KNOCK-IN SWAPTION

DESCRIPTION

A Knock-In Swaption reduces the premium of a normal Interest Rate Swaption by adding a "Knock-In" feature. The swaption only comes alive, or knocks in when some defined barrier (the knock in level) is reached during or at the end of the option period. Both Receiver and Payer Swaptions can be Knocked-In with reference to a wide range of underlyings, including LIBOR, FX, commodity and equity levels. These options are part of the Barrier Options family.

EXAMPLE

Example 1

A Japanese exporter is very profitable when USD/YEN exceeds 115.00 which is the current spot rate. However they expect the spot rate to drop below 100 in the next half year in which case cash flow would be tight and there would be need for interest rate protection.

This protection could be achieved with a pay fixed swap which would offset their interest rate debt. The first thought is a 6 month payer swaption on a 4 year swap which would cost 282 bp. An alternative is a Swaption that Knocks-In when USD/YEN reaches 100. This would cost only 213 bp.

Advantages:

a) Cheaper premium
b) The swaption is Knocked-In when the interest rate protection is required most; that is if USD/YEN reaches 100.00

Example 2

A German investor has a diversified portfolio of investments including FRNs and equity investments. They believe that rates will stay high, but would be concerned if commodity prices fall dramatically. They could purchase a receiver swaption that knocks in when the CRB index falls below 200.

Advantages:

a) Cheaper premium
b) If the falls below 200, this may indicate that interest rates will fall and therefore the yield on the FRN portfolio will fall below acceptable levels.

The product is therefore very customised to the client situation.

PRICING

A knock-in option is a form of barrier option (see Barrier Options). The savings under a Knock-in Swaption are dependent upon:

a) Volatility -lower volatility leads to higher savings
b) Strike -the closer the knock-in level to the At-the-Money strike, the more chance there is that the structure will be knocked-in and therefore the higher the premium.

TARGET MARKET

Knock-in Caps and Floors are suitable for any borrower or investor where the need for interest rate protection is contingent upon some other underlying.

ADVANTAGES

DISADVANTAGES

CREDIT RISK FACTOR

Bought options with Knock-In feature require no margin as the maximum loss to the client is the premium

PRODUCT SUITABILITY

Complex Defensive