What Is a Swaption? Guide to Understanding Swap Options
Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.
A swaption, or swap option, is a financial derivative that grants the holder the right — but not the obligation — to enter into an interest rate swap contract with specified terms. Swaptions are primarily used to hedge interest rate risk, but can also serve other strategic financial purposes.
Swaptions are often used to manage interest rate exposure, giving the holder flexibility to secure favorable borrowing or lending terms depending on market conditions. Read on for how they work, the different types, pros and cons, and more.
Key Points
• A swaption is an option giving the buyer the right, though not the obligation, to enter into an interest rate swap at a future date.
• Swaptions offers investors flexibility in managing interest rate risk.
• The upfront premium reflects factors like market volatility, time until expiration, and expected interest rate movements.
• Swaptions can be used to lock in favorable rates or hedge against rate movements.
• Exercising a swaption depends on market conditions and the swap’s terms.
How Swaptions Work
As mentioned above, a swaption is an option on a swap rate. Like other types of options contracts, the buyer pays a premium to enter into the swaption, and beyond that they are not obligated to act on the contract.
Although swaptions are a type of option, they are financial derivatives that provide the right to enter into a swap agreement. Similarities to swaps include:
• They are traded over-the-counter instead of on centralized exchanges.
• They are customizable and offer a lot of flexibility since they are not standardized exchange products.
When two parties enter a swaption agreement, they negotiate the terms of the contract, such as the premium, expiration date, notional amount, the swap’s legs (fixed vs. floating), benchmark rate,and the adjustment frequency of the variable leg.
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Who Often Uses Swaptions
Swaptions are typically used by institutional investors instead of retail investors, while retail investors rarely trade them. Some private banks offer swaptions to high-net-worth clients. Large corporations, investment banks, commercial banks, and hedge funds use them for various purposes. It takes a lot of work and experience to create a portfolio of swaptions, so they generally aren’t used by individuals or small firms.
They are often used to hedge against macroeconomic risks such as interest rate risk or securities risks. If an institution thinks interest rates might change, they can enter into an agreement to protect against that. Financial institutions can also use them to change their interest payoff terms.
Swap options tend to be used to hedge specific financings, but they can also be used to hedge a broader change in future interest rates. This can be useful if an institution holds a lot of debt maturities for the year and doesn’t want to risk losses.
A swaption’s strike price represents the fixed interest rate at which the swap will execute if the option is exercised. The holder’s risk is limited to the upfront premium, but the potential benefit depends on how market rates compare to the strike price at expiration.
Swaptions can be purchased in most major currencies, such as the U.S. Dollar, Euro, and British Pound.
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What Are the Different Types of Swaptions?
Swaptions come in two main types: payer and receiver. Both types give the holder the right to enter an interest rate swap, but the difference comes down to whether the buyer chooses to pay or receive a fixed interest rate if the option is exercised.
Payer Swaption
If a buyer enters into a payer swaption, they are purchasing the right, but not the obligation, to enter into a future swap contract. When exercised, the buyer would become the fixed-rate (non-changing) payer and receive the floating rate (variable) payments.
Fixed interest rates remain constant for the duration of a loan. Floating rates change based on a benchmark interest rate. Historically, the most common reference rate was the London Interbank Offered Rate (LIBOR), but that has been largely phased out in favor of the Secured Overnight Financing Rate (SOFR) in the United States and Euro Interbank Offered Rate (EURIBOR) in Europe. These institutions determine interbank lending interest rates, which then influence commercial and retail loan interest rates.
Receiver Swaption
In a receiver swaption contract, the swap holder has the option to pay the floating rate and receive the fixed rate. These contracts are often used by investors who anticipate falling interest rates and want to lock in a higher fixed return.
When Can a Swaption Be Exercised?
There are also swaptions that have different terms of execution. The three most common are:
American
American swaptions can be exercised on any date prior to and including the expiration date. This flexibility makes them useful for hedging against unpredictable interest rate movements.
European
European options can only be exercised on the expiration date, making them less flexible. They are often easier to price and value since they don’t require continuous monitoring.
Bermudan
Bermudan swaptions have several specific dates when they can be exercised prior to the expiration date. This structure provides a balance between flexibility and cost, often making them cheaper than American swaptions.
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Swaption Example
A borrower wants to purchase rate protection on their current floating rate debt maturities totaling $50 million. They decide that they would like to purchase the right, but not the obligation, to pay a fixed rate on their debts for ten years.
For this right, they are willing to take on the risk of 10-year interest rates up to 3.8%, but no higher than that.
The borrower enters into a swaption agreement with a settlement date in the current year, for a notional amount of $50 million, with a 10-year term and a 3.8% strike price. In the context of swaptions, the strike price represents an interest rate rather than a fixed dollar amount. The premium for this contract is $400,000.
Including the premium, the rate is actually hedged higher than 3.8%, but for the sake of this example we will call the strike 3.8%.
If the strike is lower or the settlement date is farther in the future, this increases the value of the swaption and therefore increases the cost of the premium.
The borrower enters into this agreement to hedge against a large increase in swap rates but without choosing a specific rate they want when the contract expires.
It’s important to note that the swaption isn’t tied to the 10-year Treasury, it’s tied to 10-year swap rates, although their movements tend to be related. Also, swaptions are derivatives, so they aren’t the underlying assets themselves, but contracts derived from rates or assets.
When the settlement date occurs, there are two ways the swaption could turn out:
1. If 10-year swap rates fall below 3.8%, the option contract expires worthless, the swaption seller (or counterparty) keeps the premium, and the borrower must enter a new swap at the prevailing market rate.
2. If 10-year swap rates are higher than 3.8%, the borrower exercises the option. In this case the provider of the swaption pays the borrower the difference between the swap rate and 3.8%. The borrower locks in the current swap rate for a swap agreement, and uses the payment they received to buy down the rate on this new swap.
Pros and Cons of Swaptions
There are a few reasons why financial institutions use swaptions, but there can be downsides to them as well. Some of the pros and cons of swap options are:
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Pros:
• Helps hedge against risk when interest rates may rise.
• Swaptions can have longer durations than other types of options.
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Cons:
• If the swaption expires and is not unexercised, the buyer loses the premium amount they put in.
• There is a risk of the other party defaulting on the agreement.
The Takeaway
Entering into swaption agreements is one type of options trading strategy commonly used by institutional investors. They are usually used to help with restructuring a current financial position, alter a portfolio, hedge options positions on bonds, or adjust payoff profiles.
Swaptions are primarily used by institutional investors for hedging and risk management. Retail investors more commonly trade standard stock options — such as calls and puts — on stocks, exchange traded funds (ETFs), and other types of assets to speculate on price movements or manage portfolio risk. There are other types of options on the market that retail investors often trade.
Investors who are ready to try their hand at options trading despite the risks involved, might consider checking out SoFi’s options trading platform offered through SoFi Securities, LLC. The platform’s user-friendly design allows investors to buy put and call options through the mobile app or web platform, and get important metrics like breakeven percentage, maximum profit/loss, and more with the click of a button.
Plus, SoFi offers educational resources — including a step-by-step in-app guide — to help you learn more about options trading. Trading options involves high-risk strategies, and should be undertaken by experienced investors. Currently, investors can not sell options on SoFi Active Invest®.
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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