A swaption is an option on a swap. It gives the holder the right to enter into the swap, without any obligation to do so. As the underlying asset is a swap, which is it self a derivative, a swaption is a derivative of a derivative.

The holder of a swaption may have the right to exchange a fixed interest rate for a floating rate (this is called a payer swaption) or to exchange a floating rate for a fixed rate (this is called a receiver swaption).

One thing that makes a swap very different from a simple option is that there is no strike price. An option, like futures and forwards, is a barter of one thing of value for another, so there is no need to make a separate payment.

A swaption can therefore be defined by:

  • the terms of the underlying swap,
  • the expiry date,
  • the type of option — e.g. European or American.

A swaption may be used, like any other option, as either a hedge or speculatively. Like other derivatives of derivatives, swaptions are complex instruments that are hard to value.

Copyright Graeme Pietersz © 2005-2020