A swaption is, as the name implies, a combination of a swap and an option- owners have purchased the right but not the obligation to enter into a swap at any point before expiry. Swaptions are typically on interest rate swaps, and can be payer swaptions, in which the owner has the right to pay a fixed amount, or receiver swaptions, in which the owner has the right to pay the floating amount.
Q. So, what’s a swaption?
A. As it sounds, a combination of an option and a swap. Or, more specifically, the right, but not the obligation, to enter into a swap at some point in the future. Usually, the underlying swap is an interest rate swap, so upon exercise one side would pay fixed and receive floating, and the other side would do the opposite.
Q. Seems unnecessarily complicated, doesn’t it? Why do you need the option instead of just entering into the swap straightaway?
A. Well, they can be very useful for big institutions with very large portfolios of fixed income assets, like pension plans or banks, particularly when you may be at a big turning point in the interest rate environment, as we might be right now.
Q. Can you give us an example of why?
A. Say you’re a pension plan. These days, you’re short duration because you’re not getting paid to be long; you’re dying to see long term rates rise so you can fund your future liabilities. You know you’ll be buying massively if rates go up. But you also know that you only need a certain level of longer maturities to reach your goals.
Q. But, again, why a swaption? Why not just buy what you need?
A. You could. But to reduce your total risks, including in the scenario that rates don’t rise, you could sell a swaption on the portion of the duration you would probably buy when you can, but might not need. That way, if rates don’t rise, you pocket the premium today, and reduce the amount you’re underfunded.
Q. Aha, that makes a lot of sense. And how else do people use these?
A. All sorts of ways. Companies that have lots of floating rate liabilities but lots of fixed rate assets might start buying swaptions right now to protect against big interest rate rises. And of course hedge funds are in the game, maybe selling that swaption to the company needing floating rate protection because they don’t think actually think the swaption will be exercised, and that the fund will grab the premium.