Swaption

A swaption is an option granting its owner the right but not the obligation to enter into an underlying swap. Although options can be traded on a variety of swaps, the term "swaption" typically refers to options on interest rate swaps.

There are two types of swaption contracts:

A payer swaption gives the owner of the swaption the right to enter into a swap where they pay the fixed leg and receive the floating leg.
A receiver swaption gives the owner of the swaption the right to enter into a swap where they will receive the fixed leg, and pay the floating leg.

The buyer and seller of the swaption agree on:

the premium (price) of the swaption
the strike rate (equal to the fixed rate of the underlying swap)
length of the option period (which usually ends two business days prior to the start date of the underlying swap),
the term of the underlying swap,
notional amount,
amortization, if any
frequency of settlement of payments on the underlying swap

The swaption market

The participants in the swaption market are predominantly large corporations, banks, financial institutions and hedge funds. End users such as corporations and banks typically use swaptions to manage interest rate risk arising from their core business or from their financing arrangements. For example, a corporation 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. Major investment and commercial banks such as Banc of America Securities, Morgan Stanley, Goldman Sachs, Lehman Brothers and Citibank make markets in swaptions in the major currencies, and these banks trade amongst themselves in the swaption interbank market. The market making banks typically manage large portfolios of swaptions which they have written with various counterparties -- a significant investment in technology and human capital is required to properly monitor the resulting exposure. 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.

The swaption market is over-the-counter (OTC), i.e., not traded on any exchange. Legally, a swaption is an agreement between the two counterparties to exchange the required payments. The counterparties are exposed to each others' failure to make scheduled payments on the underlying swap, although this exposure is typically mitigated through the use of "collateral agreements" whereby margin is posted to cover the anticipated future exposure.

Properties

Unlike ordinary swaps, a swaption not only hedges the buyer against downside risk, it also lets the buyer take advantage of any upside benefits. Like any other option, if the swaption is not exercised by maturity it expires worthless.

If the strike rate of the swap is more favorable than the prevailing market swap rate then the swaption will be exercised as detailed in the swaption agreement.

It is designed to give the holder the benefit of the agreed-upon strike rate if the market rates are higher, with the flexibility to enter into the current market swap rate if they are lower.
The converse is true if the holder of the swaption receives the fixed rate under the swap agreement.

Investors can also use swaptions to trade the volatility of the underlying swap rate.

An example

An example illustrating the use of swaptions is: Joe is in Mexico and he knows there's an election coming up. Joe has some variable rate bonds that are paying very well, but would like to hedge against the risk of political upheaval. Dave is in the UK and rates are low and constant. Dave would like some extra money and thinks that political change will not affect the rates too significantly. In this case, Joe would wish to purchase a swaption from Dave.

Joe and Dave engage in a swap; Joe gets fixed cash flows from the UK bond and Dave gets the variable rate bonds. They agree on terms that set the swap as even money (present valued) for both of them. However, they don't do the swap yet because Joe's debt is about to expire and he is going to reinvest, and he only wants to do the swap if the variable rates drop below a threshold (at which point his income goes down; he wants to lock in profits). In order to lock in the profits, Joe's willing to arrange the option on slightly favorable terms with Dave. Dave wants the higher temporary cash flow and if the variable rates go down (which he doesn't think will happen) and is willing to live with a little risk.

Everyone is happy; the swaption can be exercised and both people may still make a profit, depending on the timing and amounts involved. At the very least, both parties either reduced or enhanced their risks/rewards as they desired.

Another example

Here is another scenario: Doug's Tractor Company needs to engage in a swap for the following reason: They have too much risk. They have a 5 year adjustable rate business loan that they've used to buy machines to make tractors. They've just agreed to sell 10 tractors to Jimbob's Tractor Dealership at the rate of 2 per year for 5 years (they don't sell fast, etc.). The price for the tractors is set in the contract and cannot be renegotiated.

The problem is, if the interest rates go up, Doug has to pay lots of money in interest payments, and he loses money on the transaction. He needs to lock in an interest rate, even if it's a little above the current rate.

Across town, Stanley's Tire Co. owns a mortgage on their offices, that he cannot pay off for tax reasons and due to various legal problems tying up ownership of the property. However, he's locked into a higher long-term rate mortgage loan. He wants to reduce his rates.

Both of them have an opinion about the way short term rates are going to go. Stanley thinks short term rates are going to stay low, and wants to pay less. Doug thinks they're going higher than Stanley's fixed rate. But Doug only needs to do the swap if the rates get that high. Stanley agrees to a swaption. Both are making a bet, and it should help them manage risk better.

Swaption styles

There are three styles of Swaptions. Each style reflects a different timeframe in which the option can be exercised.

American swaption, in which the owner is allowed to enter the swap on any day that falls within a range of two dates.
European swaption, in which the owner is allowed to enter the swap only on the maturity date.
Bermudan swaption, in which the owner is allowed to enter the swap only certain dates that fall within a range of the start (roll) date and end date.

Valuation

The valuation of swaptions is complicated in that the result depends on several factors: the time to expiration, the length of underlying swap, and the "moneyness" of the swaption. Here the "at the money" level is the forward swap rate, the forward rate that would apply between the maturity of the option (t) and the tenor of the underlying swap (T) such that the swap, at time t, has an "NPV" of zero; see swap valuation. For an at the money swaption, the strike rate equals the forward swap rate, and "moneyness" therefore is determined based on whether the strike rate is higher, lower, or at the same level as the forward swap rate.

Given these complications, quantitative analysts attempt to determine relative value between different swaptions, in some cases by constructing complex term structure and short rate models which describe the movement of interest rates over time.

However a standard practice - particularly amongst traders where speed of calculation is more important - is to value European Swaptions using the Black model, where, for this purpose, the underlier is treated as a forward contract on a swap. Here:

The forward price is the forward swap rate.
The volatility is typically "read-off" a two dimensional grid of at-the-money volatilities as observed from prices in the Interbank swaption market. On this grid, one axis is the time to expiration and the other is the length of the underlying swap. Adjustments may then be made for moneyness; see Implied volatility surface under Volatility smile.

First known swaption

The first known swaption was constructed and executed by William Lawton in 1983.^{[dubious – discuss]} Lawton was the Head Trader for Fixed Income Derivatives at First Interstate Bank in Los Angeles at that time. Lawton worked with First Interstate's Treasury Options Desk to marry the concept of an interest rate swap and an options contract. The swaption was for a period of one year. First Interstate, for a premium, sold a Los Angeles based savings and loan the right to enter into a five year interest rate swap to pay fixed versus three month Libor on a notional amount of $5 million.

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