What is a 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)
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; 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 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 or personalized terms are also possible.
The Swaption Market
Swaptions are generally used to hedge options positions on bonds, to aid in restructuring current positions, to alter a portfolio or a 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, including the U.S. dollar, euro, and British pound. 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.