Swaption

Swaption is affected when an option is applied on a swap. Swaptions are not very desirable derivative instruments of investors. The article below reveals certain aspects of swaption. Also included in the article are forms of swaption. An option on a swap is called a Swaption.
The underlying swap being a “vanilla interest rate swap”, swaption is an OTC (over-the-counter) derivative instrument.

Working of swaption:
It is seldom that individuals invest in swaptions, however it is not uncommon for the swaption to be sold. For instance, a corporation issues debt as callable bonds and pays fixed rate of interest semiannually. The corporation as well may want to swap debt in to debt with a floating rate of interest.

For this, the corporation opts for a swap of “fixed-for-floating” from the dealer of derivatives.
The corporation now intends to liquidate the debt with the call feature; hence the corporation sells a swaption to the derivative dealer. There are instances when dealers of derivatives have swaptions sold to them.
There are yet other clients who purchase caps from these dealers of derivatives. This causes the dealers to hedge short caps with those of long swaptions.

Forms of swaptions:
Two forms of swaptions are recognized. They are:

Receiver swaption
This form of swaption may be referred to a call pertaining to “receive fixed swap”. This entitles the swaption holder for receiving “fixed on a swap”.

Payer swaption
This swaption form may be addressed to a call pertaining to “pay-fixed swap”. This entitles the holder of the swaption for paying “fixed on a swap”.

Specification of a swaption:
In specifying any swaption, usually the following are required:
The tenor pertaining to the swap
The Option’s expiration date
The underlying swap ‘s fixed rate.

Features of a swaption:
A swaption may be either:
Physically settled
Cash settled

 

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Last Updated on : 1st August 2013

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