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:
The buyer and seller of the swaption agree on:
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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 that holds a mortgage portfolio might buy a receiver swaption to protect against lower interest rates that might lead to early prepayment of the mortgages. A hedge fund believing that 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 JP Morgan Chase, Bank of America Securities and Citigroup 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 that 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.
From the point of view of the payer, swaptions increase in value with the volatility of the underlying swap rate, with curve steepness, and with the absolute level of the rate curve. For the receiver, the opposite is true. As with any other option, if the swaption is not exercised by maturity, it expires worthless.
There are three main categories of Swaption, although exotic desks may be willing to create customised types, analgous to exotic options, in some cases. The standard varieties are
The valuation of Swaptions is complicated in that the at-the-money level is the forward swap rate, being the forward rate that would apply between the maturity of the option - time m - and the tenor of the underlying swap such that the swap, at time m, would have an "NPV" of zero; see swap valuation. Moneyness, therefore, is determined based on whether the strike rate is higher, lower, or at the same level as the forward swap rate.
Addressing this, quantitative analysts value swaptions by constructing complex lattice-based term structure and short rate models that describe the movement of interest rates over time.[1] [2] However, a standard practice, particularly amongst traders, to whom speed of calculation is more important, is to value European swaptions using the Black model. For American- and Bermudan- styled options, where exercise is permitted prior to maturity, only the lattice based approach is applicable.
The first known swaption was constructed and executed by William Lawton in 1983. 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 adapt 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 [source needed]
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