What is 'Swaption (Swap Option)'

A swaption (swap option) is the option to enter into an interest rate swap or some other type of swap. In exchange for an option 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.

BREAKING DOWN 'Swaption (Swap Option)'

There are two different kinds of swaptions: 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 he becomes the fixed-rate payer and the floating-rate receiver. A receiver swaption is the opposite; the purchaser has the option to enter into a swap contract where he 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 and floating rates.

Beyond these terms, the buyer and seller must agree whether the swaption style will be Bermudan, European or American. These style names have nothing to do with geography, but instead with how the swaption can be executed. With a Bermudan swaption, the purchaser is allowed to exercise the option and enter into the specified swap on a predetermined set of specific dates. With a European swaption, the purchaser is only allowed to exercise the option and enter into the swap on the expiration date of the swaption. With an American-style swaption, the purchaser can exercise the option and enter into the swap on any day between the origination of the swap and the expiration date. Since swaptions are custom contracts, more creative terms are also possible.

The Swaption Market

Swaptions are generally used to hedge options positions on bonds, to aid in restructuring current positions another swaps, with structured notes, and to alter an entire portfolio or firm's aggregate payoff profile. Because of the nature in which swaptions are used, the market participants are typically large financial institutions, banks and hedge funds. Large corporations also participate in the market to help manage interest rate risk. Contracts are offered in most of the major world currencies. The large investment and 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.

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RELATED FAQS
  1. What is a Bermuda swaption?

    The Bermuda swaption refers to a modified American style of option. A swaption is an option on an interest rate swap in which ... Read Answer >>
  2. What is an over-the-counter derivative?

    Learn more about over-the-counter derivatives and how they work with an example of a derivative trade-off exchange. Read Answer >>
  3. What would motivate an entity to enter into a swap agreement?

    Learn why parties enter into swap agreements to hedge their risks, and understand how the different legs of a swap agreement ... Read Answer >>
  4. Do interest rate swaps trade on the open market?

    Learn how interest rate swaps are traded on the OTC and interbank markets, and how these swaps can be used to arbitrage different ... Read Answer >>
  5. When was the first swap agreement and why were swaps created?

    Learn about the history of swap agreements, the first swap agreement between IBM and the World Bank, and how swaps have evolved ... Read Answer >>
  6. Can bond traders trade on interest rate swaps?

    Read about interest rate swaps and why these transactions are performed by institutional actors in the bond market, not individual ... Read Answer >>
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