NatCity Investments, Inc.

Derivative Products Group Interest Rate Swaptions

Definition: An interest rate swaption is simply an option on an interest rate swap. It gives the holder the right but not
the obligation to enter into an interest rate swap at a specific date in the future, at a particular fixed rate
and for a specified term. For an up-front fee (premium), the customer selects the strike rate (the level at
which it enters the interest rate swap agreement), the length of the option period, the floating rate index
(Prime, LIBOR,C.P.), and tenor.

How it Works: The buyer and seller of the swaption agree on the strike rate, length of the option period (which usually
ends on the starting date of the swap if swaption is exercised), the term of the swap, notional amount,
amortization, and frequency of settlement. A swaption gives the buyer the right but not the obligation to
pay (receive) a fixed rate on a given date and receive (pay) a floating rate index. It is designed to give the
holder the benefit of the agreed upon strike rate if the market rates are higher, with the flexibility to enter
into the current market swap rate if they are lower. The converse is true if the holder of the swaption
receives the fixed rate under the swap agreement. If the strike rate of the swap is more favorable than the
prevailing market swap rate then the swaption will be exercised and National City and the customer enter
into an interest rate swap (please see sheet entitled “Interest Rate Swaps”) as detailed in the swaption
agreement. Unlike ordinary swaps, a swaption not only hedges the buyer against downside risk, it also lets
the buyer take advantage of any upside benefits. Like any other option, if the swaption is not exercised by
maturity it expires worthless.

Types: Swaptions fall into three main categories, depending uon the exercise rights of the buyer:
• European Swaptions give the buyer the right to exercise only on the maturity date of the option.
• American Swaptions, on the other hand, give the buyer the right to exercise at any time during the
option period.
• Bermudan Swaptions give the buyer the right to exercise on specific dates during the option period.

Example: A customer has a $10MM obligation due in 5 years on a non-amortizing loan with National City, paying 3
mo. LIBOR + 200 bps. LIBOR is currently at 5.75%. The company is exposed to the risk of fluctuating
interest rates. The customer has reason to believe that LIBOR will stay low for the next two years. After
the two year time period however, the outlook is at best uncertain. The customer would like to hedge this
risk but is not sure if the current swap rate is the best available. The customer wants to lock in the swap
rate in two years time for the following three years and have the flexibility to benefit from a lower swap rate
should swap rates fall. This is achieved by buying a 2 year option on a 3 year pay fixed 7% swap. The
decision that the customer will have to face in two years is illustrated below:

time (years) 0 2 Exercise Date: 5

Customer buys a -If 3-year swap rate is above 7%, swaption is exercised - Customer pays
swaption fixed (7%), and receives floating.
Customer pays -If 3-year swap rate is below or equal to 7%, swaption does not get
floating on loan exercised
-Customer pays floating on loan or enters into a 3 yr. pay fixed swap

Following is a graphic representation of what happens under two different scenarios. The customer is
hedged against rises in interest rates and enjoys the full benefits of falling rates.
 NatCity Investments, Inc.
Derivative Products Group Interest Rate Swaptions

Buyer Exercises Buyer Does Not Exercise

At the exercise date, since the 3-yr. swap rate is At the exercise date, since the 3-yr. swap rate is below
above the strike rate, the buyer chooses to the strike rate, the buyer does not exercise the
exercise the swaption. swaption and has the flexibility to enter into a 3-yr.
swap at current rates and enjoys the benefits of

Termination: Please see the Section titled “Unwinding Interest Rate Hedge Transactions.”

Documentation: Swaptions are documented by executing generic ISDA Master Agreements. Amendments or additions to
the Master Agreement are outlined in the Schedule to the Master Agreement. Specific terms and
conditions of a trade are documented using a Trade Confirmation. In addition, certificates of incumbency
for both counterparties must be executed.

Indices: Swaptions can be priced on several indices, with different interest calculation bases:

Index Days Basis Terms

Prime Actual/360 1 - 10 Yrs. *.
LIBOR Actual/360
PSA/BMA Actual/365 *On an exception
CP Actual/360 or Actual/365 basis past 10
US Treasuries Actual/365 Years

Contacts: Please call the Derivative Products Group for more information.
(216) 575-9922