Swaption

Explained:

A swaption is an OTC option on a swap. Usually, the underlying swap is a vanilla interest rate swap. Unless stated otherwise, that is how we will use the tem in this article. However, the term "swaption" might be used to refer to an option on any type of swap.

In case you are wondering why anyone would want to buy a swaption, the answer is often that they don't want to. Frequently, they want to sell a swaption. Consider a corporation that has issued debt in the form of callable bonds paying a fixed semiannual interest rate. The corporation would like to swap the debt into floating rate debt. The corporation enters into a fixed-for-floating swap with a derivatives dealer. To liquidate the call feature of the debt, it also sells the dealer a swaption. For derivatives dealers, clients often want to sell them swaptions while other clients want to buy caps from them. The dealers then face the challenge of hedging the short caps with the long swaptions.

Swaptions can be for American, European or Bermudan exercise. They can be physically settled, in which case an option is actually entered into upon exercise. They can also be cash settled, in which case the market value of the underlying swap changes hands upon exercise.

To specify a swaption, we must indicate three things:

the expiration date of the option

the fixed rate on the underlying swap

the tenor (time to maturity at exercise of the option) of the swap.

The purchaser of the swaption pays an up front premium. If she exercises, there is no strike price to pay. The two parties simply put on the prescribe swap. Note, however, the fixed rate specified for the swaption plays a role very similar to that of a strike price. The holder of the swaption will decide whether or not to exercise based on whether swap rates rise above or fall below that fixed rate. For this reason, the fixed rate is often called the strike rate.

By symmetry, a call on a pay-fixed swap is the same thing as a put on a receive-fixed swap. Similarly, a call on a receive fixed swap is the same as a put on a pay fixed swap. For this reason, it is often more convenient to speak in terms of two basic forms of swaption:

A payer swaption is a call on a pay-fixed swap—the swaption holder has the option to pay fixed on a swap.

A receiver swaption is a call on a receive fixed swap—the swaption holder has the option to receive fixed on a swap.

Suppose a party purchases a 1x5 payer swaption struck at 5%. A year later, if the four-year swap rate is 6%, she will exercise the swaption and pay 5% fixed for Libor flat on a four-year swap. If instead, the four-year swap rate is 4%, she will not exercise the swaption.

Swaptions are priced using Black 76. For this purpose, the underlier is treated as a forward on a swap.