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Form Dated March 20, 2007 Swaption Template (Full Underlying Confirmation)

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Form Dated March 20, 2007
Swaption template
(Full Underlying Confirmation)

CONFIRMATION
DATE: TO:
[Date] [Party B] Telephone No.: [number] Facsimile No.: [number] Attention: [name]

  • FROM:
  • [Party A]

  • SUBJECT:
  • Swaption on [CDX.NA.[IG/HY/XO].____] [specify sector, if any] [specify series, if

any] [specify version, if any]

  • REF NO:
  • [Reference number]

The purpose of this communication (this “Confirmation”) is to set forth the terms and conditions of the Swaption entered into on the Swaption Trade Date specified below (the “Swaption Transaction”) between [Party A] (“Party A”) and [counterparty’s name] (“Party B”). This Confirmation constitutes a “Confirmation” as referred to in the ISDA Master Agreement specified below.

The definitions and provisions contained in the 2000 ISDA Definitions (the “2000 Definitions”) and the 2003 ISDA Credit Derivatives Definitions as supplemented by the May 2003 Supplement to the 2003 ISDA Credit Derivatives Definitions (together, the “Credit Derivatives Definitions”), each as published by the International Swaps and Derivatives Association, Inc. are incorporated into this Confirmation. In the event of any inconsistency between the 2000 Definitions or the Credit Derivatives Definitions and this Confirmation, this Confirmation will govern. In the event of any inconsistency between the 2000 Definitions and the Credit Derivatives Definitions, the Credit Derivatives Definitions will govern in the case of the terms of the Underlying Swap Transaction and the 2000 Definitions will govern in other cases. For the purposes of the 2000 Definitions, each reference therein to Buyer and to Seller shall be deemed to refer to “Swaption Buyer” and to “Swaption Seller”, respectively.

This Confirmation supplements, forms a part of and is subject to the ISDA Master Agreement

  • dated as of [
  • ], as amended and supplemented from time to time (the “Agreement”)

between Party A and Party B. All provisions contained in, or incorporated by reference in, the Agreement shall govern this Confirmation except as expressly modified below.

The terms of the Swaption Transaction to which this Confirmation relates are as follows:

1.

SWAPTION TERMS

Swaption Trade Date: Swaption Notional Amount:
[date], 20__ The Original Notional Amount for the Underlying Swap Transaction

Adjusted Swaption Notional Amount: The Swaption Notional Amount multiplied by the aggregate of the Reference Entity Weightings (as defined in the Underlying Swap Transaction) in respect of each of the Reference Entities for the Underlying Swap Transaction.

  • Option Style:
  • European

Swaption Seller: Swaption Buyer: Option Type:
[Party A] [Party B] [Party B] [Party A] [Payer] [Receiver]

  • Underlying Buyer:
  • If the Option Type is “Payer”, the Swaption

Buyer; if the Option Type is “Receiver”, the Swaption Seller

  • Underlying Seller:
  • If the Option Type is “Payer”, the Swaption

Seller; if the Option Type is “Receiver”, the Swaption Buyer

Quoting Style: Strike Price:
[Spread] [Price]

  • [
  • % per annum] [

]
%]1

  • Premium:
  • USD [

  • Premium Payment Date:
  • The date that is three Business Days for

Payment following the Swaption Trade Date

Business Days for Payment: Exercise Business Days: Swaption Calculation Agent:
New York and London New York and London The Calculation Agent for the Underlying Swap Transaction

1

If the Quoting Style is “Spread,” insert spread expressed as a percentage per annum. If the Quoting Style is
“Price,” insert price expressed as a percentage of the Par Amount.

2

2.

PROCEDURE FOR EXERCISE

  • Expiration Date:
  • [date], 20__

Earliest Exercise Time: Expiration Time:
9:00 a.m. New York City time 11:00 a.m. New York City time

  • Applicable
  • Partial Exercise:

  • Minimum Notional Amount:
  • One unit of the Settlement Currency for the

Underlying Swap Transaction

  • Integral Multiple:
  • One unit of the Settlement Currency for the

Underlying Swap Transaction

Automatic Exercise: Fallback Exercise:

SETTLEMENT TERMS

Settlement:
Inapplicable Inapplicable

3.

