NYIF ONLINESM

RISK MANAGEMENT USING DERIVATIVES

Advantages and Disadvantages of Interest Rate Swaps

Compared to Swaptions

Interest Swaptions
Rate Swaps
Advantages
Interest costs or income amounts are known in local currency a
terms in advance
Interest costs or income amounts are known in advance a
based on the choice of strike rate which becomes a minimum
or a maximum borrowing or investment rate
Enables interest rate risk management by converting floating a
rate exposures to a fixed rate or vice versa
There is no cost to entering into the contract other than the a
fees charged by the bank.
Holder can choose any strike and is not restricted to the a
current market swap rate (which would be at-the-money).
Credit limits required are very small. a
A net payment reduces settlement risk. a
No credit risk for the holder as their maximum loss is the a
premium.
Easy to establish once the Master Agreement is signed and a a a
credit limit is in place.
Liquidity is high in major currencies a
Ability to lock in rate today for exchange in the future with no a
opportunity cost other than the expense of the premium

Disadvantages Interest Swaptions

Rate Swaps
Locking in the rate today for exchange in the future has an X
opportunity cost if exchange rates move to your advantage.
Premiums can be very expensive X
Liquidity is low and the transaction is difficult to unwind X
Clients will require a pre-established treasury line or limit to X
be established with their bank.
Client only receives a net payment so a separate spot X
transaction may be necessary.
A Master Agreement covers the contractual details of the X X
transaction. Although the document only needs signing once
(with perhaps an annual renewal), it is lengthy and must
typically be signed by the Board of Directors.
You must return to your original bank to reverse or extend the X X
deal and as they know the original price, their rate to close
out might not be so keen. Using another bank will mean that
you have two sets of credit limits used.

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 NYIF ONLINESM
RISK MANAGEMENT USING DERIVATIVES

To summarize, here are some key points you should remember when determining whether to
use a swap or a swaption to manage your long-term domestic interest rate risk:
• Interest rate swaps are inexpensive and highly liquid, but there is a potential opportunity
cost from locking in a particular rate, and a separate spot transaction may be necessary as
only a net payment is received.
• Swaptions have no opportunity cost, as you are not locked into a rate that may no longer be
advantageous, but they can be very expensive and are often illiquid.