What is an Interest Rate Swaption?
An Interest Rate Swaption is an option that 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 on terms protected by the Swaption.
The Buyer/Borrower and Seller agree the price, expiration date, amount and fixed and floating rates. A Swaption provides protection for a Borrower as it ensures a maximum fixed interest rate payable in the future. Furthermore, it gives the Borrower flexibility. If the rate does not rise to the Swaption strike rate at expiry the Borrower can choose not to exercise it and take advantage of the lower market rates.
The Swaption enables a Borrower to protect future costs of borrowing without making a commitment. If the Borrower no longer requires the hedge on the future date, they 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 strike rate on a pre-determined future date(s). If, on the exercise date, the market rate is higher than the Swaption strike rate, the Borrower could exercise the option. Should the market rate be lower than the Swaption strike rate on the exercise date, the Borrower could choose not to exercise the Swaption. The Borrower can also sell the Swaption and realise the monetary value.
- It provides the Borrower with a pre-agreed maximum rate of interest
- The Borrower has the flexibility to benefit from low floating rates prior to the exercise date
- 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 can sell the Swaption
- 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 Borrower may feel they received no value
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: