What is Receiver Swaption?
A swap is an agreement that allows users to exchange the cash flows or liabilities from two different financial instruments. An option is a derivative that gives the buyer, also called the option holder, the right to buy or sell an underlying at the behest of the seller, also called the option writer. A 'call options' implies that the holder has the right to buy the underlying. A right to sell the underlying (with the holder) is a put option. The combination of swaps and options yields a financial instrument called swaptions. This post sheds light on one of the types of swaptions - receiver swaption.
A call swaption or receiver swaption is a swap agreement where the holder of the options chooses to pay a fixed interest rate in exchange for receiving variable interest. Buyers of call swaptions agree to hedge against an anticipated fall in interest rates.
Like other swap agreements, a call swaption is done over-the-counter (OTC). This implies that the deal is not standardized. The parties to the contract must agree on the premium amount, notional principal, duration of the swaption, fixed and floating interest rate, and exercise price. The expiration style of call swaption can be any one of the following:
- American style - The options holder may choose to exercise their right at any time before the option expires.
- European style - The options holder can exercise the option only at one specified date.
- Bermuda style - The options holder may choose to exercise their right at set dates before the option expiration.
Elements of a Swaption
A swaption or a call swaption includes the undermentioned elements:
- Notional principal amount - The pre-decided principal amount which applies to the fixed or floating interest rate.
- Premium - This is the options’ price that the holder pays to the writer in exchange for the right to buy or sell the underlying. In case of a call swaption, the premium is paid for the right to buy a swap.
- Fixed-rate - The static rate which the holder of a call swaption agrees to pay should they decide to exercise the swaption.
- Floating rate - The variable interest rate that the holder of a call swaption agrees to receive if he exercises the option.
- Expiry date -This is the settlement date or the date on which the option matures and must be settled.
- Strike price -It is the rate which triggers the swaption. In other words, it is the fixed rate that will be swapped for the variable rate.
Who Trades Call Swaption
Investors with investments in floating interest rates who fear the interest rates to plummet may buy call swaptions to discard the potentially lower variable rate and lock a higher fixed interest rate.
Large financial corporations like commercial banks use swaptions to manage interest rate volatility. A call swaption is used to hedge against declining interest rates. For example, Bank X has disbursed massive loans to its customers. It expects the interest rates to fall, which will lead the borrowers to make early payments. The Bank can decide to hedge this risk by buying a call swaption.
Investment banks and hedge fund institutions are the market makers in a swaption market. They have a portfolio of swaption agreements which they can use to change their pay-off profile.
Swaptions are used when an organization is unsure about the anticipated movements in the interest rates. A call swaption is bought when the interest rate is expected to fall. This can restrict the loss of the buyer to the premium paid, even if the interest rate goes up.
Frequently Asked Questions Expand All
In a payer's swaption, the option holder chooses to be the fixed-rate receiver and variable ratepayer. Buyers of put swaption expect the interest rates to rise in future.
A payer swaption is also called a put swaption. A put option is where the holder buys the right to sell the underlying. Since, in a payer swaption, the holder accepts the right to sell a fixed interest rate, it is a put or put swaption.