Rates are down ~40 bps across the curve since mid-February. If you have an upcoming rate lock, a swaption can be used to put a ceiling on your index, while retaining the ability to continue floating lower too. This ensures an “about-face” on tariffs, or even market volatility, doesn’t erase any recent gain (decrease in rates) between now and when you lock.
We’ve seen a sharp increase in borrowers purchasing swaptions over the past couple weeks.
Here’s how they work
Swaptions are call options on swap rates, but since swaps and Treasurys are highly correlated, they work for protecting against increases on either. The current spread between the 5 year Treasury and 5 year OIS swap is 0.29%, so if you wanted to put a ceiling on the 5T around current levels (3.98%), you'd purchase a 3.69% strike.
- The swaption premium would be due within two business days.
- If on the expiry date the underlying swap rate is above the strike, you'd exercise and receive a cash settlement for the NPV difference between the swap rate and strike. Assume a 3.69% strike (3.98% implied 5T) is purchased for $400k.
- If on the expiry date the underlying 5 year swap rate is at 4.00% (~4.29% 5T), you'd exercise the swaption and receive a payout for $704k.
- 4.00% - 3.69% = 31 bps. 31 * $22.7k PV01 = $704k.
- These funds could be used to offset the increased expense over a 5 year term or potentially used to buy the rate down 31 bps today.
- If the swap rate is below the strike, the option expires worthless. There’s no other liability to the borrower after the premium is paid.
Below, we've outlined pricing across a few structures assuming a 45 day expiry, or protection for 45 days, to give an order of magnitude.
Since the present value of each basis point (PV01) is $22.7k on the underlying swap, the breakeven point for the 3.69% strike would be 17.6 bps. In other words, if rates are 18+ bps higher in 45 days, the premium paid is more than recouped.
5 year swap rates have traded in a 22 bp range over just the past week…
On the other hand, if you’re currently prepaying a loan that’s subject to yield maintenance or defeasance, a swaption can be used to put a floor on the rate. A swaption structured that way helps provide a max potential prepayment penalty.
A few other notes:
- Swaptions are often purchased from third party banks, just like caps.
- The entity the swaption is purchased under would need to be onboarded by the bank prior to trading. We encourage clients seriously considering the strategy to onboard ahead of time to avoid delays.
- As previously stated, there’s no potential downside/liability after the premium is paid. At expiry, the swaption would either be (i) in-the-money some amount and exercised, or (ii) worth $0.
If you’d like pricing for a particular structure or to discuss further, please reach out to pensfordteam@pensford.com, call us at 704-887-9880, or reply to this email.
