Swaptions
A swaption is a type of option that gives the holder the right to engage in a swap, usually an interest rate swap. It is important to note that the swaption holder has the right, but not the obligation, to enter into the swap, and the holder will pay a premium for this right. The holder has the right to exercise the swaption on a particular date or during a period of time at a specified rate called the strike rate.
If the swaption holder has the right to make fixed payments and receive variable payments, it is known as a payer swaption.
If the swaption holder has the right to make floating payments and receive fixed payments, it is known as a receiver swaption.
|
Position |
Description |
Price |
|
Long payer swaption |
Right to make fixed-rate payments and receive variable-rate payments |
Pays premium |
|
Long receiver swaption |
Right to make variable-rate payments and receive fixed-rate payments |
Pays premium |
|
Short payer swaption |
Obligation to make variable-rate payments and receive fixed-rate payments |
Receives premium |
|
Short receiver swaption |
Obligation to make fixed-rate payments and receive variable-rate payments |
Receives premium |
For example, let’s assume that the town of Goodville has issued variable-rate debt, but Goodville managers are worried that the Fed is going to raise interest rates, requiring the town to pay higher interest payments to their bondholders in the future. Goodville decides to hedge this risk by buying a swaption. Goodville buys a swaption from Great Bank, who gives Goodville the right to enter into a three-year in