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Trading and Capital-Markets Activities Manual

Instrument Profiles: Swaptions
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)

GENERAL DESCRIPTION 

Options on swap contracts (swaptions) are over-the-counter (OTC) contracts providing the right to enter into an interest-rate swap. In exchange for a one-time, up-front fee, the buyer of the swaption has the right, but not the obligation, to enter into a swap at an agreed-on interest rate at a specified future date for an agreed-on period of time and interest rate. As such, swaptions exhibit all of the same characteristics inherent in options (including asymmetric risk-return profiles). 

In general, an interest-rate call swaption gives the purchaser the right to receive a specified fixed rate, the strike rate, in a swap and to pay the floating rate for a stated time period. (In addition to interest rates, swaptions can be traded on any type of swap, such as currencies, equities, and physical commodities.) An interest rate put swaption gives the buyer the right to pay a specific fixed interest rate in a swap and to receive the floating rate for a stated time period. Conversely, the writer of a call swaption sells the right to another party to receive fixed (the writer will thus be obligated to pay fixed if the option is exercised), while the writer of a put swaption sells the right to another party to pay fixed (the writer will thus be obligated to receive fixed if the option is exercised). 

CHARACTERISTICS AND FEATURES 

Swaptions are typically structured to exchange a stream of floating-rate payments for fixed-rate payments in one currency. The fixed rate is identified as the strike yield and is constant throughout the life of the swaption, while floating rates are based on a variety of indexes including LIBOR, Eurodollar futures, commercial paper, and Treasury bills. 

The swap component of a swaption is not restricted to the fixed versus floating format. As with simple swaps, the structure of swaptions may vary. For a discussion of swap variations, see section 4325.1, ''Interest-Rate Swaps.'' 

Swaption maturities are not standardized, as all swaptions are OTC transactions between the buyer and the seller. Maturities for swaptions typically range from one month to two years on the option and up to 10 years on the swap. The option component of the swaption can be designated to be exercised only at its expiration date (a European swaption-the most common type), on specific pre-specified dates (a Bermudan swaption), or at any time up to and including the exercise date (an American swaption). 

Swaptions are generally quoted with references to both the option and swap maturity. For example, a quote of ''3 into 5'' references a 3-year option into a 5-year swap, for a total term of eight years. Terms can be arranged for almost any tenor from a 3-month to a 10-year option, or even longer. In general, the 5-year into 5-year swaption might be considered the end of the very liquid market. Longer-tenor instruments (for example, 10-year into 20-year) are not uncommon but do not display the same degree of liquidity. As with options, active swaption dealers are really speculating on volatility more than market direction. 

Important Variations 

Cancelable Swaps 

Cancelable (callable or putable) swaps are popular types of swaptions. In exchange for a premium, a callable swap gives the fixed-rate payor the right, at any time before the strike date, to terminate the swap and extinguish the obligation to pay the present value of future payments. A putable swap, conversely, gives the fixed-rate receiver the right to terminate the swap. (In contrast, a counterparty in a plain vanilla swap may be able to close out a swap before maturity, but only by paying the net present value of future payments.) Cancelable swaptions are typically used by institutions that have an obligation in which they can repay principal before the maturity date on the obligation, such as callable bonds. Cancelable swaps allow companies to avoid maturity mismatches between (1) assets and liabilities with prepayment options and (2) the swaps put in place to hedge them. A ''3x5 cancelable swap'' would describe a five-year swap that may be terminated by one of the counterparties after three years.

Extendible Swaps 

In exchange for a premium, extendible swaps allow the owner of the option to extend the tenor of an already-existing swap. If a firm has assets or liabilities whose maturities are uncertain, an extendible swap allows the investor to hedge the associated price risk more precisely. 

Amortizing or Accreting Swaptions 

Two additional instruments, amortizing and accreting swaptions, are useful for real estate- related or project-finance-related loans. Amortizing and accreting swaptions represent options to enter into an amortizing or accreting swap, where the principal amount used to calculate interest-rate payments in the swap decreases or increases during the life of the obligation. Specifically, the notional amount of the underlying swap decreases (amortizes) or increases (accretes) depending on loan repayments or draw-downs. For example, the swaption can be constructed to give the owner of the option some flexibility in reducing the prepayment risk associated with a loan. 

