Swaption

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A swaption is a financial instrument granting the owner an option to enter into an interest rate swap. A swaption gives the buyer the right but not the obligation to pay (receive) a fixed rate on a given date and receive (pay) a floating rate index.

The buyer and seller of the swaption agree on:

the strike rate,
length of the option period (which usually ends on the starting date of the swap if swaption is exercised),
the term of the swap,
notional amount,
amortization,
frequency of settlement.

1 Properties
- 1.1 An example
- 1.2 Another example
2 Swaption styles
3 Valuation
4 First Known Swaption
5 External links

[edit] Properties

Unlike ordinary swaps, a swaption not only hedges the buyer against downside risk, it also lets the buyer take advantage of any upside benefits. Like any other option, if the swaption is not exercised by maturity it expires worthless.

If the strike rate of the swap is more favorable than the prevailing market swap rate then the swaption will be exercised as detailed in the swaption agreement.

It is designed to give the holder the benefit of the agreed upon strike rate if the market rates are higher, with the flexibility to enter into the current market swap rate if they are lower.
The converse is true if the holder of the swaption receives the fixed rate under the swap agreement.

[edit] An example

An example of this would be helpful: Joe is in Zaire and he knows there's an election coming up. Joe has some variable rate bonds that are paying very well. But, he thinks it won't last. Dave is in the UK and rates are low and constant. Dave has some sovereign UK bonds that he'd like a better rate on, and likes the political outlook in Zaire.

Joe and Dave engage in a swap; Joe gets fixed cash flows from the UK bond and Dave gets the variable rate bonds. They agree on terms that set the swap as even money (present valued) for both of them. However, they don't do the swap yet because Joe's debt is about to expire and he is going to reinvest, and he only wants to do the swap if the variable rates drop below a threshold (at which point his income goes down; he wants to lock in profits). In order to lock in the profits, he's willing to arrange the option on slightly favorable terms with Dave. Dave wants the higher temporary cash flow and if the variable rates go down (which he doesn't think will happen) and is willing to live with a little risk.

Everyone is happy; the swaption can be exercised and both people may still make a profit, depending on the timing and amounts involved. At the very least, both parties either reduced or enhanced their risks/rewards as they desired.

[edit] Another example

Here is another scenario: Doug's Tractor Company needs to engage in a swap for the following reason: They have too much risk. They have a 5 year adjustable rate business loan that they've used to buy machines to make tractors. They've just agreed to sell 10 tractors to Jimbob's Tractor Dealership at the rate of 2 per year for 5 years (they don't sell fast, etc.). The price for the tractors is set in the contract and cannot be renegotiated.

The problem is, if the interest rates go up, Doug has to pay lots of money in interest payments, and he loses money on the transaction. He needs to lock in an interest rate, even if it's a little above the current rate.

Across town, Stanley's Tire Co. owns a mortgage on their offices, that he cannot pay off for tax reasons and due to various legal problems tying up ownership of the property. However, he's locked into a higher long-term rate mortgage. He wants to reduce his rates.

Both of them have an opinion about the way short term rates are going to go. Stanley thinks short term rates are going to stay low, and wants to pay less. Doug thinks they're going higher than Stanley's fixed rate. But Doug only needs to do the swap if the rates get that high. Stanley agrees to a swaption. Both are making a bet, and it should help them manage risk better.

[edit] Swaption styles

There are three styles of Swaptions. Each style reflects a different timeframe in which the option can be exercised.

American Swaption, in which the owner is allowed to enter the swap on any day that falls within a range of two dates.
Bermudan Swaption, in which the owner is allowed to enter the swap on a sequence of dates.
European Swaption, in which the owner is allowed to enter the swap on one specified date.

[edit] Valuation

European Swaptions are usually valued using the Black model, where, for this purpose, the underlier is treated as a forward contract on a swap.

The forward price input into the Black Model, is the appropriate forward swap rate - that is, the forward rate that would apply between the maturity of the option (t) and the tenor of the underlying swap (T) such that the swap, at time t, has an "NPV" of zero; see swap valuation.

Note that, in general, swaptions are one of the most difficult derivative instruments to value. This is because their prices are influenced by the properties of the forward contracts with maturities over the term of the underlying swap. In pratice, therefore, financial analysts usually model a term structure of implied volatility for each of the forward prices that are part of the swap.

[edit] First Known Swaption

The first known swaption was constructed and executed by William Lawton in 1983. Lawton was the Head Trader for Fixed Income Derivatives at First Interstate Bank in Los Angeles at that time. Lawton worked with First Interstate's Treasury Options Desk to marry the concept of an interest rate swap and an options contract. The swaption was for a period of one year. First Interstate, for a premium, sold a Los Angeles based savings and loan the right to enter into a five year interest rate swap to pay fixed versus three month Libor on a notional amount of $5 million.