Physical. In the event that Swaption Buyer effectively exercises this Swaption Transaction, then:

  • (a)
  • Swaption Buyer and Swaption Seller

shall be deemed to have entered into a Master Transaction (as defined in Appendix A hereto) having the terms described in “Summary of

  • Terms”
  • below
  • (the
  • “Underlying
  • Swap

Transaction”);

  • (b)
  • as soon as reasonably practicable

following the Expiration Time on the Expiration Date, the Swaption Calculation Agent shall determine the Settlement Payment and, not later than one Exercise Business Day following the Expiration Date, the Swaption Calculation Agent shall notify Swaption Buyer and Swaption Seller of the amount thereof (which notification may be given orally, including by telephone); and

  • (c)
  • not later than the third Business Day for

Payment following the Expiration Date, (i) if the Settlement Payment is a positive number, the Underlying Buyer shall pay the Settlement Payment to the Underlying Seller or (ii) if the Settlement Payment is a negative number, the Underlying Seller shall pay the absolute value of

3the Settlement Payment to the Underlying Buyer.

An amount (which may be positive or negative), in the Settlement Currency of the Underlying Swap Transaction, determined by the Swaption Calculation Agent and equal to the Strike Adjustment Amount minus the Accrued Amount.
Settlement Payment:
If the Quoting Style is “Spread,” the present value, as of the Expiration Date, of a stream of payments equal to (a) (i) the Strike Price minus (ii) the Fixed Rate for the Underlying Swap Transaction multiplied by (b) the Adjusted Swaption Notional Amount multiplied by (c) the
Strike Adjustment Amount:

  • Partial
  • Exercise
  • Factor,
  • calculated
  • in

accordance with the following assumptions:

  • (a)
  • such payments are made with the same

frequency, on the same basis, on the same dates and for the same term as the Fixed Amounts payable with respect to the Underlying Swap Transaction, except that the initial Fixed Rate Payer Calculation Period shall commence on and include the calendar day immediately following the Expiration Date;

  • (b)
  • such payments are discounted by the

Swaption Calculation Agent in a commercially reasonable manner to reflect the creditcontingent nature of payment of such Fixed Amounts, using the “J” (JP Morgan) Model Calculator available through Bloomberg page CDSW (or any successor page thereto as determined by the Swaption Calculation Agent); and

  • (c)
  • calculations are to be made assuming (i)

a single “Deal Spread” equal to the Fixed Rate for the Underlying Swap Transaction, (ii) a “Par Cds Spread” equal to the Strike Price with “Flat” selected as applicable, (iii) a “Curve Date” equal to the Expiration Date and a “Settlement Date” equal to the calendar day immediately following the Expiration Date, (iv) a “Benchmark Swap Curve” (US BGN Swap Curve) of “S23” “A” (for ask) and (v) a recovery rate following all Credit Events equal to 40%.

If the Quoting Style is “Price,” an amount equal to (a)(i) the Par Amount minus (ii) the Strike

4Price multiplied by (b) the Adjusted Swaption Notional Amount multiplied by (c) the Partial Exercise Factor. “Par Amount” means 100%.

  • (a)
  • if the entire Swaption Notional Amount is
  • Partial Exercise Factor:

exercised, one; or

  • (b)
  • if only a portion of the Swaption Notional

Amount is exercised, the fraction obtained by dividing the exercised Swaption Notional Amount by the entire Swaption Notional Amount.

  • Accrued Amount:
  • An amount equal to:

  • (a)
  • if the calendar day immediately following

the Expiration Date falls on a day that is a Fixed Rate Payer Payment Date (as defined in the Underlying Swap Transaction), zero; and

  • (b)
  • if the calendar day immediately following

the Expiration Date falls on a day that is not such a Fixed Rate Payer Payment Date, (i) the Fixed Rate for the Underlying Swap Transaction multiplied by (ii) the Adjusted Swaption Notional Amount multiplied by (iii) the Partial Exercise Factor multiplied by (iv) the actual number of days in the period from, and including, the later of the Effective Date of the Underlying Swap Transaction and the Fixed Rate Payer Payment Date falling immediately prior to the calendar day immediately following the Expiration Date to, and including, the Expiration Date divided by (v) 360.

4.

UNDERLYING SWAP TRANSACTION TERMS

Summary of Terms: Appendix A hereto, and any other documents referred to therein, evidence the full terms of the Underlying Swap Transaction; provided that, if the Swaption Transaction is exercised only in part, the Original Notional Amount of the Underlying Swap Transaction shall equal the portion of the Swaption Notional Amount that is exercised.

5

5.

