Swaptions 101

We are often asked how a borrower can lock-in long-term rates today on debt maturing in one, two years or beyond. Long-term interest rates are rather attractive by historical standards, but the borrowers dilemma is the debt they want to hedge isn’t due for a couple of years or the project is in a construction phase and term financing is 1 to 2 years in the future.

Prior to the credit crises, many borrowers hedged future term debt with a derivative to lock-in the Treasury rate or swap rate (forward starting swap). These derivatives obligated the hedger to pay or receive depending upon the pre- determined interest rate. No one foresaw the credit collapse, which resulted in term interest rates plunging and no credit market for long-term debt. The result to borrowers who had entered into these derivative obligations had to settle the contracts, and the consequences were devastating.  No long-term credit market and yields had fallen precipitously.

A Swaption is the right, but not an obligation to cash settle. If interest rates are higher than the contract rate, the hedger is compensated and if lower, the hedger receives no compensation, however the compensation is in the form of a lower term rate. The hedger sets the tenor, notional, strike rate (pain threshold), and exercise date. A paid Swaption (the premium is paid up-front) is an asset and the owner of the option receives a cash settlement only if the rate is above the level of protection. Swaptions provide a hedging solution to limit the exposure to higher long-term rates or a term loan liquidity crises.

In the above chart, there are three scenarios and two actual outcomes.
Scenario 1) Borrower is concerned if rates rise on 7-1-12 when construction is completed or a loan is maturing. In order to protect against term rates rising a Swaption is purchased usually at a higher rate (lower premium) than what the market had anticipated. If the hedger had exercised a forward starting swap on a $10mm notional at 3.77% (market expectation), the value would’ve been approximately ($1,800,000).  A Swaption at a strike of 4.50% would’ve cost approximately $180,000.
Scenario 2) Market expectations were only about 15 basis points higher.
Scenario 3) What now? The futures market, as of 2-16-16, is forecasting the 10 year swap rate to be at 1.771% one year from now, 1.952% in two years, and 2.086% in three years. As a borrower, how much of a rate increase is tolerable? What is the “pain threshold”?

Swaptions offer an alternative to hedge future long-term fixed rates. Key attributes of Swaptions: 1) Flexibility. The hedger decides on the strike, notional, and exercise date. 2) Unlike a swap, there is no yield maintenance if interest rates fall below the swap rate. 3) If term rates rise above the pre-determined rate, the Swaption is cash settled to compensate the hedger.  If rates are lower, the hedger locks in a rate below the Swaption rate.

A T-lock or forward starting swap may increase risk rather than mitigate risk. The type of hedge to lock-in future funding isn’t a simple decision. For various reasons a T-lock or forward starting swap may be the best solution based upon the yield curve, credit stipulations, borrowers view, and cost to hedge. T-locks are typically used for Life Insurance or CMBS, because those credit avenues do not have the capability to act as counterparty to a swap. A forward starting swap is an obligation to enter into a swap at a pre-determined date in the future and the counterparty is often the borrower’s bank.

Swaption Basics

• A Swaption is an option to enter into an interest rate
• A pay-fixed Swaption allows the buyer the right but not the obligation to enter into a swap as a fixed rate payer and receive a floating rate.
• A pay-floating Swaption allows the buyer the right but not the obligation to enter into a swap as a floating rate payer and receive a fixed.
• Conversely, the seller of a Swaption receives an upfront premium in exchange for the willingness to have a potential contractual obligation in the
• Value of the Swaption is based on the dollar amount, market interest rates, term of the underlying swap, time to exercise, and market
• A Swaption can also be used to extend or cancel a swap. Cancelable swap is created by combining a vanilla interest rate swap with a swaption.  Similar to a Callable Bond.  Extendable swap is the ability to extend the term of the swap at a pre-determined time and interest rate.