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Guide

Interest rate swaption

Summary

An interest rate swaption is an option that provides the borrower with the right but not the obligation to enter into an interest rate swap on an agreed date(s) in the future on terms protected by the swaption.

What is an interest rate swaption?

An interest rate swaption is an option that provides the borrower with the right but not the obligation to enter into an interest rate swap on an agreed date(s) in the future on terms protected by the swaption.

The buyer/borrower and seller agree the price, expiration date, amount and fixed and floating rates. A swaption provides protection for a borrower as it ensures a maximum fixed interest rate payable in the future. Furthermore, it gives the borrower flexibility. If the rate does not rise to the swaption strike rate at expiry the borrower can choose not to exercise it and take advantage of the lower market rates.

Objective

The swaption enables a borrower to protect future costs of borrowing without making a commitment. If the borrower no longer requires the hedge on the future date, they will not be exposed to potential hedge termination costs.

How does it work?

In return for paying a premium, the borrower acquires the option to enter into a swap at a pre-agreed strike rate on a pre-determined future date(s). If, on the exercise date, the market rate is higher than the swaption strike rate, the borrower could exercise the option. Should the market rate be lower than the swaption strike rate on the exercise date, the borrower could choose not to exercise the swaption. The borrower can also sell the swaption and realise the monetary value.

interest rate swaption table

Three scenarios of where the swap rate or fixed rate could settle and what the borrow will need to pay when using a swaption.

Advantages

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

Disadvantages

  • The borrower will incur a premium cost usually paid up front
  • If the market rate fails to rise above the swaption rate during the tenor of the swaption, the borrower may feel they received no value
interest rate swaption trade

A description of what an interest rate swaption trade could look like in practice.

Types of swaptions

There are a number of different types of swaptions that can be used to protect against rising short term interest rates:

  1. A European swaption grants the holder the right to enter into the swap only on the expiration date (exercise date) of the option
  2. A Bermudan swaption enables the holder the right to enter into the swap on a number of predetermined exercise dates
interest rate swaption example

Interest rate swaption graph showing three potential outcomes over time.

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Disclaimers

Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.

Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.

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