Interest Rate Swaption

• Right to enter into an interest rate swap at an agreed future date and hedge adverse interest rate developments
• Swaption buyer obtains a right (not an obligation) to enter into an interest rate swap, paying an option premium to the seller
• Interest rate swaptions are used in situations, where it is not certain whether or not a client would ultimately have and asset or liability to hedge
• Swaption is a unilateral transaction – payments on the part of the buyer are limited to the payment of the premium (there is no credit risk for the seller associated with the buyer following the premium collection)
• Sellers are motivated by the premium – buyers may also have slightly worse credit rating
• Swap parameters are agreed in advance – notional amount, exchanged interest payments, calculation period, maturity
• When the strike rate is more beneficial that the market swap rate, swaption will be exercised
• Opportunity to profit from current interest rates for expected potential interest rate liability/receivable with uncertain consummation
• Based on the option right type, swaptions are either call swaptions (receiver swaption) or put swaptions (payer swaption):
  - Receiver (Call) swaptions give buyers the right to enter into a swap – i.e. to pay a floating rate and receive a fixed rate. Investors hedge their variable-rate investments.
  - Payer (Put) swaptions give buyers the right to enter into a swap – i.e. to pay a fixed rate and receive a floating rate. Investors hedge against interest rate increase.

• Profit or loss from interest rate transactions is affected by interest rate fluctuations
• Buying swaptions is a lower-risk strategy than writing swaptions – in case the underlying asset prices move against the swaption buyer, the buyer simply does not exercise its right
• Maximum loss for the swaption buyer is limited to the premium paid
• Risk associated with sold swaptions is much higher than for purchased swaptions – loss of the swaption seller may significantly exceed the premium received, it can be unlimited (in theory)
• In case a swaption is exercised, the swaption seller undertakes to purchase or sell the underlying asset (i.e. expressed as a ratio of defined interest rates) - even if the market price is very far from the strike price
• In case the client already owns the underlying assets, which he undertook to sell, the risk is lower; however, if he does not, the risk is virtually unlimited
• Potential losses result from the fact that the client’s position may be in an adverse position – the client’s interest payment made under the swaption will exceed the payment made by the bank
  - In this case, the client pays the amount corresponding to the difference of the two payments to the bank
  - In case the transaction was negotiated as a hedging instrument, the client views the loss incurred as the cost of hedging
  - Hedging protects clients from significant interest rate fluctuations that could result in significant financial problems
• Swaptions writing is only suitable for experienced investors

A client expects potential interest rate liability, under which he would pay a variable interest rate. He is exposed to uncertainty with the consummation of such liability, as well as the subsequent risk of interest rate increase. Therefore, the client purchases a Put swaption that gives him the right to enter into a swap, under which he would pay a fixed rate to the bank and receive a floating rate from the bank.

Process description

• In case the agreed parameters of underlying interest rate swap are not beneficial for the client as of the option expiration date (interest rate swap value is negative from the client’s point of view), the client does not exercise the swaption
• Client’s only incurred cost is the premium
• In case the expected interest rate liability does not arise and the underlying interest rate swap is negative from the client’s point of view (swaption buyer), the client does not exercise the swaption
• In case the expected interest rate liability does not arise; however, the underlying interest rate swap is positive from the client’s point of view (swaption buyer), the client exercises the swaption to subsequently terminate the interest rate swap early and collect its market value
• In case a client enters into the underlying interest rate swap (i.e. swaption is exercised), the profit or loss from such transaction is affected by interest rate fluctuations as for any interest rate swap

This product is intended for individuals and legal entities – domiciled in the Czech Republic and abroad.