SWAPTIONS
The chapter on option products earlier in this book stated that an option gave its owner the privilege of taking a market action at a later time, if she so desired. If the owner didn’t want to, she didn’t have to—it was her option. The chapter on swaps stated that a swap involved an exchange of assets or cash flow. The terms of the swap have been agreed to and the swap is alive. However, what if a participant wanted to delay the start of the swap, but use current rates only if they were better than the then-going rates? In other words, the party to the swap can decide at a later date which rate to use. The party would have an option to choose which rate best served him. He would have an option on the swap, which is called a “swaption.”
Let’s take this one step further: suppose the party to the swap wasn’t sure the swap would be needed at a later time, but was concerned that by the time the swap was needed, the swap rates might not be as beneficial as they are at present. The parties to the swap would negotiate the terms so that, if desired, the swap could be executed at a later time. The parties would have a swaption.
Let’s look at a hypothetical situation where a swaption may be used. Say there is a company unsure whether a swap will be needed at a later date, but the company likes the current swap rates. It faces three choices: do nothing and risk having to enter into a swap on less favorable terms at a later time; get involved in a potentially adverse, hard-to-get-out-of transaction if the swap turns out not to be needed; or find a product that has an activation delay mechanism built into it. The last choice is called a swaption. This option permits its owner to enter into a swap agreement under prearranged terms and conditions only if it wants to. If it does not want to enter into it at this time, it does not have to do so and the swaption will expire.
The typical swaption contains three parts, the option itself and two “legs.” One leg is a fixed-interest-rate leg pegged to longer-term interest rates, and the other leg is a floating-interest-rate leg pegged to a floating rate such as LIBOR. The option portion of the swaption may be one of three types: Bermudan, American, or European. The Bermudan option permits the swaption owner to enter the swap on several predetermined dates. The American form can be exercised any time during its life. The European form is only exercisable at the end of the option’s life. The negotiated terms of the option include the notional amount of the swap that the option is based on; the strike price, which is obtained from the fixed rate of the underlying swap; the tenor of the option, which usually is set to expire approximately when the swap would be expected to be needed; and the premium at which the transaction will take place.
The terms of exercise are set in the negotiation stage of the swaption. However, a swaption is unlike a standard equity option, where the buyer can acquire a call option, giving its owner the ability to purchase a trading unit of the underlying issue, or a put option, giving its owner the ability to sell a trading unit of the underlying issue or product. The owner of the swap is neither buying nor selling anything. Instead, as one leg of the swaption is paying a fixed interest rate and the other leg paying a floating rate, the buyer of the swaption is either receiving or paying a fixed rate of interest. Therefore, by definition, the seller of the swaption is either paying or receiving a floating rate of interest. The term used keys off the fixed-payment side, with the buyer receiving fixed payments known as the “receiver swaption,” or paying fixed payments known as the “payer swaption.” The floating-rate side is understood or assumed.
The concept of when a call or a put option would have intrinsic value (be in the money) still applies. In the case of a call, it would be an advantageous exercise when the market price of the reference issue’s value is greater than the strike or exercise price of the option. A put would have intrinsic value when the referenced issue’s value is lower than the strike or exercise price of the put option. When working with swaptions, the buyer of the swaption who is paying fixed payments has an “in the money” option when the going fixed rate for a similar product with the same tenor and credit risk has a higher rate than the swaption rate.
An example of this would be a swaption with a fixed rate of 6 percent in a market of equivalent products paying a fixed rate of 7 percent. Likewise, a swaption owner who is a fixed-income receiver has an in-the-money option when the going fixed-income rate is lower than the swaption rate. For example, a swaption receiver has a fixed rate of 6 percent when the going rate for a similar product is 5 percent. Another way of saying the same thing involves the difference between the swap rate that was set at the time the swaption was negotiated and the actual swap rate that is applicable at the end of the swaption on the same referenced asset for the same tenor, quality, etc.
Upon expiration of a European swaption, the buying counterparty has the choice of letting the option expire or exercising it. The decision is based on whether the option portion of the swaption is in the money or not. If expiration is the decision, the opportunity ceases to exist and the seller retains the premium. On the other hand, if the option is in the money and the holder counterparty decides to exercise, the holder will enter into the swap.
Here is a simplified explanation of these concepts:
Negotiated Swap Rate at the beginning of the swaption = NSR
Actual Applicable Rate for swap at end of swaption tenor = AAR
In the money when (Payer) = AAR > NSR
In the money when (Receiver) = NSR > AAR
Swaptions trade in an over-the-counter environment. The participants are primarily financial institutions such as banks, corporations, and hedge funds. The product is used as a tool for managing the interest rate risk brought about by these companies’ primary business activities. It is not a main product but is necessary in managing interest rate risk. While swaptions involve only two parties to the trade, there are major swap dealers who make markets in swaptions and maintain large swap positions. Among these are Bank of America and Merrill Lynch.
Market price of the swaption is discussed in basis points. As covered earlier, a basis point is one one-hundredth of 1 percent (that is, 25 basis points is a quarter of a percent). The basis point price amount that the swap trades at follows the usual sources that option premiums are based on. These include the relationship between current interest rates and the strike rate of the swap, the tenor of the option, and the volatility of the interest rates at present. The value of the swaption when it is at the money is the forward swap rate of the option.