How does Swaption Works ?
What is Swaps?
Swap is an over-the-counter trading deal between two firms to swap cash reserves in the future. The agreement specifies the dates on which cash flows are to be paid and the manner in which they are to be measured. Typically, the calculation of cash flows includes the future value of the interest rate, the exchange rate, or some other market element.
Often there are alternatives included in the Swap Deal. For example, in an expandable swap, one party has the option of extending the life of the swap beyond the specified period. One party has the right to end the swap early in the puttable swap.
Options on swaps, or swaptions, are also available. A swaption is an option granting its owner the right but not the obligation to enter an underlying swap.
Fixed and Floating legs.
Before moving to the different types of Swaptions, we take an example to understand the fixed and floating interest rate.
Imagine a potential three-year exchange negotiated between company X and company Y. We presume that X agrees to pay Y an interest rate of 3% a year on a principal of $100 million, and in exchange, Y agrees to pay X the six-month LIBOR rate on the same principle. X is a fixed rate payer; Y is a floating ratepayer.
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Different types of Swaptions:
- Payer swaption gives the swap owner the option to perform a swap where he or she pays a fixed leg and gets a floating leg.
- Receiver swap grants the owner the option to enter the exchange in which the fixed leg is received, and the floating leg is paid.
A “straddle” is a combination of a receiver and a payer option on the same swap.
Swaption Process: An Example
Suppose that within six months, X Company has a credit capacity that would need re-financing. The annual budget process for X has taken into account the average interest rate and is aware that, prior to the rollover date, the rate may increase above that limit. It decides to take a Swaption. If the interest rate rises past the negotiated Swap rate before the re-financing was expected, the Swap will be initiated. If the interest rates on the rollover date were below the Swap rate, they would not continue with the Swap and then borrow at the prevailing interest rate.
Thus, companies enter into Swaptions to insulate themselves from the risk of changing interest rates. By purchasing Swaptions, companies acquire the assurance that if the prices escalate past the negotiated point before the rollover or drawdown period, they will be excluded from these rises. If the prices do not rise past the negotiated Swap rate, they will not continue with Swap, but you would borrow at the prevailing market rate.
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Disadvantages and risks involved.
- The main risk of Swaption arises after you claim your right and continue with the Swap. When interest rate fluctuations are inconsistent with your intentions, the Swap may have a reverse impact on what you were hoping to do with the deal.
- However, if that occurs, you may cancel or end the swap remembering that you will be forced to pay the bank, or the bank will pay you the remaining value of the swap.
- Another disadvantage of Swaption is that, if the interest rate does not increase past the interest rate specified in the Swaption on the exercise date, the company does not earn any gain from the premium charged from it, for the purchase of the Swaption. The premium is the expense of receiving insurance against an increase in interest rates.
Author: Abhay Kanodia
About the author: An undergraduate student from the Birla Institute of Technology and Sciences, Pilani(BITS Pilani). Exploring the fields of finance and data analytics and its applications in other different domains.
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