NOTICE AND ACCOUNT DETAILS

Telephone, Telex and/or Facsimile Number and Contact Details for Notice:

Party A: Telephone No.: Facsimile No.:

Party B: Telephone No.: Facsimile No.:

Account Details: Account Details of Party A: For the Account of: Name of Bank: Account No: Fed ABA No:

Account Details of Party B: For the Account of: Name of Bank: Account No: Fed ABA No:

6.

ADDITIONAL PROVISIONS Disclaimers

6.1

(a)

CDX™ is a service mark of the Index Sponsor and has been licensed for use in connection with the Swaption Transaction. Dow Jones® is a service mark of Dow Jones & Company, Inc. (“Dow Jones”) and, with respect to a Swaption Transaction relating to an Index with an Effective Date prior to March 20, 2007 (a “Prior Index Swaption Transaction”), has been licensed for use in connection with the Swaption Transaction.

(b)

The Index referenced herein is the property of the Index Sponsor and has been licensed for use in connection with the transaction hereunder. Each party acknowledges and agrees that the transaction hereunder is not sponsored, endorsed or promoted by Dow Jones, the Index Sponsor or any members of the Index Sponsor (the Index Sponsor, together with its members and, with respect to any Prior Index Swaption Transaction only, Dow Jones, the “Index Parties”). The Index Parties make no representation whatsoever, whether express or

6implied, and hereby expressly disclaim all warranties (including, without limitation, those of merchantability or fitness for a particular purpose or use), with respect to the Index or any data included therein or relating thereto, and in particular disclaim any warranty either as to the quality, accuracy and/or completeness of the Index or any data included therein, the results obtained from the use of the Index, the composition of the Index at any particular time on any particular date or otherwise, and/or the creditworthiness of, or likelihood of the occurrence of a Credit Event with respect to, any entity in the Index at any particular time on any particular date or otherwise. The Index Parties shall not be liable (whether in negligence or otherwise) to the parties or any other person for any error in the Index, and the Index Parties are under no obligation to advise the parties or any person of any error therein. The Index Parties make no representation whatsoever, whether express or implied, as to the advisability of entering into the transaction hereunder, the ability of the Index to track relevant markets’ performances, or otherwise relating to the Index or any transaction or product with respect thereto, or of assuming any risks in connection therewith. The Index Parties have no obligation to take the needs of any party into consideration in determining, composing or calculating the Index. Neither party to this transaction, nor any Index Party, shall have any liability to any party for any act or failure to act by the Index Parties in connection with the determination, adjustment, calculation or maintenance of the Index. Although the Swaption Calculation Agent will obtain information concerning the Index from sources it believes reliable, it will not independently verify this information. Accordingly, no representation, warranty or undertaking (express or implied) is made, and no responsibility is accepted by either party, its Affiliates or the Swaption Calculation Agent, as to the accuracy, completeness or timeliness of information concerning the Index. Each party acknowledges that the other party or one of its Affiliates may be, or may be affiliated with, an Index Party and, as such, may be able to affect or influence the determination, adjustment or maintenance of the Index. For purposes of Sections 9.1(b)(iii) and (iv) of the Credit Derivatives Definitions, references to “each party” therein shall be deemed to include each Index Party.

6.2

Operation of Underlying Swap Transaction

Each of Swaption Buyer and Swaption Seller acknowledge and agree that:

(a)

the Underlying Seller is subject to the risk of any Credit Event occurring with respect to a Reference Entity on or after the Effective Date of the Underlying Swap Transaction, irrespective of whether such Effective Date precedes the Swaption Trade Date, but only if Swaption Buyer effectively exercises this Swaption Transaction; and

(b)

if Swaption Buyer effectively exercises this Swaption Transaction, on or following (but not prior to) such exercise, a Notifying Party may deliver Credit Event Notices and Notices of Publicly Available Information in accordance with the terms of the Underlying Swap Transaction, and any such notice delivered prior to such exercise will be ineffective.

6.3

Merger of Reference Entity and Seller

7
Section 2.31 of the Credit Derivatives Definitions shall not apply to this Swaption Transaction.

6.4 6.5

Additional Representation

Section 9.1 of the Credit Derivatives Definitions is incorporated into this Confirmation and, for purposes of such Section, all references to a “Credit Derivative Transaction” shall refer to this Swaption Transaction, all references to “Buyer” are replaced with “Swaption Buyer” and all references to “Seller” are replaced with “Swaption Seller”.

[Other Provisions]2

2

Include any additional provisions agreed to by the parties.

8
Please confirm your agreement to be bound by the terms of the foregoing by executing a copy of this Confirmation and returning it to us at the contact information listed above.

