What is a Put Swaption?
Swaptions (Swap + options) is a derivative financial instrument with a swap as the underlying. One party called the writer or seller of the option gives another party called the holder or buyer of the option the right to exchange interest rates. Swaptions can be of two types - put swaption and call swaption. A third type can be a mix of the two called straddle swaption. This article highlights how a put swaption works.
What is a put swaption?
In a put swaption, also called payer swaption, the option writer gives the option holder the right to pay a fixed interest rate and receive a floating interest rate in return. If the holder chooses to exercise the option, the option writer has an obligation to receive fixed interest and pay interest at a floating rate.
In a put swaption, the option holder anticipates an increasing interest rate. However, if the interest rates fall below the fixed interest rate, the holder stands to lose and will have a net cash outflow.
A put swaption, like other swaptions, is an over-the-counter (OTC) contract. The parties to the contract must agree on the premium/price to be paid by the holder, expiration date, fixed interest rate, floating interest rate, strike price, notional principal and everything else they might think is essential.
An example of put swaption - Bank X has huge floating interest debt standing on its Balance Sheet. It fears the interest rates to rise. On the other hand, Bank Y has fixed interest rate debt in its books and anticipates a decline in interest rates. It offers a put swaption to Bank X. Bank X pays a premium and buys the swaption from Bank Y.
Case 1: Interest rate rises
Bank X exercises the put swaption. It now pays interest at a fixed rate of say 5% to Bank Y and receives interest at an increased rate of 7%. Bank Y stands to lose 7-5=2% in this case.
Case 2: Interest rate falls
Bank X does not exercise the option. It loses only the premium it had paid to Bank Y.
Bank X gains when the interest rate rises but loses only the premium amount when the interest rate falls.
Importance of swaptions
Large corporations like banks or hedge fund institutions primarily use swaptions like banks to handle interest rate volatility. The put swaption hedges against rising interest rates. The buyer institution stands to capitalize on the difference between the lower fixed interest paid and the higher floating interest received.