What is a Bermuda Swaption
A Bermuda swaption is a variation of a regular swaption that gives the holder the right, but not the obligation, to enter into an interest rate swap on any one of many predetermined dates. It is a derivative that gives the holder the ability to only exercise the swaption on any one of these dates, provided it has not already been exercised. The swaption is similar to a Bermuda option, which offers the same predetermined schedule of potential exercise dates.
BREAKING DOWN Bermuda Swaption
Swaptions or swap options are one of the four fundamental ways for an investor to exit a swap before it has reached its termination date. The swaption allows the investor to offset the option they wish to exit. The Bermuda swaption allows exit on any one of several different dates. By contrast, a plain vanilla swaption would give the holder the ability to enter into a rate swap only on the expiration date of the derivative. Swaptions are over-the-counter contracts that need both buyer and seller agreement on terms.
Swaptions are frequently used with interest rate swaps. An interest rate swap is an agreement between counterparties, where one stream of future interest payments is exchanged for another. Interest rate swaps usually involve the exchange of a fixed interest rate for a floating rate or vice versa. The swap helps to reduce or increase exposure to fluctuations in interest rates. They may also offer the ability to obtain a marginally lower interest rate than would have been possible without the swap. Only cash flows are exchanged in this swap.
Bermuda vs. American and European Styles
The exercise feature of Bermuda swaptions falls somewhere between American and European styles. Holders may exercise American style options and swaptions at any time between the issue and the expiration dates. Holders may utilize European style options and swaptions only at maturity. Buyers and sellers determine the allowable expiration dates for Bermuda options and swaptions. Monthly expirations are customary, although the days are up to the counterparties.
Bermuda swaptions have several advantages and disadvantages. Unlike American and European swaptions, Bermuda swaptions give writers and buyers the ability to create and purchase a hybrid contract. Writers of Bermuda swaptions can have more control over the exercising of the swaptions.
Pricing Bermuda Swaptions
Pricing of such swaptions is more complex than vanilla swaptions. With the inclusion of more potential exercise dates, the calculations become more complicated. Therefore, counterparties use Monte Carlo Simulation pricing rather than other, more common, option and swaption pricing models.
The cost to buyers of Bermuda swaptions is usually less expensive than buying an American swaption. Also, the Bermuda swaption is less restrictive than a European swaption. European swaptions and Bermuda swaptions are typically less expensive than American swaptions because of the larger premium that American swaptions demand from their flexibility. With an American swaption, there's a greater chance that the swaption hits its strike price when the holder can exercise it at any time, which makes it more expensive and more likely to be exercised.