Swaption - Guide to Swap Options
A swaption, also known as a swap option, refers to an option to enter into an interest rate swap or some other type of swap. A swaption, also known as a swap option, refers to an option to enter into an interest rate swap or some other type of swap. In a payer swaption, the purchaser has the right but not the obligation to enter into a swap contract where they become the fixed-rate payer and the floating-rate receiver. A receiver swaption is the opposite i.e. the purchaser has the option to enter into a swap contract where they will receive the fixed rate and pay the floating rate. **European swaption:** the purchaser is only allowed to exercise the option and enter into the swap on the expiration date of the swaption.
What is a Swaption - Swap Option?
A swaption, also known as a swap option, refers to an option to enter into an interest rate swap or some other type of swap. In exchange for an options premium, the buyer gains the right but not the obligation to enter into a specified swap agreement with the issuer on a specified future date.
What Does a Swaption - Swap Option Tell You?
Swaptions come in two main types: a payer swaption and a receiver swaption. In a payer swaption, the purchaser has the right but not the obligation to enter into a swap contract where they become the fixed-rate payer and the floating-rate receiver. A receiver swaption is the opposite i.e. the purchaser has the option to enter into a swap contract where they will receive the fixed rate and pay the floating rate.
Swaptions are over-the-counter contracts and are not standardized, like equity options or futures contracts. Thus, the buyer and seller need to both agree to the price of the swaption, the time until expiration of the swaption, the notional amount and the fixed/floating rates.
Beyond these terms, the buyer and seller must also agree whether the swaption style will be Bermudan, European or American. These style names have nothing to do with geography; instead referring to the methodology in which the swaption will be executed.
Since swaptions are custom contracts, more creative, personalized and/or unique terms can be included in the terms.
How Does the Swaption - Swap Option Market Work?
Swaptions are generally used to hedge options positions on bonds, to aid in restructuring current positions, to alter a portfolio or to adjust a party's aggregate payoff profile. Due to the nature of swaptions, market participants are typically large financial institutions, banks and/or hedge funds. Large corporations also participate in the swaption market to help manage interest rate risk.
Swap contracts are offered in most of the major world currencies, including the U.S. Dollar (USD), Euro and British Pound. Commercial banks are generally the main market makers because the immense technological and human capital required to monitor and maintain a portfolio of swaptions is usually out of the reach of smaller-sized firms.
Related terms:
Bermuda Swaption
A Bermuda swaption is an option on an interest rate swap with a predefined schedule of potential exercise dates instead of just one date. read more
Call Swaption
A call swaption is a position on an interest rate swap that gives the holder the right to pay a floating rate of interest and receive a fixed rate of interest from the swap counterparty. read more
Derivative
A derivative is a securitized contract whose value is dependent upon one or more underlying assets. Its price is determined by fluctuations in that asset. read more
Expiration Date
The expiration date is the date after which a consumable product like food or medicine should not be used because it may be spoiled, or ineffective. read more
Extendable Swap
An extendable swap has an embedded option that allows either party to extend that swap, on specified dates, past the original expiration date. read more
Fixed Interest Rate
A fixed interest rate remains the same for a loan's entire term, making long-term budgeting easier. Some loans combine fixed and variable rates. read more
Floating Interest Rate
A floating interest rate is an interest rate that moves up and down with the rest of the market or along with an index. read more
Notional Value
Notional value is a term often used to value the underlying asset in a derivatives trade. read more
Option Premium
An option premium is the income received by an investor who sells an option contract, or the current price of an option contract that has yet to expire. read more
Over-The-Counter (OTC)
Over-The-Counter (OTC) trades refer to securities transacted via a dealer network as opposed to on a centralized exchange such as the New York Stock Exchange (NYSE). read more