An option contract called a swaption, also called a swap option, gives its holder the right but not the responsibility to participate into a predefined swap contract. The owner of the swaption must give the contract's issuer a premium in exchange for the right. The rights to engage in interest rate swaps are normally provided via swaptions, but other types of swaptions can also be created.
Swaptions are more similar to swaps than to options in terms of their trading features. Swaptions, for instance, are over-the-counter instruments that resemble swaps. In other words, rather than being traded on centralized exchanges, derivative contracts are transacted over-the-counter. Additionally, because the contracts are not provided in a standardized format, swaptions have a high degree of freedom.
Prior to the transaction, the counterparties in a swaption must agree on all of the contract's terms. For instance, the parties decide the amount of the swaption (sometimes referred to as the premium on the swaption) and the duration of the option.
The elements of the underlying swap must also be decided by the counterparties. The notional amount, the swap's legs (fixed vs. float), and the frequency of adjustment for the variable leg are the aspects that are typically mentioned. Also, the benchmark for the floating leg of a swap is decided by the counterparties.
Swaptions are typically used to amend a party's aggregate payment profile, help restructure present positions, hedge options bets on bonds, or change a portfolio. Owing to the nature of swaptions, major financial institutions, banks, and/or hedge funds are frequent market participants. To assist manage interest rate risk, large organizations also participate in the swaption market.
The U.S. Dollar (USD), Euro, and British Pound are just a few of the major foreign currencies in which swap contracts are available. Due to the enormous technology and human resources needed to monitor and maintain a portfolio of swaptions, commercial banks are typically the primary market makers. Smaller businesses typically cannot afford such resources.
Based on the types of legs included in the expected swap contract, swaptions are categorized. According to this classification, payer swaption and receiver swaption are the two main categories of swaption.
The buyer of a payer swaption gains the ability to enter into a swap contract, meaning that they will get the floating swap leg in return for the fixed swap leg.
Instead, the receiver swaption gives the holder of a swap the option, but not the responsibility, to join into a swap contract in which the fixed swap leg is exchanged for the floating swap leg.
Swaption contracts have many execution styles, just like standard options do. In other words, separate swaptions have different terms that specify the dates on which they can be exercised. European, American, and Bermudan styles are the most often used swaption types.
- European swaption: A swaption which may only be exercised on the exercise day.
- American swaption: A swaption that is exercisable not only on the exercise date, but also on any date between the origination and exercise dates.
- Bermudian swaption: A swap that has multiple preset dates between the origination and exercise dates where it may be exercised.
In order to choose the best valuation approach, it is essential to consider swaptions styles. For instance, the Black valuation model is frequently used to evaluate swaptions in the European style. On the other hand, Black-Derman-Toy or Hull-White models are typically used to price American and Bermudan swaptions, which are seen to be more complex than European options.