Swaption – (Swap Option): Meaning, Features, Benefits, Types, and More

It’s an option to enter in an interest rate and other types of swaps. The Swaption gives the buyer a right to enter into a specified swap agreement on a specific future date. However, the buyer of the Swaption has to pay for options premium.

An option premium is an income earned by the seller for writing the swap option. It’s an expense for the buyer of swap options. However, it gives them a right to swap their interest rate/other cash flows against costs they have incurred.

Types of the Swaption based on nature of cash flow/liability

Based on the exchange of fixed and floating rates, there are two types of swap options: payer Swaption and receiver Swaption.

The payer Swaption is when the owner of the Swaption has the right to enter in a swap agreement where they give away a standing leg of liability/cash flow and presume liability/cash flow for the floating rate.

On the contrary, the receiver Swaption is when the owner of the Swaption has the right to enter in a swap agreement where they give away floating liability/cash flow and presume the cash flow/liability for the fixed rate.

How Swaption is traded

The Swaption is traded over the counter, and the price and other terms can be decided between the parties entering the contract.

The terms of the Swaption include expiration time, notional time, fixed/floating rates, etc. Further, the style of the Swaption changes with the change of the exercise time. These styles of Swaption include the following.

Bermudan Swaption

The specific set of dates are pre-agreed for the exercise of the Swap option. In other words, the options can only be exercised on pre-determined dates in the option.

See also  What Is a Treasury Stock and How Does It Work?

European Swaption

The option can only be exercised on the date of expiration, in other words. The expiration date of the vote is agreed upon in advance.

American Swaption

The option can be exercised between the day of the origination and the day of expiration. Although, there may be some lock period in the initial life of the Swap life.

The Swaption market

Usually, financial institutions, banks, and other funds make use of the Swaption agreement. These financial institutions manage the exposure of the risk by using Swaption is a risk-mitigating strategy.

For instance, the bank may enter Swaption to manage the risk of an increase in interest rate.

The Swap options are available in major currencies globally, including Dollars, Euros, Sterling, Yen, and other major currencies of the world.

Swaption features

Following are some of the features of the Swaption features.

  1. These are the customized contracts. So, more flexibility can be experienced when deciding on the terms of the agreement.
  2. Usually, companies use Swaption agreements to manage the interest rate risks.
  3. Swaption agreements are used mainly by banks, hedge funds, and other large institutions.
  4. Swaption agreements are sensitive and complex for smaller firms to manage. Hence, the leading players of the Swaption market are banks and other large financial institutions.
  5. Swap options are available on significant currencies globally, including US dollars, Starlings, Euro, Yen, etc.        

Swap and Swaption

A swap is an agreement to trade the derivatives. It’s a decision to presume the cash flow of others and giving away their cash flow to them. On the other hand, Swaption gives a right to enter into the Swap agreement. It’s the discretion of the buyer to exercise the option or no.

See also  Debt Covenants: Definition, Types, And How does it work?

Types of the Swaps

Usually, the following types of Swaption are conducted in the market.

Interest rate swaps

The interest rate Swap is when two parties exchange their liabilities for paying floating interest rate/fixed interest rate with each other. For instance, the party with liability depending on the floating rate expects interest to increase, and simultaneously, another party with fixed-rate liability expects the interest rate to fall.

Hence, both parties enter into an agreement to swap/exchange their cash flows (fixed/floating) to satisfy their expectations.

Currency Swaps

The currency Swaps is when two parties exchange their principal amount and interest in one currency for another currency.

At the time of swap inception, the covered amount for both loans is exactly the same. However, the fluctuation in the rate of interest in any of the currencies might put one party in an adverse and another part in a favorable position.

Commodity Swaps

The commodity swap is when two parties agree to exchange/swap the cash flow based on the underlying commodity.

Commodity swaps are usually carried for as a hedging strategy against price fluctuations. The commodity swaps are customized deals and are not traded on the exchange.

Debt-equity Swaps

The debt-equity swap is when the lender of the loan gets equity interest in the company by the cancellation of the receivable loan. This helps to reduce leverage and improve the financing structure.

On the other hand, the lender might not perceive it as a viable option until some incentive is offered for the exchange as debt holders stand first in line if the company goes into liquidation.

See also  How Are Exotic Options Traded? (Explained)

Total Return Swaps

A total return swap is when two parties enter in a contract to exchange the total return. One party to the contract makes payments as per the set rate, while the other party makes payment at the rate of an underlying asset.

Advantages of Swaption

Following advantages of the Swaption are affiliated with the Swap option-(Swap options).

  1. It is an excellent tool to manage the interest rate risk.
  2. Financial companies can manage their payoff profile by opting for the Swaption.
  3. The current position of the investment can be restructured.
  4. In the American style of the Swaption, the option can be exercised at any time before expiration. So, there is a wide span of getting hedged.

Disadvantages of Swaption

Following are some of the disadvantages affiliated with the Swaption.

  1. The buyer has to incur the cost in the form of premium options.
  2. If the market rate of interest does not rise above the rate of Swaption, the buyer perceives no value from the purchase.
  3. It’s a time-sensitive trade. So, due care needs to be taken to get benefits from it.