Options on derivatives: swaps

Figure 12 is presented here for the sake of orientation. We discussed swaps in some detail in a previous section. An option on this derivative is the option on the swap, called the swaption.

We saw earlier that there are four types of swaps that relate to the financial markets and the commodity market (see Figure 13). We also saw that there exists a forward swap (or deferred swap) (it is mentioned here again because it is touched upon below).

Options are not found on all these swaps, but only on the interest rate swap, i.e. a swaption is a combination of an interest rate swap and an option. As elucidated above, in interest rate swaps, fixed-rate obligations (cash flows) are swapped for floating rate obligations. In swaptions, the underlying instrument is the fixed-rate obligation. Thus, a call swaption imparts the right to the holder to receive the fixed rate in exchange for the floating rate, while in put swap to the holder the right to pay fixed and receive floating.

Figure 12: options

Figure 13: swaps

An example may be useful.52 A company knows that in six months' time it is to enter into a five-year floating rate loan (i.e. borrowing) agreement at 3-month JIBAR, and wants to swap the floating rate payments into fixed rate payments, i.e. to convert the loan into a fixed rate loan (because the company believes that rates are about to rise).

For a premium, the company can buy a (put) swaption from a broker-dealer in this type of paper. The swaption gives the company the right to receive the 3-month JIBAR rate on a notional amount that is equal to its loan, and to pay a fixed rate of interest every three months at 14% pa (assumed) for the next five years, starting in six months' time. The "options" the company has are clear:

• If in six months time the fixed rate on a normal 5-year swap is lower than 14%, the company will allow the swaption to lapse (remember the company wants to pay fixed).

• The company will then undertake a normal interest rate swap at the lower fixed rate (the floating rate will probably still be 3-month JIBAR).

• If the fixed rate on normal swaps is higher than 14%, the holder will exercise the swap and take up the swap.

The company is guaranteed that the fixed rate it will pay on the future will not exceed an agreed fixed rate. Thus the company has protection against rates moving up, while retaining the option to benefit from lower rates in the future.

The swaption is an alternative to the forward swap. The latter obliges the holder to enter into a swap after a stipulated period, but the holder pays no premium for it. In the case of the swaption, the holder is not obligated and can allow the swaption to lapse, i.e. it allows the holder to benefit from favourable interest rate movements.

Options on debt market instruments


The options market illustration presented here again is designed to orientate the reader in terms of the place of the market being discussed (see Figure 14).

The term "debt market instruments" in respect of options encompasses money and bond market specific instruments ("physicals") (or rather some of them) and notional instruments (indices) (or some of them). They may be classified as follows:

• Money market options:

- Options on specific money market instruments.

- Interest rate caps and floors.

• Bond market options:

- Options on specific bonds.

- Options on bond indices.

- Bond warrants (retail options).

- Bond warrants (call options).

- Callable and put table bonds (bonds with embedded options).

- Convertible bonds.

Money market options are comprised of options on specific money market instruments (and this includes ordinary deposits) and caps and floors (these are option-like instruments). As seen in the list, there are a number of bond option varieties. The first three mentioned above are full-blooded bond options, while the latter three may be termed option-like securities in the bond market. We discuss all these a little later. Options on bond futures are obviously not discussed in this section (they were discussed under "options on derivatives").

Figure 14: options

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