This is the best explanation that I’ve read about American Capital Agency Corp’s (AGNC) swaptions. They are important because AGNC made a chunk of their 4Q2010 earnings on swaptions. The rest of the article lavished AGNC with praise. I believe that AGNC will lose its ability to pay its hefty dividend when the next financial crisis hits.
Here is one definition of a swaption I found using the Google search term “define: swaption”
A swaption is an option granting its owner the right but not the obligation to enter into an underlying swap. Although options can be traded on a variety of swaps, the term "swaption" typically refers to options on interest rate swaps.
en.wikipedia.org/wiki/Swaption
“American Capital Agency’s fourth quarter results were positively affected by non-recurring net realized and unrealized gains on its derivative instruments, and net realized gains on available-for-sale securities. The derivative instruments, such as to-be-announced (TBA) mortgage short positions and payer swaptions, are primarily utilized by the company to hedge increases in interest rates.”
The Wikipedia entry explains that there is counterparty risk to each swaption. Keep counterparty risk in mind when you read about how AGNC made money in 4Q2010. AGNC doesn’t disclose which banks it enters into swaptions contracts with. Imagine what would have happened if they entered into swaption with AIG. That would simply be trading interest rate risk with counterparty risk.
From the Wikipedia entry: “The swaption market is over-the-counter (OTC), i.e., not traded on any exchange. Legally, a swaption is an agreement between the two counterparties to exchange the required payments. The counterparties are exposed to each others' failure to make scheduled payments on the underlying swap, although this exposure is typically mitigated through the use of "collateral agreements" whereby margin is posted to cover the anticipated future exposure.”
“A payer swaption is a tool to enter into an interest rate swap where the buyer pays fixed rate and receives floating, thereby benefiting from interest rate rises. The initial cost of the swaption comes in the form of a premium, and this is the maximum amount the buyer can lose.”
“The participants in the swaption market are primarily large corporations, banks, financial institutions and hedge funds, who typically utilize swaptions to manage interest rate risk arising from their financing arrangements.”
“Agency lenders such as American Capital, which holds a mortgage portfolio, purchases payer swaptions to protect against lower interest rates that might lead to early prepayment of the mortgages. This measure ultimately facilitates the company to continue making money by collecting premium.”
Here is the link to the original article: http://www.dailymarkets.com/stock/2011/02/14/american-capital-agency-4q-rocks/
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