Swaption
AdvancedA swaption is an option that gives the holder the right, but not the obligation, to enter into an interest rate swap on agreed terms at a future date.
A swaption combines features of options and swaps. A payer swaption gives the right to enter a swap paying a fixed rate and receiving a floating rate, which becomes valuable if rates rise. A receiver swaption gives the right to receive a fixed rate and pay floating, which becomes valuable if rates fall.
For example, a company expecting to borrow in one year might buy a payer swaption with a fixed rate of 4%. If swap rates rise to 5% by then, it exercises the swaption and locks in 4%. If rates fall, it lets the swaption expire and borrows at the lower rate, having paid only the premium.
Swaptions are widely used by banks, insurers, pension funds and companies to manage interest rate risk, and by mortgage investors to hedge the effects of borrowers refinancing.
They can be European, exercisable only on one date, American, or Bermudan, exercisable on several set dates. Their prices depend heavily on interest rate volatility. Swaptions are traded over the counter.
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