Very truly yours, [PARTY A]

By _______________________________
Name: Title:

Agreed and Accepted by: [PARTY B]

By _______________________________
Name: Title:

9
Appendix A

Underlying Swap Transaction Terms

The terms of the particular Underlying Swap Transaction to which the Swaption Transaction relates are as follows:

The Underlying Buyer and Underlying Seller, determined as provided in the Confirmation to the Swaption Transaction to which this Appendix A relates, agree that, by entering into the Underlying Swap Transaction, they have entered into a separate and independent Credit Derivative Transaction (a “Component Transaction”) in respect of each Reference Entity listed

  • in the Relevant Annex (as defined below) (collectively, the “Master Transaction”).
  • A

Confirmation in the form of this Appendix A shall be deemed to be entered into in respect of each Component Transaction in respect of each of the Reference Entities listed in the Relevant Annex, provided that if, in respect of a Reference Entity, a Succession Event occurs or has occurred on or following the earlier of the Effective Date and the Trade Date, the provisions of Section 2.2 of the Credit Derivatives Definitions shall apply in respect of such Reference Entity.

Subject to Paragraph 7.5 below, each Component Transaction (a) constitutes a separate and independent Credit Derivative Transaction between the Underlying Buyer and Underlying Seller with respect to one of the Reference Entities listed in the Relevant Annex, (b) shall not be affected by any other Credit Derivative Transaction between the Underlying Buyer and Underlying Seller and (c) shall operate independently of each other Component Transaction in all respects.

The terms of each Component Transaction to which this Appendix A relates are as follows:

1.

GENERAL TERMS

  • Index:
  • [CDX.NA.[IG/HY/XO].____] [specify sector, if

any] [specify series, if any] [specify version, if any]

  • Index Sponsor:
  • CDS IndexCo LLC

  • Trade Date:
  • The Exercise Date of the Swaption Transaction

  • [Effective Date of Index Contract]
  • Effective Date:

Scheduled Termination Date: Original Notional Amount: Floating Rate Payer: Fixed Rate Payer: Reference Entity:
[Scheduled Termination Date of Index Contract]

  • USD [
  • ]

Underlying Seller (the “Seller”) Underlying Buyer (the “Buyer”) Subject to Paragraph 7.4 below, the applicable Reference Entity contained in the Index and listed in the Relevant Annex, and any Successor.

A-1

  • Reference Obligation(s):
  • The Reference Obligation (if any) specified in

the Index and set out opposite the Reference Entity in the Relevant Annex, subject to Paragraph 7.4 below, Sections 2.2(d) and 2.30 of the Credit Derivatives Definitions and the following paragraph:

If the Index Sponsor publishes a replacement Reference Obligation for a Reference Entity or one or more Reference Obligations for a

  • Reference Entity in connection with
  • a

Succession Event, the Calculation Agent shall select such Reference Obligation(s) as the Reference Obligation(s) hereunder for such Reference Entity in lieu of applying the provisions of Sections 2.2(d) or 2.30 of the Credit Derivatives Definitions.

  • Calculation Agent:
  • [
  • ]

Calculation Agent City: Business Days:
New York New York and London

  • Business Day Convention:
  • Following (which, subject to Sections 1.4 and

1.6 of the Credit Derivatives Definitions, shall apply to any date referred to in this Appendix A that falls on a day that is not a Business Day)

  • Relevant Annex:
  • [The list attached as Annex A hereto] [The list

for the relevant Index with an Annex Date of

  • [
  • ], as published by the Index Publisher

(which can be accessed currently at

http://www.markit.com). “Index Publisher”

means Markit Group Limited or any replacement therefor appointed by the Index Sponsor for purposes of officially publishing the relevant Index.]

All Guarantees: Reference Price:

INITIAL PAYMENT

Initial Payment:
Not Applicable 100%

2.

With respect to the Master Transaction to which the Component Transactions relate, on the date that is three Business Days following the Trade Date, the Initial Payment Payer shall pay to the other party an aggregate amount equal to the

A-2 Initial Payment Amount.

  • Not Applicable
  • Initial Payment Payer:

Initial Payment Amount:

FIXED PAYMENTS

Not Applicable

3.

