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About Interest Rate Swaptions
- Right to enter into an interest rate swap at an agreed future date and hedge cash flow interest rate risk
- 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 be less creditworthy and still be able to purchase swaption
- Swap parameters are agreed in advance – notional amount, exchanged interest payments, calculation period, maturity
- The receiver and payer swaption will be exercised when the strike rate is above or below the market swap rate
- It allows to benefit from current interest rate environment for expected potential interest rate liability/receivable with uncertain consummation
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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 pay a floating, receive fixed. Investors hedge their variable-rate investments
- Payer (Put) swaptions give buyers the right to enter into a swap pay fixed, receive floating. Investors hedge against interest rate increase.
Important information for you
- Profit or loss from interest rate transactions including swaptions is affected by interest rate fluctuations
- Buying swaptions is a lower risk stategy than writing swaption – in case the underlying asset prices move against the swaption buyer, the buyer simply does not exercise
- 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 in theory unlimited
- In case the transaction was negotiated as a hedging instrument, the client views the premium paid or loss incurred as the cost of hedging
- Hedging protects clients from significant interest rate fluctuations that could result in financial problems
- Swaptions writing is only suitable for experienced investors
Example of risk
Please review our model transaction:
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
Client purchases a Put swaption that gives him the right to enter into a swap pay fixed, receive floating when he expects to incur potential future floating rate liability
- 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