Swaptions as the name implies, are options on swaps which gives the holder the right to enter into an interest rate swap at some later date. The notation for swaptions is similar to FRA's. If there is a 3 x 5 swaption it is an option that matures in 3 years and gives the holder the right to enter into a 2 year swap after expiration. One important thing to understand is the option gives the holder the right to enter into a swap, and it depends upon the discretion of the holder, not a binding commitment. The predetermined fixed rate of the swap (at the time of swaption) is called the strike rate or exercise rate.
Swaptions could be of two types Payer Swaptions and Receiver Swaptions. The former gives the holder the right to enter into a specific swap at some future date as the fixed rate payer and floating rate receiver whereas the latter gives the holder the right to enter into a swap to receive fixed rate and pay floating rate based upon LIBOR. Holder of the Payer swaption (European) exercises if swap fixed rate in the market is greater than the strike rate whereas Holder of the Receiver swaption (European) exercises the option if swap fixed in the market at expiration is less than the strike rate.
Swaptions can be either American, which can be exercised at any time prior to expiration, and European which can only be exercised at expiration. The price of the swaption is the premium which is an amount paid by the buyer to the seller upfront. As options are asymmetrical, this is the only loss which can be borne by the option buyer.
Swaptions could be exercised in many ways. If someone has floating rate debt in some future time he could enter into a payer swaption to lock in the fixed rate. If some one expects the rates to rise in the future and on the other hand some one expects the rates to fall, the former can buy the payer swaption while the latter can buy a receiver swaption. Moreover in order to Terminate an existing Swap one could enter into a swaption. The pay fixed swap could be terminated by exercising a receiver swaption whereas the received fixed swap can be terminated by exercising a payer swaption. A fixed rate payer, for example, on a 5 year swap could buy a 3 x 5 receiver swaption if he would like to terminate swap after 3 years.
The holder of a payer swaption can exercise it in the following ways:
1. The holder can exercise the swaption by paying the predetermined fixed rate.
2. The holder can exercise the swaption and then enter into a swap in the market to receive fixed and pay floating. This will cancel out the floating payments and the holder of the payer swaption will pay fixed and receive fixed. Both the swaps would be with different parties. The credit risk is maximum in this way.
3. The holder can exercise the swaption with offsetting swap netted. This could be done by entering into an offsetting swap with the same party with whom the swaption had been done. In this case the difference of the fixed rate of swaption and the fixed market rate of the new swap will be received by the swaption holder.
4. Cash Settlement. This is the most common way and the holder can receive an up-front cash payment which is equal to the Present value of net payment streams. The discount factors used are based upon the prevailing LIBOR rates at the time when swaption expires.
At expiration the value of the payer swaption is the maximum of zero and the present value of a stream of payments equal to the fixed-rate payments on a current market rate swap minus the fixed-rate payments on the swaption swap. Whereas at expiration the value of the receiver swaption is the maximum of zero and the present value of a stream of payments equal to the fixed-rate payments on the swaption swap minus the fixed-rate payments on a current market rate swap.
Irrespective of the trickiness and complexity related with swaps, they are excellent tools to hedge risk and reduce uncertainty. If we visualize ourselves as actually involved in swaps and hedging risk; we can develop in-depth understandings of such financial instruments. Knowing them and being able to apply them can add real value to our skills and improve our capabilities significantly.