Back-to-Basics: Swaptions

Teri Geske
Senior Vice President, Product Development

A swaption (or swap option) gives the holder the right, but not the obligation, to enter into an interest rate swap of an agreed-upon tenor. A “receiver” swaption gives the holder the right to receive the fixed rate under the swap agreement, while a “payer” swaption gives the holder the right to pay the fixed rate. A swaption can be used for a variety of purposes – for example, corporations issuing debt can use a swaption to hedge future borrowing costs or to monetize the value of the embedded option in a callable issue, and financial institutions can use swaptions as protection against rising swap rates or against an increase in the floating rate index of the underlying swap, depending upon whether the swaption is to receive or pay the fixed rate of the swap. Consider a financial institution with primarily short-term, floating-rate liabilities and fixed rate assets with an average maturity of five years. Although the firm is at risk if short-term rates rise, assume that short-term rates are considerably below what the institution would have to pay to receive the floating rate and pay fixed in a five year interest rate swap, so the firm does not wish to enter into such a swap at the present time. Nonetheless, there is a possibility that short term rates will rise, causing the institution’s net interest margin to decline. A payer swaption would give the firm the right to enter into a swap at a future date to receive a floating rate payment in exchange for a fixed rate that is known today. If rates do rise, the institution would exercise the swaption to receive the floating rate, paying a fixed rate that would be below the prevailing swap rate at that future date.

As with all fixed income options, a swaption has an expiration date and the underlying instrument on which the option is written, in this case a swap, has a maturity date. To avoid confusion regarding these two dates, traders will describe swaptions by saying, for example, “six months into five years”, meaning a swaption that expires in six months, giving the holder the right to enter into a five year swap at that point in time. The strike rate for a swaption is an interest rate; specifically, it is the fixed rate of interest on the underlying swap. In a standard swaption, the strike rate is the at-the-money swap rate as of the forward start date (the date the swaption expires) corresponding to the maturity of the underlying swap. For example, in a six month swaption on a five year swap, the strike rate would be the five year swap rate for forward settlement in six months. European swaptions give the buyer the right to exercise only on the expiration date; most swaptions have European exercise. American swaptions allow the buyer to exercise at any time prior to the expiration date, and Bermudan Swaptions give the buyer the right to exercise on specific dates during the option period.

The buyer of a receiver swaption will exercise if the prevailing swap rate at the swaption’s expiration is lower than the strike rate on the swaption – in this case, the swaption would have a positive market value because the holder could exercise and receive an above-market rate in exchange for paying the floating rate under the terms of the swap. Conversely, the buyer of a payer swaption benefits if the then-prevailing swap rate is above the strike rate, as the holder could exercise and pay a below-market rate in exchange for the floating rate. Buying a receiver swaption is similar to holding a call option on a fixed rate bond, because the holder of such an option would exercise if the fixed rate bond paid an above-market rate of interest. Similarly, holding a payer swaption is similar to owning a put option on a fixed rate bond, since the holder benefits when interest rates rise. In a portfolio context, holding a payer swaption will shorten duration of a portfolio (if exercised, the portfolio will pay fixed and receive floating in the underlying interest rate swap), while holding a receiver swaption will lengthen the duration. Swaptions can be cash-settled or physically settled (the counterparties enter into the underlying swap).

Like any other option, the value or price of a swaption depends on the expected future volatility of the underlying – in this case, the underlying is a swap rate. So, the buyer of a payer (receiver) swaption pays a premium that is a function of the probability that the strike rate will be below (above) the prevailing market swap rate at the expiration date of the swaption. As with caps and floors, traders typically quote swaption prices for swaptions in terms of volatility levels – so, for example, the price of a one month into five year swaption would be quoted as, say, 25%, referring to the volatility of the five year swap rate in one month. Since volatility is a key determinant of swaption value, investors sometimes sell swaptions to earn the premium when they believe implied volatilities are high. For example, an investor who believes that swaption volatilities are high (overstated) and that interest rates will be stable or are most likely to increase could sell a receiver swaption; if rates do increase, the swaption buyer would not exercise and the seller would earn the swaption premium (this is a popular strategy when rates are low). Since prices in the swaptions market reveal the consensus expectations for the volatility of swap rates, these implied volatilities are often used in financial models that require interest rate volatilities as inputs. The pricing algorithm in the new swaptions model in BondEdge will be calibrated daily with volatilities from the swaptions market; clients will also be able to price swaptions by inputting their own volatility rate.

We hope this review of the basics of swaptions has been useful. If you have any questions, comments, or suggestions for other Back-to-Basics topics, please e-mail marketing at fia.marketing@interactivedata.com.