What is a Swaption?
A swaption is an option to enter into an interest rate swap. In a receiver swaption, or the put swaption, the buyer enters into a forward swap to receive fixed and pay floating interest rates. In a payer swaption, or the call swaption, the buyer enters into a forward swap to pay fixed and receive floating interest rates. In the usual Black’s model for the swaption the strike price is , the fixed rate. Thus the payoff of a payer swaption becomes: ……………………………………..(1) Where, L is the floating rate and K is the fixed rate. But the option has a maturity and at maturity both the fixed rate and the floating rate will have some value that is not known today. If at maturity the value of the fixed rate is say, and the value of the floating rate is then the payoff function for a payer swaption should actually be: ……….(2) In the above payoff function, , the value of the fixed interest rate is used as a strike price rather than simply, which is the fixed interest r
Swaptions are options that grant the owner a right to enter into an underlying swap, but do not require the owner to actually engage in the swap process. Generally, the use of the identification of a swaption is reserved to refer to options that involve interest rate swaps. There are essentially two types of swaption strategies that are in common use. The first is referred to as a payer swaption. This form of swaption provides the owner of the option 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 concept of a swaption is the receiver method. This approach is the opposite of the payer swaption. With this type of call swaption, the owner can enter into a swap situation where he or she will receive a fixed leg and pay a floating leg. Regardless of the type of swaption involved, there are several points that the buyer and the seller both agree to as p
Interest rate swaptions give the holder the right, but not the obligation, to enter into or cancel a swap agreement at a future date. The buyer may purchase either the right to receive a fixed rate in the underlying swap or to pay the fixed rate. Managing Liabilities with Swaptions Financial managers buy or sell swaptions to hedge future interest rate exposures or manage borrowing costs: • Hedge Contingent Financing. A company’s future financing needs may be uncertain, or contingent upon other events. A swaption provides protection against rising rates without obligating the purchaser in the event the financing doesn’t materialize. • Lower Borrowing Costs. One way to reduce financing costs is to use swaptions to monetize points of indifference. For example, an active issuer of debt in several maturities may be indifferent at any point in time to issuing in one maturity versus another. A company indifferent between three- and five-year debt can combine the issue of three-year fixed- rat
