3.2.2.10 The basics and Australian specific commentary

Set out below are the following:

  • "What is an interest rate swaption?";
  • "Preliminary issues about swaptions"; and
  • "Special issues".

What is an interest rate swaption?

A swaption is an option to enter into a new interest rate swap for either physical settlement or cash settlement. 

**This part of the Guide deals only with interest rate swaptions**

It does not deal with Transactions involving an option to vary the terms of a new Transaction, which option is given at the time the new Transaction is entered into.  In that situation it is recommended that the provisions relating to that option be set out in the Confirmation for that Transaction.

***

Preliminary issues about swaptions

To document swaptions under Australian law using the ISDA Master Agreement participants should ensure that they have executed an ISDA Master Agreement with their counterparty. 

Has the participant used ISDA documents before? If a participant is not familiar with the ISDA documents, it is recommended that they:

  • read the User's Guide and the ISDA Master Agreement;
  • read the 2.1 "ISDA";
  • read the July 1990 Addendum and the July 1990 Commentary (in doing so participants can ignore paragraphs (1), (2) and (3) of the July 1990 Addendum because they have been incorporated into the 1991 Definitions), read the Sections headed "Addenda to Standard Agreement" and "Cash Settlement Provisions" on pages vi and vii of the introduction to the 2006 Definitions and read Article 11 of the 2006 Definitions;
  • read this part of the Guide, "Interest Rate Swaptions".

If a participant is familiar with the ISDA documents, it is recommended that they start by reading this part and refer to the other portions of the Guide as necessary.

Unless otherwise stated, this commentary on swaptions is prepared on the assumption that participants use the 2006 Definitions and the 2002 ISDA Master Agreement.

A number of important changes were made to the hard-copy version of the Guide on 1 January 2002. Updates 1 to 8 in 6.1.2 "Updates as at June 30 2007" which can be found in 6.2  "History", explain these changes. It is recommended that participants carefully read these items. Take particular care in relation to the comments at the February 2005 Update to Part 5 in 6.1.2 "Updates as at June 30 2007" (ISDA Definitions booklets). 

The issues discussed in 4 "Issues", such as regulation, tax/stamp duty, netting, investment managers, novation and collateral, may also be relevant to interest rate swaption transactions.

***

Special issues

  • What is the July 1990 Addendum and is it relevant?

    The July 1990 Addendum is an addendum issued by ISDA in July 1990 to assist in documenting various types of options. It was published in conjunction with the July 1990 Commentary which explains various features of the Addendum. For documenting swaptions under Australian law participants do not need to consider the July 1990 Addendum for the reasons set out below. But it is helpful to understand what is in the July 1990 Addendum. It contains 5 paragraphs.

    Commentary on paragraphs (1) (2) and (3) of the July 1990 Addendum.  Paragraphs (1), (2) and (3) of the July 1990 Addendum contain a number of definitions and operative provisions in relation to options. Each of these definitions and provisions now is included in the 2006 Definitions.  Some vary slightly from the wording in the July 1990 Addendum. If a participant's Confirmations incorporate the 2006 Definitions, then paragraphs (1), (2) and (3) of the July 1990 Addendum need not be incorporated in a participant's ISDA Master Agreement. 

    Commentary on paragraph (4) of the July 1990 Addendum. Paragraph (4) is intended to clarify the application of the definition of Market Quotation under the 1992 ISDA Master Agreement to an Option. This is not relevant under the 2002 ISDA Master Agreement. So long as any right granted by the Option is or may become exercisable, the Option will have, in most cases, some value to the Buyer.

    Commentary on paragraph (5) of the July 1990 Addendum.  See paragraph 11 of the July 1990 Commentary.

    Paragraph (5) limits the right of the Seller to terminate Options. The argument is that, if the Buyer is fully paid and therefore the Seller has no credit exposure, the right of the Seller to terminate should be limited to when the occurrence imposes some hardship on the Seller. Paragraph (5) is not incorporated in the 2006 Definitions.

    AFMA recommends that it is preferable to give the Seller the right to terminate all swaptions. This is because it will probably be desirable for the Seller to terminate all Transactions with the Buyer immediately following an Event of Default. There is no adverse effect on the Buyer because it receives full value from the Seller for the Terminated Transactions.**Accordingly, it is recommended that participants not include paragraph (5) of the July 1990 Addendum in their ISDA Master Agreement** 

    However, when this approach is followed it is recommended that an additional clause relating to conditions precedent be included in the Master Agreement. See 2.1.4.70.9 "Amended Condition Precedent or Additional Termination Event". 
  • What is the Australian Addendum No. 2 Swaptions and is it relevant?

    Until 1 January 2002 AFMA recommended using Australian Addendum No. 2 - Swaptions. This is no longer recommended. The reasons for this together with a copy of the Addendum and commentary on it are in 6 "History" (see pre-February 2005 revision). See also Update 1 in 6.1.2 "Updates as at June 30 2007".

Last Update Date 29 Jun 2011