Interest Rate Swaption

An interest rate swaption is an option to enter into an interest rate swap agreement on pre-set terms at a future date. The purchaser and seller of the swaption agree on the expiration date, option type (e.g., payer's swaption), exercise style (e.g., European), the terms of the underlying swap and the type of settlement (e.g., cash or swap). As the expiration date approaches, the swaption holder can either notify the seller of its intention to exercise or let the option expire. The terminology used in describing and analyzing swaptions, like the name swaption itself, combines the terminology of swaps and options. Like swaps, swaptions are easier to understand and the relationships are easier to remember if everything is viewed from the fixed rate side rather than the floating rate (money market) side of the underlying swap transaction. A payer's swaption is the right to pay a fixed rate.
A payer's swaption is similar to a put on a fixed rate instrument (the fixed rate side of the swap). The most common objective in buying a payer's swaption is to obtain protection from having to pay a substantially higher fixed rate over the life of a projected swap agreement. Because the swap rate is a specific rate--analogous to a coupon rate on a security with a life equal to the term of the underlying swap--a swaption provides highly specific interest rate risk protection. In contrast, a bond or note futures contract may be based on an instrument with a substantially different coupon or duration than the payer's swaption purchaser needs for effective risk management.
EXAMPLES OF PAYMENT FLOWS If interest rates rise over the life of the payer's swaption, the holder of the swaption will exercise the right to pay the pre-set fixed rate (now lower than the market rate). The seller of the payer's swaption will receive a lower fixed rate on the swap than it would have received if the terms had been set at market rates on the start date of the swap, but the swaption premium will increase his effective fixed rate. If interest rates fall, the value of the fixed rate payments will fall and the payer's swaption will not be worth exercising. The swaption buyer will pay a higher effective rate than the market rate in effect on the exercise date as he amortizes the swaption premium and adds it to the market rate. The seller of a swaption can view the premium as increasing the effective rate he receives in the swap with the caveat that , like any option seller, he may be incurring an opportunity loss if the swaption is exercised.
TYPICAL CHARACTERISTICS

Type: Fixed rate payer, fixed rate receiver
Exercise Style: European, American, Bermudan
Underlying Swap: Virtually any type of swap
Strike(s): Constant or at varying Levels
Term: Up to 10 Years
Settlement: Cash or swap

TYPICAL PAYER'S SWAPTION APPLICATIONS
Liability Management
Situation 1: A borrower is entering into a new syndicated bank credit facility priced at a floating rate(LIBOR + Spread). The facility will not close for 180 days, but the borrower is concerned about an increase in interest rates and wants to purchase protection today. The borrower wants three year protection one percent above current three year rates.
Solution: The borrower purchases a payer's swaption. The option period is 180 days and the term of the swap is three years. If interest rates rise, the borrower will exercise the swaption. If interest rates fall, the option will not be exercised, and the borrower will hedge at a lower rate with the only cost being the swaption premium.

Situation 2: A corporation with fixed rate public debt maturing in one year plans to refinance the debt for ten years at maturity. The company likes today's interest rate levels and wants to protect against a rise in interest rates over the next year.
Solution: The company purchases a payer's swaption. The option period is one year and the swap term is ten years. The swaption would be cash settled if exercised. The
corporation hedges against a rise in rates over the next year, but if rates remain unchanged or decline the company borrows at a lower rate. The corporation's only cost is the option premium.

Asset Management
Situation 1: An investor holding a portfolio of fixed rate securities is concerned about a rise in interest rates over the next year. The maturity of the portfolio is six years.
Solution: The investor purchases an American style payer's swaption. If the swaption is exercised, it would be cash settled. If interest rates rise, the investor can exercise the option. If interest rates remain unchanged or decline, the investor does not exercise the swaption and the only cost is the swaption premium.

An interest rate swaption is an option to enter into an interest rate swap agreement on pre-set terms at a future date. The purchaser and seller of the swaption agree on the expiration date, option type (e.g., receiver's swaption), exercise style (e.g., European), the terms of the underlying swap and the type of settlement (e.g., cash). As the expiration date approaches, the swaption holder can either notify the seller of an intention to exercise or let the option expire. The terminology used in describing and analyzing swaptions, like the name swaption itself, combines the terminology of swaps and options. Like swaps, swaptions are easier to understand and the relationships are easier to remember if everything is viewed from the fixed rate side rather than the floating rate (money market) side of the underlying swap transaction. A receiver's swaption is the right to receive a fixed rate.
A receiver's swaption is similar to a call on a fixed rate instrument (the fixed rate side of the swap). The most common objective in buying a receiver's swaption is to obtain protection from having to receive a substantially lower fixed rate over the life of a projected swap agreement. Because the swap rate is a specific rate--analogous to a coupon rate on a security with a life equal to the term of the underlying swap--a swaption provides highly specific interest rate risk protection. In contrast, a bond or note futures contract may be based on an instrument with a substantially different coupon or duration than the receiver's swaption purchaser needs for effective risk management.
EXAMPLES OF PAYMENT FLOWS If interest rates fall over the life of the receiver's swaption, the holder of the swaption will exercise the right to receive the pre-set fixed rate (now higher than the market rate). The effect is similar to an issuer having a callable bond deep in-the-money and calling the bond. The seller of the receiver's swaption will pay a higher fixed rate on the swap than he would have paid if the terms had been set at market rates on the start date of the swap, but the swaption premium will reduce his effective fixed rate payments. If interest rates rise, the value of the fixed rate payments will fall and the receiver's swaption will not be worth exercising. The swaption buyer will receive a lower effective rate than the fixed rate in effect on the exercise date as he amortizes the swaption premium against the market rate.
The seller of a swaption can view the premium as lowering the effective rate he pays in the swap with the caveat that, like any option seller, he may be incurring an opportunity loss if the swaption is exercised.
TYPICAL CHARACTERISTICS

