Mar
22
2023
Explaining the Different Types of Asset Classes
If you’re new to investing, you might ask, “What is an asset class?” Here’s an explainer—plus learn how this can help you diversify your portfolio.
Read more
SoFi
Student Loan Consolidation and Refinancing
Mar
22
2023
What Is a Money Market Account and How Does it Work?
Money market accounts can offer higher interest rates than a traditional checking account but may come with high minimum balances and fees.
Read moreMar
21
2023
What Is a Swaption? Guide to Understanding Swap Options
A swaption, also known as a swap option, is an option contract that grants the owner the right but not the obligation to enter into a swap contract with specified terms. The swap contracts tend to be interest rate swaps, but can be other types of swaps as well.
With swaptions, one party can exchange a currency of the same value, an interest rate, or the liability of repaying a loan. Read on for how they work, the different types, pros and cons, and more.
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 more similar to a swap than to an option. 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 want to enter into a swap option agreement, they decide on the terms of the contract, such as the the premium, the expiration date, the notional amount, the swap’s legs (fixed vs. float), the benchmark for the floating leg, and the frequency of adjustment for the variable leg.
Recommended: Options Trading 101 Guide
Who Often Uses Swaptions
Swaptions are typically used by institutional investors instead of retail investors, although some private banks offer them to their 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.
They 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.
The way swaptions are generally set up, their strikes are a strike above the current 10 year swap rate. Therefore the borrower takes on risk between the current rate and the higher rate, but not more than that.
Swaptions can be purchased in most major currencies, such as the U.S. Dollar, Euro, and British Pound.
Recommended: Popular Options Trading Terminology to Know
What Are the Different Types of Swaptions?
There are different types of swap options that each have different types of ‘legs’ in the predetermined swap contract they represent. The two types of options are payer and receiver.
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 don’t change with the market, they stay the same through the duration of a loan. Floating rates change based on a reference rate, the most common one being LIBOR. LIBOR is an average of interest rates that are collected from some of the top banks in London.
Receiver Swaption
In a receiver swaption contract, the swap holder has the option to pay the floating rate and receive the fixed rate.
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.
European
European options can only be exercised on the expiration date, making them less flexible.
Bermudan
Bermudan swaptions have several specific dates when they can be exercised prior to the expiration date.
Finally, user-friendly options trading is here.*
Trade options with SoFi Invest on an easy-to-use, intuitively designed online platform.
*Check out the OCC Options Disclosure Document.
Swaption Example
A borrower wants to purchase rate protection on their current floating rate debt maturities totalling $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 an agreement with a settlement date in the current year, for a notional amount of $50 million, with a 10 year term and a strike of 3.8%. The premium they must pay to enter in 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.
- If 10 year swap rates are below 3.8%, the option contract expires, the lender keeps the premium and the borrower uses the current swap rate.
- 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:
| Pros | Cons |
|---|---|
| Can be used to hedge against risk when there is a possibility that an interest rate will go up. | Swaptions can have longer durations than other types of options. |
| If the swaption is not exercised, 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.
There are other types of options on the market that retail investors often trade.
If you’re ready to try your hand at options trading, You can set up an online options trading account and trade from the SoFi mobile app or through the web platform.
And if you have any questions, SoFi offers educational resources about options to learn more. SoFi doesn’t charge commissions, and members have access to complimentary financial advice from a professional.
SoFi Invest® INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below:
Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.
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.
SOIN0821366
Mar
21
2023
What Are Asian Options and How Are They Priced?
Asian options (also known as average strike options or average options) are a type of exotic option that is priced according to the average price of the underlying commodity, as opposed to the spot price.
Read on for how they’re priced, how they work, pros and cons, and more.
What Is an Asian Option?
Asian options are a type of exotic option that trade differently than standard American or European options.
American and European options allow the holder to exercise an option at a strike price known on the purchase date. They differ in when the option can be exercised.
American options can be exercised at any time up to and including the expiration date. European options can only be exercised on the expiration date.
Asian options, on the other hand, are priced based on the average price of the asset over a period of time and like European options they are exercised on the expiration date.
The various parameters of an Asian option are negotiable, but there are two different types of Asian options, average strike options and average price options.
Average strike options are sold with an unknown strike price. The strike price will be determined based on the average price of the underlying asset at selected time intervals.
Average price options are sold at a known strike price. The exercise price will be determined based on the average price of the underlying asset at selected time intervals.
In addition, both types of Asian options may be priced according to arithmetic or geometric averages.
Who Buys Asian Options?
Asian options are usually purchased to solve a particular business problem:
- A buyer wants to lock in an average price or exchange rate over a period of time.
- A buyer wants to protect against price manipulation in the market.
- A buyer wants to protect against volatility in the price movement of the underlying asset.
- A buyer wants to mitigate against inefficient pricing due to an asset being thinly traded.
How Asian Options Work
Like standard options, the price of a call or put in Asian options depends on the price of the underlying asset when the option expires. But unlike standard options, the price of an Asian option will depend on the average price of the underlying over a specified period of time.
Different kinds of Asian options will define average in different ways, so make sure that you check the details of the contract before investing. It’s common for Asian options to define average either as an arithmetic or geometric mean over a period of time.
One example might be for an Asian option to be priced as the arithmetic mean of the underlying stock’s price as measured every 30 days.