USES 

Swaptions are most commonly used to enhance the embedded call option value in fixed-rate callable debt and to manage the call risk of securities with embedded call features. Swaptions may be used to provide companies with an alternative to forward, or deferred, swaps, allowing the purchaser to benefit from favorable interest-rate moves while offering protection from unfavorable moves. Swaptions are also used to guarantee a maximum fixed rate of interest on anticipated borrowing. 

Enhancing Embedded Call Option Value in Fixed-Rate Callable Debt 

Through a swaption, the bond issuer sells the potential economic benefit arising from the ability to call the bonds and refinance at lower interest rates. This technique, known as ''call monetization,'' is effectively the sale (or early execution) of debt-related call options. The following example illustrates call monetization. 

A firm has $100 million of 11 percent fixed-rate debt which matures May 15, 2002, and is callable May 15, 1999. The company sells to a bank a $100 million notional principal European call swaption with a strike yield of 11, an option exercise date of May 15, 1999, and an underlying swap maturity date of May 15, 2002. In return for this swaption, the firm receives $4 million. The company has sold to the bank the right to enter into a swap to receive a fixed rate of 11 and pay a floating rate. As a result of the sale, the firm's financing cost is reduced by $4 million, the amount of the premium. From the bank's perspective, a fee was paid for the right to receive fixed-rate payments that may be above market yields at the exercise date of May 15, 1999. 

If, at May 15, 1999 (the call date), the company's three-year borrowing rate is 10, the debt will be called and the bank will exercise the call swaption against the firm. The company becomes a fixed-rate payer at 11 percent on a three-year interest-rate swap from May 15, 1999, through May 15, 2002, while receiving the floating rate from the bank. The firm will now attempt to refinance its debt at the same or lower floating rate than it receives from the bank. As long as the floating rate that the company receives does not fall below the firm's net refinancing cost, the monetization of the call lowers net borrowing costs because the firm starts out paying 11 percent interest and is still paying 11 percent interest, but has received the $4 million premium. 

If, on the other hand, the company's three-year funding rate, as of May 15, 1999, is 11 percent or higher, the bank will allow the option to expire and the firm will not call the debt. The company will continue to fund itself with fixed-rate debentures at 11 percent, but the $4 million premium will reduce its effective borrowing cost. 

Managing the Call Risk of Securities with Embedded Call Features 

Investors also use swaptions to manage the call risks of securities with embedded call features. For example, an investor buys a seven-year $100 million bond that has a 12 coupon and is callable after five and wishes to purchase protection against the bonds' being called. Thus, in year four, the investor purchases from a bank a one-year European call swaption, with a strike yield of 12 and a swap maturity of two years based on a notional principal of $100 million. The firm pays the bank a $1 million up-front fee for this option. In this case, the higher the strike yield, the higher the up-front fee will be. 

At year five, if two-year floating rates are 10, the bond will be called, and the investor will exercise the swaption. The investor will reinvest its money at the current floating rate of 10, pass along the 10 interest to the bank, and receive 12 from the bank. Thus, the investor guarantees that it will not earn less than 12 on its investment. If, on the other hand, two-year floating rates are above 12, the bonds will not be called and the investor will let the option expire. 

Guaranteeing a Maximum Interest Rate on Variable-Rate Borrowing 

An additional use of swaptions is to guarantee a maximum interest rate on variable-rate borrowing. A company, for example, issues a two-year $10 million floating-rate note. The firm does not want to pay more than 10 interest so it purchases from a bank a one-year European put swaption for the right to enter into a one-year swap in which it will pay a fixed rate (strike yield) of 10 on a notional principal of $10 million. The bank, on the other hand, agrees to pay floating-rate interest payments to the firm if the option is exercised. The company pays the bank an up-front fee of $100,000 for this option. At the end of the first year, if the floating rate increases to 12, the firm will exercise the option and pay 10 interest to the bank, and the bank will pay the current floating rate of 12 to the company. While this option will cost the firm $100,000, it will save $200,000 in interest costs ((12 - 10) $10 million). Therefore, in total, the company will save $100,000. Once the option is exercised, however, the firm cannot return to floating rates even if floating rates should fall below 10 (unless the company reverses the swap, which can be very expensive). On the other hand, if the floating rate is below 10 at the end of the first year, the firm will let the option expire and continue to pay a floating rate. 

