Hedge against adverse movements in interest rates

Swaptions are options on swaps. Like swaps, they offer protection against adverse movements in interest rates, and are frequently used to minimize financing or hedging costs. Combined with other instruments, swaptions are often used to solve more complex risk management challenges.

What is a Swaption?
Interest rate swaptions give the holder the right, but not the obligation, to enter into or cancel a swap agreement at a future date. The buyer may purchase either the right to receive a fixed rate in the underlying swap or to pay the fixed rate.

Managing Liabilities with Swaptions
Financial managers buy or sell swaptions to hedge future interest rate exposures or manage borrowing costs:

• Hedge Contingent Financing. A company's future financing needs may be uncertain, or contingent upon other events. A swaption provides protection against rising rates without obligating the purchaser in the event the financing doesn't materialize.

• Lower Borrowing Costs. One way to reduce financing costs is to use swaptions to monetize points of indifference. For example, an active issuer of debt in several maturities may be indifferent at any point in time to issuing in one maturity versus another. A company indifferent between three- and five-year debt can combine the issue of three-year fixed- rate notes with the sale of a 3 x 2 receiver swaption (the right to receive the fixed rate in a two year swap starting three years hence).

  The premium received on the swaption provides an immediate cash inflow and reduces the company's net borrowing cost compared to both the straight three-year or five year debt issue.

• Capture Excess Call Value. Swaptions can be used to translate the value of call options embedded in debt securities into cash.

Investors in these instruments use swaptions and related derivatives to manage unwanted optionality.

Swaptions, alone or in combination with other hedging tools offer hedgers and portfolio managers significantly increased risk management flexibility.