Fed Makes Swaptions Cheaper

Callable swaps are a combination of an interest rate swap with an embedded, offsetting swaption.  There are several factors that go into pricing swaptions and volatility is one of these.  One of the unintended consequences of the Fed’s decision to purchase mortgage securities is a reduction in volatility.  From the graph below, we can see that normalized swaption volatility for 10 year swaptions with a 3 month expiration (“3M10YR”) are near their lowest levels in history.

In today’s environment we recommend considering purchasing swaptions in conjunction with long term swaps to:

  1. Provide call/prepayment flexibility in the future
  2. Take advantage of the relative cheapness of swaptions
  3. Extend the term of interest rate swaps (swap providers have little or no exposure beyond the call date and therefore allow borrowers to swap beyond the term of the underlying hedged item)

The following article describes the impact of the Fed’s action on the market for interest rate volatility.

http://www.bloomberg.com/news/2012-09-20/bond-volatility-approaches-record-low-as-fed-drains-convexity.html

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