Maximum Payoff
Like standard options, the maximum payoff for an Asian option will depend on whether it is a call or put option. Even though the prices in an Asian option are determined by the average price instead of the spot price, the maximum payoff for Asian options works in the same way.
For a call option, the maximum payoff is unlimited, since there is no limit on how high the stock’s price can go.
For the purchase of a put option, the maximum payoff will be if the stock’s price goes to zero.
Maximum Loss
Losses on Asian options are limited to the premiums paid at initiation of the trade. Because of average pricing and lowering the volatility of large price swings, the purchase premiums are also typically lower than available with regular options.
Breakeven
The breakeven price of an Asian option depends on the strike price of the option and the amount of premium that you paid for the option originally. If you paid $1.50 for a call option with a strike price of $50. Your breakeven price in this scenario will be $51.50 (the strike price of 50 plus the $1.50 in premium paid originally).
If the stock’s average price when the option expires is above $51.50, you will earn a profit on the option investment.
It’s more complicated to know in advance what the breakeven will be on an Average strike option but the calculation is the same.
Finally, user-friendly options trading is here.*
Trade options with SoFi Invest on an easy-to-use, intuitively designed online platform.
*Check out the OCC Options Disclosure Document.
Pros and Cons of Asian Options
Here are some of the pros and cons of trading with Asian options:
| Pros | Cons |
|---|---|
| Less volatility than standard options due to the averaging of the price | Not supported by all brokers |
| Generally less expensive than standard options due to lower volatility | Lower liquidity than standard options |
| Useful for traders who have exposure to the underlying asset over time, like suppliers of commodities | More complicated to price than standard options |
Asian Option Pricing
Because Asian options are priced based on an average price instead of the closing price on the date of expiration, they experience lower volatility. This makes intuitive sense, since averaging several price values over time will tend to dampen out extreme values. Because volatility is a key measure of the price of an option, the lower volatility of Asian options generally means lower prices for options.
How Asian Option Pricing Works
The pricing of Asian options is calculated using an average value. Different types of Asian options calculate the average in different ways, and it’s important to understand how the average will be calculated before you purchase the contract. The two most common ways that an average is calculated with Asian options are the arithmetic mean and the geometric mean.
Asian Options Pricing Example – Average Price Option
On March 1, you buy a 90-day call option for stock XYZ with a strike price of $50. This option costs you $1.25 and the average price is defined as the arithmetic mean of the underlying asset price taken every 30 days.
XYZ has a price of $51.00, $48.50 and $52.00 at the 30, 60 and 90 day mark. The arithmetic mean of those 3 prices is ($51 + $48.50 + $52) / 3, or $50.50. Since the option has a strike price of $50, the option closes with a value of $0.50 (calculated price at expiration less spot price, $50.50 – $50).
Because you purchased the option for $1.25 originally, in this scenario you would take a loss on the position.
As with standard options, if the average price of the underlying asset is below the strike price (for a call option), the option expires worthless.
Asian Options Pricing Example – Average Strike Price Option
On March 1, you buy a 90-day call option for stock XYZ. This option costs you $1.25 and the average strike price is defined as the arithmetic mean of the underlying asset price taken every 30 days.
XYZ has a price of $51.00, $48.50 and $52.00 at the 30, 60 and 90 day mark. The arithmetic mean of those 3 prices is ($51 + $48.50 + $52) / 3, or $50.50. Therefore, at expiration the strike price will be $50.50. The option closes with a value of $1.50 (price at expiration less calculated spot price, $52 – $50.50).
Because you purchased the option for $1.25 originally, in this scenario you would have a gain on the position.
The Takeaway
Unlike standard options that are valued based on the spot price of the underlying asset when the option expires, Asian options are valued based on an average price taken in discrete time periods before expiration.
Because the value of an Asian option is based on an average of prices, there is less volatility in the prices. Lower volatility leads to generally cheaper prices than standard options.
If you’re ready to try your hand at online stock options trading, You can set up an Active Invest account and trade options from the SoFi mobile app or through the web platform.
And if you have any questions, SoFi offers educational resources about options to learn more. SoFi doesn’t charge commissions, and members have access to complimentary financial advice from a professional.
FAQ
Are Asian options cheaper?
Asian options are usually (but not always) cheaper than standard American or European options. This is because Asian options are priced using an average price rather than the spot price of the underlying commodity on the date of expiration. Because an average price is used, this makes Asian options less volatile, and consequently, generally cheaper.
How are Asian options priced?
Rather than using the spot price of the underlying stock or commodity on the date of the option’s expiration, Asian options are priced using an average price over the preceding period of time. While there are different methods for calculating the average price, it’s usually calculated as either the arithmetic or geometric mean of the underlying stock or commodity.
Why can’t Black-Scholes models value Asian options?
The Black-Scholes pricing model is one of the most common ways to price standard American or European options. To price options, the Black-Scholes method makes a variety of assumptions about the price of the underlying stock. One assumption required by Black-Scholes is that the stock’s price will move following something called Brownian motion. Because arithmetically-priced Asian options do not follow Brownian Motion, the standard Black-Scholes pricing model does not apply.
Photo credit: iStock/Boris Jovanovic
SoFi Invest® INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below:
Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.
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.
SOIN0422028
Mar
20
2023
Explaining the 3-Legged Stool of Retirement
The three-legged stool analogy refers to the three sources of income investors can tap in retirement. Here’s a summary of each, and who has access.
Read moreSee what SoFi can do for you and your finances.
Select a product below and get your rate in just minutes.