Definition: an option to enter into a swap at a fixed rate.

The most widely used swaption is the plain vanilla interest rate swaption. It allows the holder to establish a fixed rate on the underlying swap in advance and have the option of entering into the swap with that fixed rate or allowing the swaption to expire and entering into the swap at the fixed rate that prevails in the market.

Basic characteristics of swaptions.

• Types:
  • Payer swaption: an option to enter into a swap as a fixed-rate payer.
  • Receiver swaption: an option to enter into a swap as a fixed-rate receiver.

• Expiration date: Swaptions can be European style (exercisable only at expiration) or American style (exercisable at any time prior to expiration).

• Underlying: A swaption is based on a specific underlying swap. For example, MPK considers the need to engage in a $10 million three-year swap in two years. Worried about rising rates, it buys a payer swaption at an exercise rate of 11.5 percent. Swap payments will be annual. The underlying can be viewed as a five-year swap at the time the swaption is initiated, and will be a three-year swap when the swaption expires.

• Price: A swaption has a price or premium, which is an amount paid by the buyer to the seller up front.

• Settlement: there are a number of ways to settle a swaption at expiration.

Uses of swaptions.

• Anticipation of the need for a swap in the future.
  Parties often expect to need a swap later and would like to hedge against unfavorable interest rate moves while preserving the flexibility to gain from favorable moves.

• Anticipation of the need to terminate an already existing swap.
  A party may wish to terminate an existing swap before expiration. Suppose a party in a swap is paying fixed and receiving floating. If it owned a receiver swaption, it could exercise the swaption, thereby entering into a swap to receive fixed rate a pay a floating rate. It would then have offset the floating parts of the swap, effectively removing any randomness from the position.

• Speculating on interest rates.
  As with any interest rate sensitive instrument, swaptions can be used to speculate. Their prices move with interest rates and they contain significant leverage like all options.