Notional amount. This can often include amortization amounts if there are any.
- The fixed-rate, which equates to the strike of the swaption. Additionally, the frequency of payment for the fixed leg.
- Frequency of observation concerning the floating leg of the swap.
On the whole, there are two possible settlement conventions. A physical settlement of swaptions is possible. For instance, upon expiration, the swap enters between the two parties. Alternatively, a settlement can be made by way of cash. In this case, there is a payment of the swap value in accordance with a market-standard formula.
The predominant participants in the swaption market tend to be large corporations, banks, financial institutions, and hedge funds. End users, like corporations and banks, typically utilize swaptions as a way to manage interest rate risk. Specifically, risks from either their core business or from their financing arrangements. A corporation in need of protection from rising interest rates may purchase a payer swaption.
A bank holding a mortgage portfolio might buy a receiver swaption for protection against lower interest rates. These rates could lead to the early prepayment of the mortgages. A hedge fund that thinks interest rates will not rise by more than a specific amount may sell a payer swaption. It aspires to make a profit by collecting the premium. Investment banks are able to make markets in swaptions in the major currencies. These banks commonly trade amongst themselves within the swaption interbank market.
The market-making banks usually oversee large portfolios of swaptions that they write with numerous counterparties. A substantial investment both in technology and human capital is a requirement for properly monitoring and risk-managing the ensuing exposure.
Swaption markets are an entity in a majority of the major currencies in the world. The largest of these markets being in USD, Euro, Sterling, and Japanese Yen.
The swaption market is primarily over-the-counter. Legally speaking, a swaption is a contract that grants a party the right to enter an agreement with another counterparty. This way, they are able to exchange the required payments. The owner (“buyer”) of the swaption is vulnerable to a failure by the “seller” to enter the swap upon expiration. Alternatively, to pay the payoff in the case of a cash-settled swaption. This exposure is often subject to mitigation through collateral agreements. With this, variation margin posts to cover the future exposure that’s expected.
The buyer of a call swaption anticipates the fall of interest rates, plus they desire to hedge against this possibility. For example, take into consideration an institution that has a considerable amount of fixed-rate debt. Moreover, consider that it wishes to increase its exposure to falling interest rates. With the use of a call swaption, the institution is able to convert its fixed-rate liability to a floating-rate one. Not only that, but it can remain that way throughout the duration of the swap. Consequently, the receiver swaption is now able to plan for the payment of a floating rate on their balance sheet debt. From here, they may receive the fixed rate from the put swaption position.
Should the interest rates end up falling, then the call swaption can benefit from it by paying lower interest. It is important to note that neither position will guarantee a profit. What’s more, if interest rates exceed the call swaption payer’s fixed-rate, they could lose from the unfavorable market move.
The valuation of swaptions is a tricky topic to talk about. This is because the at-the-money level is the forward swap rate, being the forward rate that would apply between two points. Those being the maturity of the option – time m – and the intent of the underlying swap such that the swap, at time m, would have a net present value of zero. So, moneyness is determinable by the strike rate. It depends on if it is higher, lower, or at the same level as the forward swap rate.
To address this, quantitative analysts value swaptions by way of constructing a complex lattice term structure. Additionally, short rate models that illustrate the movement of interest rates over a period of time. However, a standard practice – particularly concerning traders – to whom speed computation is more important, is to value European swaptions. They do this by employing the use of the Black model. For both American and Bermudan style options, where the permittance of exercise predates maturity, only the lattice approach is pertinent.
Put: what’s the difference?
‘Put swaptions’ are the opposite position to call swaptions and also go by the name ‘payer swaptions’. A put swaption position is of the belief that interest rates will eventually increase. In order to capitalize on – or hedge – this possibility, the put swaption holder is open to paying the fixed rate. To do so will give them the opportunity to profit from the fixed-rate differential as the floating rate escalates.
The buyer of a put swaption is expecting interest rates to rise and is hedging against this potential circumstance. For example, imagine an institution that possesses a large amount of floating-rate debt. Furthermore, imagine that they want to hedge its exposure to rising interest rates. By using a put swaption, the institution can convert its floating-rate liability to a fixed-rate one for the swap’s duration. Therefore, the payer swaption is now able to plan the payment of a fixed rate on their balance sheet debt. Moreover, they can receive the floating rate from the call swaption position.
If interest rates end up rising, the put swaption can take advantage of it by receiving additional interest. There is no guarantee that either position will make a profit. For that matter, if interest rates drop below the payer’s fixed-rate, they could lose from the adverse market move.