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Interest Rate Swaption

What is an Interest Rate Swaption?

An Interest Rate Swaption is an option which provides the Borrower with the right but not the obligation to enter into an Interest Rate Swap on an agreed date(s) in the future. If exercised, the Borrower is entitled to enter into the Swap on the terms protected by the Swaption.

A Swaption provides protection for a Borrower as it ensures a maximum fixed rate payable in the future. Furthermore, it gives flexibility if the fixed rate does not rise to the Swaption strike rate at expiry – in this case, it will not be exercised and the borrower can take advantage of the lower market rates at that time.

Purpose

The Swaption enables a Borrower to protect the costs of borrowing in the future in a manner that does not involve a commitment on the part of the Borrower. If the hedge is no longer required on the future date, the Borrower will not be exposed to potential hedge termination costs.

How does it work?

In return for paying a premium, the Borrower acquires the option to enter into a Swap at a pre-agreed fixed rate (strike rate) on a pre-determined future date(s). If, on the exercise date, the market swap rate is higher than the Swaption strike rate, the Borrower would exercise the option and enter into the pre-determined Swap. Should the Borrower not wish to enter into the pre-determined Swap then they can sell the Swaption and realise the monetary value. Should the market rate be lower than the Swaption strike rate on the exercise date, the Borrower will not exercise the Swaption.

Advantages
  • It provides the Borrower with a pre-agreed maximum rate of interest from a future date
  • It provides the Borrower with the flexibility to benefit from low floating rates prior to exercise date of Swaption
  • There are no additional costs arising on early termination. The Borrower will be entitled to receive any residual value attributable to the Swaption
  • The Borrower is not obliged to enter into the Swap if interest rates should fall instead of rise
  • The Borrower is not obliged to enter into the Swap if it is no longer required
Disadvantages
  • The Borrower will incur a premium cost, usually paid up front
  • If the market rate fails to rise above the Swaption rate during the tenor of the Swaption, the Swaption will expire worthless and the Borrower may feel that no value was received

Types of Swaptions

There are a number of different types of swaptions that can be used to protect against rising short term interest rates:

A European Swaption grants the holder the right to enter into the swap only on the expiration date (exercise date) of the option.

A Bermudan Swaption enables the holder the right to enter into the swap on a number of predetermined exercise dates.

Interest Rate Swaption example:

 

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