What is Swaption?

Derivative contracts have become standard financial instruments for people who either want to diversify or hedge against the losses due to unforeseen circumstances. Investors who have invested in other asset classes invest in derivatives as they allow them to earn better profits. However, as there are numerous liabilities attached to derivatives, especially an Options contract, investors use other financial tools such as Swaption to exchange the cash flows and liabilities with other financial instruments.

What are Swaps?

Swaps are derivatives contracts (contracts that derive their value from an underlying asset) where the two parties agree to exchange the liabilities or cash flows from two different financial instruments. The idea behind swaps is to protect against losses incurred due to an unfavourable event such as an interest rate hike or default.

Most Swaps include the exchange of cash flows based on a notional principal amount such as a bond or loan. However, the principal amount is not exchanged, only the liabilities or obligations. Under swaps, one cash flow is fixed while the other fluctuates based on the benchmark interest rate.

What is Swaption?

Swaption meaning is a swap contract that is created in the form of an options contract to enter into a swap contract to exchange cash flow or liabilities of two different investment instruments. Swaption gives the holder of such a contract the right but not the obligation to enter into a predefined swap contract with another party. In return, the holder of the swaption contract pays the other party (issuer of the contract) a premium. Even if the holder does not realise the right, the premium remains non-refundable and becomes the maximum loss for the holder of the swaption.

Swaptions are of two types where the purchaser has the right but not the obligation to enter into a swap options contract:

• Payers Swaption: The holder pays the fixed rate and receives the floating rate in exchange.
• Receivers Swaption: The holder pays the floating rate and receives the fixed rate in exchange.

Applications of Swaption

Swap options or swaptions are traded over-the-counter (through the broker-dealer network and not on the stock exchanges) and are not standardised. Hence, both the buyer and the seller personally set the terms and conditions of the contract and create the contract on agreed-upon terms. The investors use swaption for various applications, the most common of which is to hedge options positions on bonds. The hedging is done to adjust current derivative positions, restructure the portfolio or modify a party’s aggregate payoff profile. The entities that utilise swaption are large financial institutions such as banks, pension funds, hedge funds etc. One swaption example is to use a swaption contract to hedge against the various macroeconomic risks as a result of a change in the prevailing interest rates.

Types of Swaption

A swaption contract is of three types:

• American Swaption: The purchaser of such swaption can exercise the right of the contract on any day from the issuance of the swaption and the expiration. However, there may be a lockout period after the issuance.
• Bermudan Swaption: The purchase of Bermudan swaption allows the holder the right to exercise the swap options contract on a predetermined set of specific dates.
• European Swaption: Under the European swaption, the purchaser is allowed to exercise the swap option only on the expiration date of the swaption.

Final Word

Investors can use a Swaption agreement to ensure they limit their losses in unfavourable situations by exchanging the cash flows or liabilities with different financial instruments held by another party. The terms and conditions are mutually agreed upon by the two parties, allowing both of them to customise their investments such that they remain profitable. However, as it is important to have the swaption favourable, investors must understand in detail the swaption definition before entering a contract.

Frequently Asked Questions

What is Bermudan Swaption?

Bermuda swaption is a financial agreement which gives the holder the right to exercise the interest rate swap options contract on a predetermined set of specific dates.

How are swaptions priced?

Mostly, swaptions are valued by using the Black Model but some analysts use complex short-rate models and lattice-based term structures that describe the movement of interest rates over time.