Swaptions are options to enter into an underlying swap without committing to it. There are two types: payer and receiver swaptions. Both parties agree on fixed strike rate, premium, option period, depreciation calculation, and frequency of payments. Swaptions are used by large corporations, banks, brokerage firms, and hedge funds to manage interest rate risk. Swaption markets exist in major currency markets.
Swaptions are options that grant the owner the right to enter into an underlying swap, but do not require the owner to actually commit to the swap process. Generally, the use of a swaption identifier is reserved to refer to options involving interest rate swaps.
There are essentially two types of swaption strategies in common use. The former is referred to as a payer swaption. This form of swaption provides the option holder with the ability to enter into the swap and pay a fixed leg while receiving a floating leg. This approach is sometimes referred to as a fixed rate payer swaption.
A second approach to the swaption concept is the receiver method. This approach is the opposite of payer swaption. With this type of call swaption, the owner can enter into a swap situation where he will receive a fixed leg and pay a variable leg.
Regardless of the type of swaption involved, there are several points the buyer and seller agree on as part of the transaction. Firstly, both the strike rate and the premium are considered fixed. Next, the length of the option period is set, based on terms acceptable to both parties. Often this is within two business days before the underlying wrap start date for the swaption. If depreciation is envisaged in the options, the two parties agree on the method of calculation in question. Finally, the seller and buyer agree on the frequency of payments associated with the underlying swap.
A swaption usually does not involve the individual investor. Instead, it is more common for investors engaging in swaptions to be large corporations, banks or brokerage firms, and possibly hedge funds. Using swaption has a fair amount of appeal, since the strategy can be used to manage the amount of interest rate risk associated with banks and other types of financial institutions. Swaption markets exist in most of the world’s major currency markets, especially those associated with the US dollar, euro and Japanese yen.
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