Interest Rate Options Strategy: Receiver Swaptions
Trade Strategy
As we continue to see uncertainty with future interest rates, we must devise strategies which allow some of this to be mitigated, whilst still allowing us to place a directional view. When thinking of strategies to hedge ourselves, we turn to option contracts, but more specifically we think about whether a 'swaption' contract would be useful to us.
What is a Swaption?
A swaption is evidently a merger of a 'swap' and an 'option' contract.
An option contract is one which offers the buyer the right but not obligation to buy/sell an asset at a pre-specified price
A swap contract is an agreement for two parties to exchange a series of cashflows for a certain period of time. Usually this involves swapping a sequence of cashflow with a fixed interest payment for one which has a floating interest payment, otherwise known as a 'fixed-floating swap'
Putting these two concepts together gives us a swaption - an option contract which gives the buyer the right but not the obligation to enter a swap contract at a pre-specified price on a pre-specified date.
These are OTC contracts, and so mutual agreement is needed for the contract to be in place.
Types of Swaptions
A deeper look into swaptions reveals a great number of technical details. To keep it simple, let's start with an overview of some swaps terminology.
'Paying' a swap always refers to paying the fixed leg of a fixed-floating swap contract. 'Receiving' a swap always refers to receiving the fixed leg of a fixed-floating swap contract.
Therefore, someone who is paying a swap originally was obliged to pay a floating interest rate, but swaps their interest payments so they now pay a fixed rate. Vice versa for a receiver of a swap.
We translate the same terminology to swaption contracts to derive the two types of swaptions:
Payer Swaption - the buyer has the right but not obligation to enter a swap contract, where they become the fixed-leg payer and floating-leg receiver
Receiver Swaption - the buyer has the right but not obligation to enter a swap contract, where they become the floating-leg payer and fixed-leg receiver
There is further intricacies relating to the style of a swaption, which I will briefly mention:
European Swaption - the buyer can only exercise the option (enter the swap) at expiration date of the swaption
American Swaption - the buyer can exercise the option (enter the swap) at any point of time between initiation and expiration of the swaption
Bermudan Swaption - the buyer can only exercise the option (enter the swap) on a pre-determined set of specific dates between initiation and expiration of the swaption
The specifics of the style are less important since European swaptions are most common for simplicity.
Why Would I Use a Swaption?
Swaptions are a useful asset for their combination of two of the most heavily traded contracts. They are helpful for two important reasons: hedging and direction.
Directional view - allows investors to place bets
When to use payer swaptions and when to use receiver swaptions:
Payer swaptions are when the buyer pays a fixed interest rate and receives a floating rate. Therefore, since only the floating rate can change, the buyer of a payer swaptions benefits when the floating rate is higher.
Receiver swaptions are when the buyer pays a floating interest rate and received a fixed rate. Therefore, the buyer will benefit when they pay less and so when the floating rate is lower.
By definition between initiation and expiration of a swaption, the only interest rate that can change is the one which is linked to the floating rate, usually EURIBOR (in Europe), SONIA (in the UK) and SOFR (in the US). These are all overnight rates used to calculate the interest when rolling over payments.
Optionality - hedging
You may wonder why we would use a swaption instead of a standard interest-rate swap (IRS). And this leads on to the second key advantage of a swaption: optionality.
The distinction is in the name, and it means we do not have to enter the swap if we do not want to. What this does is protect us as investors from downside risk, something which is essential in volatile economic climates, which none of us are unfamiliar with.
Optionality means is we buy a payer swaption, and interest rates actually fall, then we do not have to exercise the contract and enter the swap, protecting us from the downside.
Pricing a Swaption
The details of pricing swaptions are indeed complicated, since they are OTC contracts, and so individually drawn.
However, we can see what factors affect the price of a swaption:
Volatility - the higher the volatility of interest rates, the higher the premium of the swaption. This is standard option theory, as higher volatility means there is greater chance of larger interest rate movements and so a higher chance of the contract ending in-the-money at expiry. This is the idea of the Option Greek Vega.
Time to Expiration - the longer the tenor of the swaption, the higher the premium. If the tenor is longer, this means there is more time for the interest rate to change and so for the swaption to end in-the-money at expiry. This is the idea of the Option Greek Theta.
Strike Interest Rate - the closer the strike interest rate is to the prevailing floating interest rate, the higher the premium of the swaption. This is because there is a greater chance the interest rate will move to make the contract in-the-money, since there is only a small change needed.
Receiver Swaption Trading Strategy
Now that we have determined the conditions for which a swaption would be used, let's use it in practice.
Over the course of the past year we have seen interest rate hikes to unprecedented levels. These have come as shocks and emergency measures to inflationary issues, the consequences of which we are all seeing. However, there have been promising data releases recently hinting at inflation slowing down and the peak just around the corner. This is especially the trend seen with the US, and should be seen with the UK following a dramatic political turnover, but some stability with Jeremy Hunt's vision for the economy.
What this all means is that interest rates will continue to be hiked for the next few Central Bank meetings, as was seen with the ECB 75bps hike in their October meeting just a few days ago.
However, there is increasingly more hope of interest rates falling in 2023. With somewhat more stability this should be the case, and is a reasonable prediction supported by what is priced in for meetings mid-2023.
If we do believe interest rates could fall, from what we have learnt, the best strategy to implement would be buying a receiver swaption:
Allows us to take a directional view on interest rates falling, as the contract will only be exercised if the floating rate falls since the buyer is paying a floating rate
Allows for short-term horizons of one year, which will be a good timeframe to maintain the strategy. This will allow for inflation to peak and cool off towards the start of 2023, and so allow an appropriate response by Central Banks to take effect, accounting for lags
Protects against downside risk of unexpected interest rate hikes. This is an issue to be wary of even with rates as high as they are. Surprise inflation is still on the table, and further rate hikes may be seen if this becomes runaway inflation as was seen towards Q2 of 2022.
These are arguments in favour of buying the receiver swaption. There are of course downsides to swaptions, namely the premium cost of entering the contract. Due to the optionality protection, swaption premiums are higher than IRS premiums, however the value of the benefit gained is best left to be decided by the investor. However, since it is an impossible task to predict the interest rate in a weeks time, let alone a years time, the added assurance a swaption may give over an IRS is undoubtedly needed.