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Interest Rate Swap Option

Interest Rate Swap Option (SWAPTION) – FAQs

Swaptions are helpful in managing possible interest rate risk occurring at some time in the future.

An Interest Rate Swaption gives you the right (but with no obligation), as a borrower of substantial funds, to enter into an Interest Rate Swap at an agreed interest rate on a set date in the future.

Swaptions are intended for borrowers who want the option to take forward cover on interest rates or the option to obtain forward cover on the rollover of an existing loan facility.

They are a useful tool when there is uncertainty as to the timing or need to borrow, and movements in interest rates are an important component of the potential transaction. Alternatively, a borrower who has purchased an asset on extended terms may use a Swaption to obtain flexibility in their future financing requirements.

FAQs about Bank of Melbourne Interest Rate Swap Options.

What is a Swaption?

A Swaption provides you with the right but not the obligation to enter into an Interest Rate Swap at a predetermined interest rate on a fixed date in the future.

How does a Swaption work?

With a Swaption you can fix an interest rate on your future borrowings. This is via an option on a Interest Rate Swap. By acquiring the Swaption you have obtained comfort that if rates rise beyond the agreed level prior to rollover or draw down date you are insulated from these increases. If rates do not rise above the agreed rate of the Swaption you would not proceed with the Swap, instead you would borrow at the prevailing market rate.

Let's see how this would work. XYZ Corporation has a borrowing facility maturing in six months time that will require re-financing. The annual budget process for XYZ has factored in a maximum interest rate and XYZ is concerned that, prior to rollover date, rates may rise above this rate. XYZ elects to take out a Swaption. If interest rates have risen above the agreed Swap rate when the re-financing is due, XYZ would proceed with the Swap. Should interest rates on rollover date be below the Swap rate they would not proceed with the Swap and instead borrow at the prevailing interest rate.

What is the Strike Date?

The Strike Date is the date when you must exercise or waive your right to enter into the Interest Rate Swap.

How much does a Swaption cost?

The cost of a Swaption is know as the premium. The premium for a Swaption depends on the structure of the Swap you require and in particular the fixed interest rate of the Swap when compared to current market interest rates. For example, if current market rates are 6%, you would pay more for a Swaption at 7% than a Swaption at 8.5%.

The premium on a Swaption also depends on the rollover frequency and how you make your premium payments. We will endeavour to structure the payments to suit your cash flows. Your Bank of Melbourne Financial Markets representative will be happy to provide an indication of costs when you discuss your requirements with them.

Over what period can I obtain a Swaption?

A Swaption can be bought with option periods as short as ten days and up to three years from the transaction date.

Is there a minimum amount for a Swaption?

The Bank will be pleased to quote on Swaptions of $1,000,000 and above.

What happens if I don't proceed with my loan?

Swaptions are totally separate to your loan facility. If at any time you decide not to proceed with the loan you can terminate the Swaption. Depending on interest rate movements the Swaption may have some residual value. The Bank will pay this residual value to you on termination.

Alternatively, you can enter into the Swap agreement and allow it to run to maturity in which case you will be obliged to meet the payments and receipts in the Swap agreement.

What happens if the interest rate outlook changes after I proceed with the Swap?

If your view on interest rates change at any time after proceeding with the Swap you have two choices. You can terminate the Swap, in which case the Bank will calculate any residual value and either will pay you this amount or you will pay the amount to the Bank. The residual value will depend on current interest rates at the time of termination. Alternatively, you can enter into an offsetting Swap transaction when market conditions are appropriate.

What happens if I repay my loan early? Is the Swap cancelled?

As the Swap is totally independent of your underlying borrowings you have two choices. You may terminate the Swap as explained above or you may decide to let the Swap run until completion, in which case your obligations for payments or rights to receipts will continue in accordance with the Swap agreement.

Are there any risks associated with a Swaption?

Yes. The primary risk with a Swaption occurs after you have exercised your right and proceeded with the Swap. Should interest rate movements be different to your expectations, the Swap may have the opposite effect to what you were trying to achieve with the transaction. You can however reverse or terminate the Swap should this happen (remembering you may be required to pay the Bank, or the Bank will pay you, the residual value of the Swap).

It is also important to note, that if interest rates do not rise above the interest rate nominated in the Swaption on the exercise date, you have not obtained any benefit from the premium paid for the purchase of the Swaption. The premium is the cost of obtaining protection against a rise in interest rates.

Is their any other information I should know?

If you decide that Swaptions are of use to you, the Bank will require you to sign its standard terms and conditions. These documents are easy to read as they have been written in plain English. They summarise the terms and conditions under which you agree to deal with the Bank.

Entering into an interest rate Swaption will also involve credit decisions by the Bank in relation to the Swap. This aspect of the transaction will be discussed with you by your Bank of Melbourne Financial Markets representative.

How do I arrange a Swaption?

Simply phone your Bank of Melbourne Financial Markets representative to discuss your needs.

Need more information?

If you have any questions or want more information, you can contact us online or call us toll free on 1300 665 616.

Read the Product Disclosure Statement.