Type: Fixed rate payer, fixed rate receiver
Exercise Style: European, American, Bermudan
Underlying Swap: Virtually any type of swap
Strike(s): Constant or at varying Levels
Term: Up to 30 years
Reset Frequency: Semi-annually, Quarterly, Monthly, or Daily
Settlement: Cash or swap

TYPICAL CAP APPLICATION
Liability Management

Situation 1: A borrower with all floating rate debt (LIBOR + Spread) wants to fix the interest rate on the floating debt for two years, but feels two year swap rates are too high.
Solution: The borrower enters into a two year swap and sells a receiver's swaption. The receiver's swaption has an option period of two years and a swap term of one year. The borrower collects a premium for the swaption that decreases the rate on the swap. If the swaption is exercised, the borrower would be required to pay fixed for additional year.
Situation 2: A corporation has callable debt at an interest rate level well above current rates. The company wants to realize the value of the call prior to any potential increase in interest rates.
Solution: The corporation sells a receiver's swaption. The terms of the swaption mirror the terms of the call on the debt. The corporation collects the swaption premium, but gives up the right to call the debt.

Asset Management

Situation 1: An investor holds a portfolio of fixed rate assets. The investor feels long term rates will remain unchanged or increase over the next year and wants to enhance the yield on the portfolio.
Solution: The investor sells a receiver's swaption. The investor collects the premium and benefits if rates remain unchanged or rise If interest rates decline, the swaption would be exercised and the yield on the portfolio could decline.

Callable interest rate swap is a fixed/floating interest rate swap in which the fixed rate payer buys the right to terminate the swap at some point or points during the swap's term. For this right to terminate the fixed rate payer pays an above market fixed rate to the floating rate payer. Two variations of callable swaps are: European and Bermudan.
European Style Callable Swap In a European style callable swap the fixed rate payer gets a one time right to terminate the swap. For example, a five year swap callable after one year European style gives the fixed rate payer the right to terminate the swap at the end of year one, but only at the end of year one. If the swap is not terminated at the end of year one, the swap stays in place until the final maturity date (year five). The floating rate payer receives an above market fixed rate for the first year, but if rates fall the trade will probably be called.
Bermudan Style Callable Swap In a Bermudan style callable swap the floating rate payer gives the fixed rate payer the right to terminate the swap on specific dates after a specified future date. For example, a five year swap callable after year one. Bermudan (quarterly) style gives the fixed rate payer the right to terminate the swap quarterly beginning at the end of year one. The floating rate payer receives an above market fixed rate for the first year, but if interest rates fall may be called at the end of year one or quarterly thereafter.
The more popular swap is the Bermudan structure, followed by the European. The multiple call opportunities inherent in the Bermudan structure create more value and, therefore, demand a higher coupon rate for the fixed rate receiver. A comparison of the terms and rates for typical Bermudan and European Swaptions appears below.
Five Year Swap Callable after One Year

Structure: Bermudan European
Lockout Period: One Year One Year
Call Points: Quarterly Starting on Lockout Date On Lockout Date
Coupon: 50 bps below 5 yr. swap rate 35 bps below 5 yr. swap rate

Treasury Lock is a customized agreement that fixes the yield or price on a specified treasury security for a specific period. The buyer of the treasury lock is protected from a rise in the yield (prices fall) of the underlying treasury security during the lock period. The period or term of the treasury lock is normally from one week to twelve months. A treasury lock is not an option. The instrument is cash settled; no exchange of securities will take place. If interest rates increase (prices fall) during the lock period, the seller of the lock will make a payment to the buyer at the
maturity. If interest rates decline (prices rise), the buyer of the lock will make a payment to the seller. Normally, a treasury lock requires no up front fee.
Treasury locks are most often utilized by issuers of fixed rate debt. The issuer may be planning an offering of fixed rate debt in the near term (one week to twelve months), but is concerned about interest rates rising between today and the offering date. The issuer can fix the underlying treasury yield today for a forward date through the treasury lock. For example, an issuer planning a ten-year fixed rate offering to be priced in three months that will be priced as a spread over the then current ten-year treasury can fix the yield on the forward ten-year treasury today through a treasury lock. The ten-year treasury today is 5.67% and a three-month treasury lock is 5.73%. This difference reflects the shape of the yield curve and the cost of carrying the position for three months. In three months if the ten-year treasury yield is 6.00%, the seller of the lock pays the buyer of the lock the equivalent of the present value of .27% (6.00% - 5.73%) for ten years on the agreed upon notional amount. If the ten-year treasury yield is 5.50%, the buyer pays the seller the equivalent of the present value of .23% (5.73% - 5.50%) for ten years.
The issuer has hedged himself against an increase in the treasury yield, but does not benefit from a decline in the treasury yield. The issuer has not hedged his exposure to a widening of credit spreads (spread over treasury) during the lock period. If the issuer, its industry, or the general market encounters credit problems over the three month lock period, the issuer's spread over treasury may be higher on the offering date.
Advantages:
• Eliminates treasury yield risk
• No up front cost
• Can be unwound or terminated at any time (Earlier Issue Date)
• Qualifies for hedge accounting treatment

Disadvantages:
• Opportunity cost of a decline in the treasury yield
• Cost of forward rate in upward sloping rate environment
• Not an option - If the issue is canceled, the treasury lock remains