Description:-
A Swaption is a financial instrument granting the owner an option to enter into an Interest Rate Swap. A swaption gives the buyer the right but not the obligation to pay/receive a fixed rate on a given date and receive/pay a floating rate index. If the strike rate of the swap is more favorable than the prevailing market rate, then the swaption will be exercised. If a swaption is not exercised on maturity, it expires worthless. There is also a premium, which is paid by the buyer for the right to pay/receive a fixed rate on the swap at a future date. It hedges against the buyer’s downside risk, and also lets the buyer tale advantage of the upside benefits.
If the buyer of the option has the right to pay fixed rate and receive floating then it is referred to as a Payer Swaption. In this case, the buyer will benefit if the interest rate rises and the loss would be limited to the extent of the premium paid. A second type of a swaption is termed as a Receiver Swaption. This is a right for the buyer to receive fixed rate and pay floating rate. The buyer will benefit if the interest rate decreases. Premium paid would be the loss to the buyer of the option.
American swaption – the owner of the option is allowed to enter the swap on any day that falls within a range of two dates.
European swaption – the owner of the option is allowed to enter the swap only on the maturity date.
Bermudan swaption – the owner of the option is allowed to enter the swap only certain dates that fall within a range of the start (roll) date and end date.
Example:-
ABC company has a 10 year floating rate loan to run their business. They have a deal with XYZ Company to sell 4-5 tractors to them every year for next 10 years. Price is set on the contract for next 10 years. ABC needs to lock on the interest rates as if it goes up they will pay lots of money in interest payments towards their loan. ABC feels rate will go up in short term however XYZ company believes rates are going to stay low. They both agree to do a swaption and manage their risk better
Why are they traded?
Large corporations, banks, financial institutions and hedge funds normally trade Swaptions to manage their interest rate risk. For example, a large corporate wanting protection from rising interest rates might buy a payer swaption. A bank which holds a mortgage portfolio might buy a receiver swaption to protect against lower interest rates which might lead to early prepayment of the mortgages. A hedge fund believing interest rates will not rise by more than a certain amount might sell a payer swaption aiming to make money by collecting the premium. Swaption markets exist in most of the major currencies in the world, the largest markets being in U.S. Dollars, Euro, Sterling and Japanese Yen.
Life cycle events: –
Premium and Pay off’s. Once Swaption is exercised then we exchange the interest amounts on the underlying swap.
OTCWIRE 