Everything you need to know about Swaptions

Meaning, Types, Features, Use, Category & Bottomline

Sep 03, 2022

What is Swaptions ?

An interest rate Swaptions 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.

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Types of swaption contracts

There are two types of swaption contracts: -

A fixed rate payer swaption gives the owner of the swaption the right but not the obligation to enter into a swap where they pay the fixed leg and receive the floating leg.
A fixed rate receiver swaption gives the owner of the swaption the right but not the obligation to enter into a swap in which they will receive the fixed leg, and pay the floating leg.

Features of Swaptions

A swaption is effectively an option on a forward-start IRS, where exact terms such as the fixed rate of interest, the floating reference interest rate and the tenor of the IRS are established upon conclusion of the swaption contract.
A 3-month into 5-year swaption would therefore be seen as an option to enter into a 5- year IRS, 3 months from now.
The 'option period' refers to the time which elapses between the transaction date and the expiry date.
The swaption premium is expressed as basis points.
Swaptions can be cash-settled; therefore at expiry they are marked to market off the applicable forward curve at that time and the difference is settled in cash.

Use of the Swaptions

Swaptions can be applied in a variety of ways for both active traders as well as for corporate treasurers.
Swap traders can use them for speculation purposes or to hedge a portion of their swap books.
Swaptions have become useful tools for hedging embedded optionality which is common to the natural course of many businesses.
Swaptions are useful to borrowers targeting an acceptable borrowing rate.
Swaptions are also useful to those businesses tendering for contracts.
Swaptions also provide protection on callable/puttable bond issues.

Categories of Swaption Styles

There are three main categories of Swaption, although exotic desks may be willing to create customized types, analogous to exotic options, in some cases. The standard varieties are

Bermudian swaption, in which the owner is allowed to enter the swap on multiple specified dates.
European swaption, in which the owner is allowed to enter the swap only on the expiration date. These are the standard in the marketplace.
American swaption, in which the owner is allowed to enter the swap on any day that falls within a range of two dates.