DESCRIPTION OF MARKETPLACE 

Swaptions are OTC-traded instruments, and they can easily be customized to suit a particular investor's needs. The market is very active and can be loosely coupled with other markets (for example, Eurodollar caps and floors and the OTC bond options market) in certain maturities. In addition, there is a very active secondary market. In general, U.S. dollar swaptions with an option component of less than five years can be thought of as relatively short-term; the five-year to seven-year maturity is considered medium-term, with 10-year and longer options being considered long-term and displaying relatively more limited liquidity. A tenor such as a 10-year into 10-year swaption can be thought of as the upper bound on the liquid market. 

PRICING 

The pricing of swaptions relies on the development of models that are on the cutting edge of options theory. Dealers differ greatly in the models they use to price such options, and the analytical tools range from modified Black-Scholes to binomial lattice versions to systems based on Monte Carlo simulations. As a result, bid/ask spreads vary greatly, particularly from more complicated structures that cannot be easily backed off in the secondary markets. The price of a swaption, known as the premium, depends on several factors: the expected shape of the yield curve, the length of the option and swap periods, the strike yield's relationship to market interest rates, and expected interest-rate volatility. 

HEDGING 

Swaptions are often hedged using Eurodollar futures, Treasuries, and interest-rate swaps. Market participants have introduced a variety of features to mitigate counterparty credit risk, such as cash settlement and posting of cash collateral. Of these, cash settlement, in which the seller pays the net present value of the swap to the buyer upon exercise of the option, has been the most common. Cash settlement has two significant benefits: (1) it limits the length of credit exposure to the life of the option and (2) banks are not required to allocate capital for the swap, since neither party actually enters into the swap. 

RISKS 

The risks of purchasing or selling a swaption include the price and credit risks associated with both swaps and options. For a more detailed discussion of the risks connected with these instruments, see sections 4325.1 and 4330.1, "Interest-Rate Swaps" and "Options," respectively. As a hybrid instrument, a swaption generates two important exposures: the probability of exercise and the credit risk emerging from the swap. The first risk is a function of the option's sensitivity to the level and volatility of the underlying swap rates. The swaption's credit risk is the cost to one counterparty of replacing the swaption in the event the other counterparty is unable to perform. As mentioned earlier, liquidity risk is most pronounced for swaptions with option components of greater than 10 years. However, swaptions with five-year option components will have greater liquidity than those with 10-year option components. 

ACCOUNTING TREATMENT 

The accounting treatment for swaptions is determined by the Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 133, " Accounting for Derivatives and Hedging Activities." (See section 2120.1, " Accounting, "for further discussion.) 

RISK-BASED CAPITAL WEIGHTING 

The credit-equivalent amount of a swaption contract is calculated by summing - 

1. the mark-to-market value (positive values only) of the contract and 
2. an estimate of the potential future credit exposure over the remaining life of each contract. 

The conversion factors are listed below: 

                                            Credit-Conversion
Remaining Maturity                Factor 
One year or less                       0.00 
Five years or less                    0.50 
Greater than five years           1.50 

If a bank has multiple contracts with a counterparty and a qualifying bilateral contract with the counterparty, the bank may establish its current and potential credit exposures as net credit exposures. (See section 2110.1, "Capital Adequacy.") 

LEGAL LIMITATIONS FOR BANK INVESTMENTS 

Swaptions are not considered investments under 12 USC 24 (seventh). The use of these instruments is considered to be an activity incidental to banking within safe and sound banking practices. 

REFERENCES 

Arditti, Fred D. Derivatives. Harvard Business School Press, 1996. 
Burghardt, Belton, Lane, Luce, and McVey. "Options on Swaps."Eurodollar Futures and Options. Discount Corporation of New York Futures, 1991. 
Das, Satyajit. Swap and Derivative Financing. Chicago: Probus Publishing, 1994. Fabozzi, Frank, and Dessa. The Handbook of Fixed Income Securities. 4th ed. Irwin, 1995. 
Hull, John C. Options, Futures and Other Derivative Securities. 2d ed. Prentice-Hall, 1993.

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