Today, I was thinking, what to write on and was confused whether to discuss on some current market situation or to go with some basic concept again for our finance freshers. And, finally decided to write on SWAPTION, so as to add a thought again to our “back to School Series”.
Definition:- A swaption is an option on a swap. The option to enter into an underlying interest rate swap usually with strike price zero. In exchange for an option premium, the buyer gains the right to enter into a specified swap agreement with the issuer on a specified future date, But he is actually not obliged to do the same. This is just an option reserved to the buyer of the swaption.
The buyer and the seller of the swaption have to pre-decide certain points and these are:-
- The premium of the swaption.
- Length of the option period (which usually ends two business days prior to the start date of the underlying swap).
- The terms of the underlying swap, such as: notional amount; the fixed rate (which equals the strike of the swaption); & the frequency of observation for the floating leg of the swap (for example quarterly, semi-annually or annually).
A swaption, where the buyer gets the right to make the payments based on pre-fixed interest rate and receives float rate payments is known as PAYER SWAPTION. While, A swaption, where the buyer gets the right to make the payments based on Float rate (Market rate or usually the LIBOR rates) and receives fixed rate payments from the seller is known as RECEIVER SWAPTION. A sawption Diagram has a start date, an expiration date (the end date of swaption), a start date of underlying interest rate swap, an execution date of underlying swap and the termination date (end date) of underlying swap. In between execution date and termination date of underlying swap, there are various pre-fixed payment dates on which an exchange of interest rate payments between buyer & seller happens.
Based on the styles of expiration, swaption is also classified as:-
- Bermudian swaption- in which the owner is allowed to terminate the swaption on specified multiple dates.
- European swaption- in which the owner is allowed to terminate the swaption deal only on the expiration date.
- American swaption, in which the owner is allowed to terminate the swaption on series of dates.
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), and not traded on any exchange and hence is a customized agreement which may involve a risk of default by either of the counter-parties.
A Line of Caution:- Think Before you actually go for it.