Looking for a way to hedge your future takeout today or just protect against general rate movements? Swaptions could be the solution.
Swaptions are call options on swap rates, but since swaps and Treasurys are highly correlated, they work well for protecting against increases on either. For more swaptions 101, check out our resource here.
A swaption scenario
We touched on forward locking a swap in our previous piece here as a way of providing rate certainty on construction to mini-perm loans. Swaptions are an alternative to forward locking. If the plan is to refi into a longer-term fixed product near the end of our hypothetical 3 year construction loan, a swaption could be used to provide certainty on the index.
For instance, if borrower expected to lock a 10 year fixed rate loan, a swaption putting a ceiling on 10 year rates could be structured. Below we’ve outlined pricing for that scenario.
By way of example, a 4.50% strike with a July 2027 expiry would cost around $1.7mm today. 10 year swaps are currently ~0.42% below 10 year Treasury yields, so holding the spread constant, the 4.50% strike implies a ~4.92% 10 year Treasury. In July 2027…
- If the 10 year swap is above 4.50%, the swaption is in-the-money (ITM) and will payout. This could be used to buy down the rate at closing, pocketed and allocated internally, etc.
- For example, at 6.00%, the swaption is ITM 150 bps. You'd receive a payout based on the PV01 (present value of each basis point) times the number of bps the swaption is ITM, or $6.18mm (150 * $41.2k).
- If rates are below 4.50%, the swaption expires worthless and you'd just lock in at the market rate.
Walk me through the math to determine the breakeven point.
The upfront cost of the 4.50% strike is $1.7mm and the PV01 is $41.2k.
$1.7mm / $41.2k = 41 bps. 4.50% strike + 0.41% swaption cost = 4.91% breakeven point
If the 10 year swap is 4.91% or greater, you more than recoup the upfront cost. If we hold swap spreads constant at (-0.42%), this implies a 5.33% 10 year Treasury in July 2027.
$1.7mm is certainly substantial, but if the upfront cost is a deal killer, swaption corridors are a thing too. However, the tradeoff for a lower upfront cost is a max potential benefit under the hedge. More about swaption corridors here.
Is there any potential liability to me?
Nope. After you’ve paid the premium, the swaption is an asset and at worst is worth $0. It's not a forward that ties you to a future transaction with the hedge provider (or lender) and has no potential breakage either.
What happens if I buy a swaption and end up selling or refinancing prior to the expiry?
If the asset is sold or refinanced before July 2027, we'd terminate the swaption early and recoup whatever residual value remains. If rates are much higher at that time, the value could be material, and if they're way lower, it could be $0. In either case, it's a super liquid market and early unwinds are common.
How does the forward lock compare to a swaption?
A few of the key differences include:
- The forward lock has no upfront cost whereas the swaption premium is due T+2.
- The forward lock means you’re subject to a potential breakage in the future whereas the swaption is never worth less than $0 after the premium has been paid.
- The forward lock would be done directly with the lender whereas the swaption can be auctioned among third party banks.
Conclusion
Swaptions are excellent tools for putting a ceiling on a specific index with no potential liability, but the flexibility comes with a high upfront cost. Swaptions also do not hedge loan spreads or guarantee a loan could actually be obtained in the future.
Swaptions also have other use cases such as Rate Lock Remorse or Hedging a Prepayment Penalty.
