Options on Interest-Rate Swaps (Swaptions) for borrowers
The firm has a loan substantial loan and this is on a floating-rate basis. People are uncertain about what interest rates will be in the future. Some people think rates will be higher, others feel they will be lower. The firm wants to protect the firm against the risk of higher borrowing costs. In the past the firm have used Interest-Rate Swaps but the firm knows that if the firm uses an Interest-Rate Swap now, the firm may give up the possible benefit of lower interest rates.
A Swaption is another product which can be very useful in these circumstances. Basically, it is an option on an Interest-Rate Swap. It gives the firm the chance to use an Interest-Rate Swap at a certain fixed rate, but the firm does not have to do so. In this way it protects the firm against an increase in rates while giving the firm the freedom to enjoy cheaper borrowing costs if rates fall. If the firm enters into a Swaption the firm will need to pay a premium.
A Swaption gives the firm a period of time when the firm can take advantage of a fixed borrowing cost. The firm might do this if this guaranteed rate is a better rate than would be available in the market.
The firm has borrowed substantial funds for a 3-year period. The firm want to protect the itself against rising interest rates and guarantee a maximum cost of funds of 8%. At the same time the firm want to be able to take advantage of any possible fall in interest rates. The firm buys a Swaption at a rate of 8% for a 3-month period.
In 3 months' time the Interest-Rate Swap rate for 2¾ years is at 8.4%. The firm make use of its Swaption and ask the bank to provide the firm with an Interest-Rate Swap for this period at the agreed rate of 8%. Banks do this and the firm’s 8% cost of funds for the period is protected. As an alternative the firm could ask you to pay the firm compensation equal to a margin of 0.4% on the amount for the rest of the loan.
In 3 months' time the Interest-Rate Swap rate for 2¾ years is at 7.5%. The firm does not want to take up the firm’s Swaption and instead the firm will borrow at the cheaper rate of 7.5%. In these circumstances the Swaption protected the firm against a higher borrowing cost and also allowed the firm to take advantage of the fall in rates.
The Swaption will give the firm full protection against rising interest rates.
The Swaption will give the firm freedom to benefit if rates move lower.
The firm can sell the Swaption to us at any time and receive some of its value back.
Banks can provide Swaptions to meet the firm’s needs.
Banks provide Swaptions for borrowers in all major currencies and many maturities. The option is generally not more than 12 months.
The firm can negotiate a Swaption with any bank. It does not have to be the bank who lent the firm the money.
Generally the firm should pay us a premium beforehand, but banks will also accept payment as a margin on an underlying loan.
The premium the firm pay will depend on:
the guaranteed rate compared with the Interest-Rate Swap rate;
how long the firm want the Swaption for; and
how interest rates may do in the future.
The premium may be tax deductible - check with the firm’s tax advisers.