## Swap option

#### General

It is a kind of interest rate option: It endows the buyer with the right to initiate a transaction of interest rate swap per postulated conditions. Swap option has the same characteristics with other options. The buyer of options pays option fees and is endowed with absolute right to determine whether to transact per agreed price or not. The seller receives option fees and is obliged to transact unconditionally per agreed price.

#### Features

The non-linear risk characteristics of option products make many choices available for assets and debt management. The purchase of swap option may provide more flexibility and better adaptation to market changes. The sale of swap option and waiver of flexible calculation methods of interest in the future provide the possibility of benefiting from the price higher than that of the current market price.

#### Conditions for application

Customers who meet the stipulations of related policies.

#### Interest rate swap price

The trade price shall be subject to the trade price at each branch of CGB.

#### Cases

**1. A case of purchase of swap option**

A company borrows a 5-year loan of floating interest rate, which is 6-month LIBOR＋2%. Currently, 6-month LIBOR falls to a low level, merely 1.7625%. The company predicts that LIBOR will still be kept a relatively low level in the next two years and its loan cost will be lower. The company worries that the interest rate may rise three years later, so it enters into an agreement on swap option with the bank to evade the risk of rising interest rate three years later. The agreement is as follows: The company purchases a 2 × 3 (it means that the term of swap option is 2 years and the term of swap after exercise of swap option is 3 years) swap option. The exercise price is 3.7625% of European fixed interest rate for payment of swap option (that is, after the exercise of option, the company pays 3.7625% of fixed interest rate and receives 6-month LIBOR interest rate). The option fees paid by the company are 0.5%/year for a total of 5 years.

In the first two years, the loan cost of the company is still: 6-month LIBOR + 1.7625%. Taking account of option fees, the actual cost is 6-month LIBOR + 2.2625%.

Two years later, if the interest rate rises higher than 3.7625%, the company will exercise option. The actual loan cost of the company in the last three years will be as follows:

Original loan cost of the company? -(6-month LIBOR＋2%)

Floating interest rate of swap income +6-month LIBOR

Fixed interest rate of swap payment -3.7625%

Payment of swap option fees -0.5%

The actual loan cost of the last three years is 6.2625%.

Three years later, if the interest rate does not rise higher than 3.7625%, the company will not exercise swap option, and the loan cost will still be 6-month LIBOR + 2%. Taking account of option fees, the actual cost is 6-month LIBOR+ 2.5%.

If the interest rate rises significantly 2 years later, the company will assume greater financing cost compared with those companies that are not engaged in swap option. For example, if 6-month LIBOR rises up to 5.5%, the original loan cost will be 7.5%, which is higher than 6.2625%, the actual cost after engagement of swap option.

**2. A case for sale of swap option**

A company holds bonds of 8-year term with the earning rate of 12-month LIBOR. Currently the 12-month LIBOR is about 2%. The company wishes to realize the earning higher than the level of LIBOR and the company considers that LIBOR will not rise higher than 6.5% in 3 years. Therefore the company reaches an agreement on swap option with the bank. The agreement is as follows: The company sells a 3 × 5 (it means that the term of swap option is 3 years and the term of swap after exercise of swap option is 5 years) swap option. The exercise price is 6% of European fixed interest rate for payment of swap option (that is, after the exercise of option, the company pays 12-month LIBOR interest rate and receives 6% of fixed interest rate). The option fees paid by the company are 0.5%/year for a total of 8 years.

For the first 3 years, the earnings of the company are: 12-month LIBOR+ 0.5%

3 years later, if the interest rate rises, the sale of option will be executed. Therefore, the earnings of the company for the last 3 years will be as follows:

Company’s yield of bonds? + the LIBOR of 12 months

Fixed interest rate of swap income +6%

Floating interest rate of swap payment -the LIBOR of 12 months

Receipt of swap option fees +0.50%

The net income of the last 3 years is 6.50%.

Three years later, if the interest rate falls, the swap option will not be exercised, and the company’s earnings will be maintained at the LIBOR of 12 months + 0.5%.

Therefore we come to the conclusion that the company 1) enhances the earnings of current investment to the level higher than that of the market; 2) enhances the earnings of future investment to the level higher than that of the current market through sale of swap option with the payment of fixed interest rate.

#### Kind Reminders

If unfavorable rate trend appears after the sale of option, the seller may suffer losses therein. In the above case, if the market interest rate rises higher than 6.5% in 3 years, the net earnings of the company are still 6.5%. Thus the company will lose the income arising from the interest portion of higher than 6.5%.

#### Related Financial Instruments

FCY deposit interest rate

Inquiry at banking outlets