What Is an Extendable Swap?
- An extendable swap is one whose tenor can be extended beyond the original maturity.
- The swap is extended by means of an embedded option, which is customized and agreed-upon by the counterparties before the swap is consummated.
- The opposite of an extendable swap is a cancelable, or callable swap, which gives one counterparty the right to terminate the agreement early.
- A swaption is an option that provides one party with the right, but not the obligation, to enter into a particular swap at an agreed-upon fixed price on or before the specified expiration date or dates.
Understanding Extendable Swaps
The embedded option in an extendable swap can be tailored to either the fixed or floating party, but is, usually, utilized by the fixed price payer. The opposite of an extendable swap is a cancelable, or callable swap, which gives one counterparty the right to terminate the agreement early.
If a trader sells an extendable swap and the fixed price payer decides to exercise their option to extend the swap, the swap seller must continue to pay the floating price already agreed upon, which will likely result in a swap with less favorable terms than with a plain vanilla fixed-for-floating swap at the time of the extension.
An extendable swap is useful for swaps involving commodities. The fixed price payer might wish to exercise their right to extend the swap if the underlying security's price is rising, since the fixed price payer will benefit from continuing to pay a fixed price below market levels, while at the same time receiving a floating price corresponding to the higher market price.
Fixed price payers, because they can benefit from this feature, are likely to pay a premium for an extension option, usually by paying a higher initial fixed price than they otherwise would pay for a plain vanilla swap.
The risks involved with extendable swaps come in two main forms. The first part of an extendable swap is simply a swap agreement, and will therefore involve the risks and characteristics associated with a plain vanilla swap with similar terms. However, an extendable swap also intrinsically contains an option to enter into another swap (the extension), and therefore involves the same risks and characteristics as swaptions.
Extendable Swaps and Swaptions
A swaption is an option that provides one party with the right, but not the obligation, to enter into a particular swap at an agreed-upon fixed price on, or before, the specified expiration date or dates.
In a "pay-fixed" swaption, the holder of the swaption has the right to enter into a commodity swap as a payer of the fixed price and receiver of the floating price, whereas in a "receive-fixed" swaption, the holder has the right to enter into a commodity swap as a receiver of the fixed price and a payer of the floating price. In either case, the writer of the swaption has the obligation to enter into the opposite side of the commodity swap from the holder.
With an extendable swap, the fixed price payer enjoys access to a pay-fixed swaption. The additional feature of an extendable swap makes it more expensive than a plain vanilla interest rate swap. That is, the fixed ratepayer will pay a higher fixed interest rate and possibly an extension fee. The extra cost can also be construed as the cost of the embedded swaption.