Swaptions
A swaption is a type of option that gives the holder the right to engage in a swap, usually an interest rate swap.
If the swaption holder has the right to engage in a swap in which it pays the fixed interest rate and receive the floating rate, it is known as a payer swaption.
If the swaption holder has purchased the right to receive the fixed interest rate and pay the floating rate, it is known as a receiver swaption.
For example, Goodville buys a swaption from Great Bank that gives Goodville the right to enter an interest rate swap in the next two years. Goodville will pay a 5% rate to Great Bank, and Great Bank will pay Goodville a LIBOR + 2% rate. Goodville will pay Great Bank a premium to engage in this option over the life of the swaption. If Goodville does exercise the option, Great Bank is obligated to carry out the swap. Great Bank will get to keep the premium regardless of whether the swaption is exercised or not. If interest rates rise, Goodville will exercise the option and profit from the lower fixed rate. If interest rates remain the same or decline, Goodville will not choose to exercise the swaption, and it will lose the price of the option. Thus, Goodville will purchase the option to hedge against a rise in interest rates. It has essentially bought protection against a rise in interest rates without having to engage in a potentially risky swap contract. Like swaps, swaptions are used to hedge against changing interest rates, but they allow for greater flexibility because the holder of the swaption is never required to enter into the swap.