Interest rate swaption
An Interest rate option agreement that gives your business protection against upswings or downswings in the interest rate swap rate.
How does an interest rate swaption work?
An interest rate swaption gives your business the right, but without the obligation, to use a predetermined interest rate swap agreement in the future. Depending on the structure of the agreement, the swaption can be exercised at a set date in the future (European option), or at any time during the duration (US option).
Example of an interest rate swaption agreement:
Swaptions are often used to hedge future borrowing. The following example explains how an interest rate swaption can be used:
A property developer will be constructing a new building in the future, and the building will be financed using an overdraft facility. To ensure the project does not become unprofitable as a result of high interest costs, the company buys a 5-year swaption with a strike price at 2 per cent p.a. and expiry in one year. If the swap interest is more than 2 per cent in a year’s time, the company will exercise the swaption and enter into a five-year interest rate swap at 2 per cent p.a.
Should the swap rate instead be lower than 2 per cent p.a. in a year’s time, the swaption will expire and the company will instead enter in to an interest rate swap at a lower rate.
What is the benefit of entering into such an agreement?
If the market rate, or the swap rate, rises above the strike price, the buyer or borrower will be able to exercise the option on the agreed terms. If the swap rate does not rise above the strike price, the option will expire, and the buyer or borrower will be able to sign a swap agreement at a lower market rate instead.
Would you like to learn more about fixed-income securities and currency hedging?
DNB markets offers corporate clients a variety of methods for hedging and eliminating currency risk. Contact us to find the right method for your business. We also offer courses and training in handling commodities, interest rates and currency risk.
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