The 10 Year Treasury was 25bps higher a week ago and 55bps 6 weeks ago. If you’re planning on locking a rate in the next few months and want to hedge against yields rebounding, you can buy an option on fixed rates.
Swaptions are options on swap rates. Like an interest rate cap, you pay a one time upfront fee and will never owe the hedge provider more. Cost is a function:
Settlement: how far into the future is settlement? A swaption that settles next week is less expensive than one that settles in a year.
Term: hedging a 10 year is roughly twice as expensive as a 5 year.
Strike: hedging the 10T at 4.10% is more expensive than 4.25%.
For example, if you expect to lock a rate on the T10 in two weeks, you would buy a 10yr swaption to be settled in two weeks. You pay an upfront fee today and go back to working on the loan closing.
In two weeks, the payout will be determined by 10 year swap rates at that time.
- If the 10 year swap rate is above your strike, the hedge provider pays you the PV difference. You use that payout to either buy the rate down with the lender or internally amortize the cost over the life of the financing.
- If the 10 year swap rate is below your strike, the option expires worthless and you lock in the prevailing rate.
You can generally be in a position to trade within two days, you can hedge just a portion (eg, 50%), and you can terminate the option early.
Here’s illustrative pricing on a $50mm swaption.
Swaps and Treasury yields are 98% correlated, so while there are a few other considerations to understand, swaptions will be highly effective against a Treasury yield retracement.
Tariffs were enacted with a single stroke of the pen, which means they could be undone just as quickly.