Fixed Rate Payer Calculation Amount:
The Floating Rate Payer Calculation Amount

  • Fixed Rate Payer Payment Dates:
  • Each March 20, June 20, September 20 and

December 20 in each year

Fixed Rate Payer Calculation Each period from, and including, one Fixed Rate

  • Period:
  • Payer Payment Date to, but excluding, the next

following Fixed Rate Payer Payment Date, except that (a) the initial Fixed Rate Payer Calculation Period will commence on, and include, the later of the Effective Date and the Fixed Rate Payer Payment Date falling on or immediately prior to the calendar day immediately following the Trade Date and (b) the final Fixed Rate Payer Calculation Period will end on, and include, the earlier to occur of the Scheduled Termination Date and the Event Determination Date.

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  • Swaption Straddle, Transaction Reference No: [ ]/[ ] Unique Identifier: [ ] [ ]

    Swaption Straddle, Transaction Reference No: [ ]/[ ] Unique Identifier: [ ] [ ]

    PLEASE NOTE THAT THIS IS A DRAFT CONFIRMATION AND IS BEING PROVIDED FOR YOUR INFORMATION AND CONVENIENCE ONLY. A FINAL CONFIRMATION WILL BE FORWARDED TO YOU UPON COMPLETION OF THE TRANSACTION. THIS DRAFT DOES NOT REPRESENT A COMMITMENT ON THE PART OF EITHER PARTY TO ENTER INTO ANY TRANSACTION STANDARD CHARTERED BANK FINANCIAL MARKETS OPERATIONS 1 BASINGHALL AVENUE 6TH FLOOR LONDON EC2V 5DD UNITED KINGDOM TELEPHONE 1: +44 207 885 8888 TELEPHONE 2: +65 6225 8888 FACSIMILE 1: +44 207 885 6832 FACSIMILE 2: +44 207 885 6030 FACSIMILE 3: +44 207 885 6219 FACSIMILE 4: +44 207 885 6163 FACSIMILE 5: +65 6787 5007 [CP name] Address1 Address2 Address3 Address4 Date: [dd mm yyyy] Dear Sirs, Re: Swaption Straddle, Transaction Reference No: [ ]/[ ] Unique Identifier: [ ] [ ] The purpose of this letter agreement (this "Confirmation") is to confirm the terms and conditions of the Transaction entered into between STANDARD CHARTERED BANK ("Party A") and [ ] ("Party B") on the Trade Date specified below (the "Transaction"). The definitions and provisions contained in the 2006 ISDA Definitions (as published by the International Swaps and Derivatives Association, Inc.) (the “2006 Definitions”) are incorporated into this Confirmation. In the event of any inconsistency between the 2006 Definitions and this Confirmation, this Confirmation will govern. References herein to a “Transaction” shall be deemed to be references to a “Swap Transaction” for the purposes of the 2006 Definitions. This Confirmation constitutes a “Confirmation” as referred to in, and supplements, forms part of and is subject to, the ISDA Master Agreement dated as of DD MM YYYY, as amended and supplemented from time to time (the “Agreement”), between Party A and Party B.
  • Riding the Swaption Curve

    Riding the Swaption Curve

    RIDING THE SWAPTION CURVE Johan Duyvesteyn Gerben de Zwart TopQuants Autumn event Amsterdam – 18 November 2015 MOTIVATION Volatility risk is priced in swaption markets – Negative premium: realized volatility is lower than implied volatility – Investors are willing to pay a compensation to volatility sellers – Supported by various research methods and many authors Term structure across the swaption maturity spectrum – Higher volatility risk premium for low maturities – Very little attention in the literature 2 LITERATURE OVERVIEW Volatility risk premium Term structure VRP Goodman & Ho (1997) Hedging Based tests THIS STUDY Duarte, Longstaff & Yu (2007) Almeida & Vicente (2009) Fornari (2010) Model free tests Mueller, Vedolin & Yen (2011) Fornari (2010) Merener(2012) Trolle & Schwartz (2012) 3 HEDGING-BASED TEST Straddle refresher • Combination of call and put option • Very sensitive to changes in volatility • Risk exposures measured by Greeks: delta, gamma, vega Hedging-based test • Isolate movement in volatility and neutralize interference from directional movement in underlying instrument • The return on buying a straddle and dynamically delta-hedging is related to the volatility risk premium (Low & Zhang, 2005) 4 THIS STUDY We develop a novel hedging-based test to empirically examine the presence of a term structure of the volatility risk premium in the swaption market - Long-short combinations of two at-the-money swaption straddles with different maturities - Analyse the profit/loss to examine the difference in the VRP between maturities Short: short term Long: longer term straddle straddle 3M 6M 9M 12M premium Volatility Risk Volatility Swaption maturity 5 DATA Sample: Four largest and most liquid swap markets – U.S., EMU, Japan, U.K.
  • The Swaption Cube

    The Swaption Cube

    The Swaption Cube Anders B. Trolle Ecole Polytechnique F´ed´eralede Lausanne and Swiss Finance Institute Princeton-Lausanne workshop, May 13, 2011 Introduction I A standard European swaption is an option to enter into a fixed versus floating forward starting interest rate swap at a predetermined rate on the fixed leg I Understanding the swaption market is important from a practical perspective... I By some measures (such as the notional amount of outstanding options) the world's largest derivatives market I Many standard fixed income securities, such as fixed rate mortgage-backed securities and callable agency securities, embed swaption-like options I Many exotic interest rate derivatives and structured products also embed swaptions I Many large corporations are active in the swaption market either directly or indirectly (through the issuance and swapping of callable debt) I and from an academic perspective... I Swaptions contain valuable information about interest rate distributions Many empirical studies on the swaption market. This paper differs from these in two important ways I All existing studies are limited to only using data on at-the-money (ATM) swaptions. In contrast, we analyze a proprietary data set consisting of swaption cubes, which sheds new light on the swaption market. I Existing studies are mostly concerned with the pricing and hedging of swaptions using reduced-form models. Key objective of the paper is to understand the fundamental drivers of prices and risk premia in the swaption market. I Vast literature on interest derivatives
  • Special Report

    Special Report

    XVA Risk.net July 2017 Special report Sponsored by Get ahead of the pack with Murex’s real-time, cross-asset, integrated xVA solution. — FOR XVA MANAGEMENT Murex is the world’s leading provider of trading, risk and processing solutions. Our award-winning technology platform is used by 60 of the world’s top 100 banks*. Find out more at www.murex.com www.murex.com * Source: The Banker Database (as of 30th November 2016). MUREX, Murex logos and product names are trademarks of Murex S.A.S and Murex S.A.S reserves all intellectual property rights with respect to the trademarks. Opinion Mnuchin makes life harder for quants Lukas Becker, Desk Editor, Derivatives he add-on to a derivatives contract’s fair value to account for the cost of [email protected] capital, known as the capital valuation adjustment (KVA), is already Joanna Edwards, arguably the most complex of the suite of adjustments out there. But US Senior Director, Marketing Solutions Treasury secretary Steven Mnuchin’s review of bank regulation, released [email protected] T on June 13, looks set to send quants further down the rabbit hole. Stuart Willes, Commercial Editorial Manager The review recommends that the US Federal Reserve Board’s annual stress [email protected] test – the Comprehensive Capital Analysis and Review (CCAR) – be amended Alex Hurrell, Commercial Subeditor so that, if a bank fails the qualitative element, it cannot be the ‘sole basis’ for the [email protected] Fed to object to dividend payments. Antony Chambers, Publisher, Risk.net The dividend question is already vexing US banks that are trying to work out [email protected] how much KVA to charge for a trade.
  • Swaptions Product Nature • the Buyer of a Swaption Has the Right to Enter Into an Interest Rate Swap by Some Specified Date

    Swaptions Product Nature • the Buyer of a Swaption Has the Right to Enter Into an Interest Rate Swap by Some Specified Date

    Swaptions Product nature • The buyer of a swaption has the right to enter into an interest rate swap by some specified date. The swaption also specifies the maturity date of the swap. • The buyer can be the fixed-rate receiver (put swaption) or the fixed-rate payer (call swaption). • The writer becomes the counterparty to the swap if the buyer exercises. • The strike rate indicates the fixed rate that will be swapped versus the floating rate. • The buyer of the swaption either pays the premium upfront or can be structured into the swap rate. 1 Uses of swaptions Used to hedge a portfolio strategy that uses an interest rate swap but where the cash flow of the underlying asset or liability is uncertain. Uncertainties come from (i) callability, eg, a callable bond or mortgage loan, (ii) exposure to default risk. Example Consider a S & L Association entering into a 4-year swap in which it agrees to pay 9% fixed and receive LIBOR. • The fixed rate payments come from a portfolio of mortgage pass-through securities with a coupon rate of 9%. One year later, mortgage rates decline, resulting in large prepayments. • The purchase of a put swaption with a strike rate of 9% would be useful to offset the original swap position. 2 Management of callable debt Three years ago, XYZ issued 15-year fixed rate callable debt with a coupon rate of 12%. −3 0 2 12 original today bond bond bond issue call maturity date Strategy The issuer sells a two-year receiver option on a 10-year swap, that gives the holder the right, but not the obligation, to receive the fixed rate of 12%.