A swaption is an option on a forward start swap which provides the purchaser the right to either pay or receive a fixed rate. A buyer of a swaption who has the right to pay fixed and receive floating is said to have purchased a 'payers swaption'. Alternatively, the right to exercise into a swap whereby the buyer receives fixed and pays floating is known as a 'receivers swaption'.
Since the underlying swap can be thought of as two streams of cash flows, the right to receive fixed is the same as the right to pay floating. In this sense, swaptions are analogous to foreign exchange options where a call in one currency is identical to a put on the other currency. However, the option terminology of calls and puts is somewhat confusing for swaptions as it is not used consistently in the market. Some participants describe the right to pay fixed as a call since it provides the right to buy the swap (i.e. pay fixed). Others look at a swaption's relationship to the bond market and say that if you pay fixed you are short the bond and therefore look at this swaption as a put. To eliminate any confusion, market participants generally describe swaptions as 'payers' versus 'receivers' with respect to the fixed rate.
Swaptions can be used as hedging vehicles for fixed debt, floating debt or swaps. The primary purposes for entering into a swaption are:
- to hedge call or put positions in bond issues
- to change the tenor of an underlying swap
- to assist in the engineering of structured notes
- to change the payoff profile of the firm
Original interest arose from the issuance of bonds with embedded put features. Often, the price of the bond did not fully reflect the fair value of the embedded option and the issuer would sell a swaption to obtain a lower fixed cost of funds. This application of swaptions continues today for both bonds with call or put features.
A significant percentage of these debt issues are swapped out to obtain cheaper LIBOR funding. In these cases the issuer needs a facility to cancel the swap if the bonds are put or called. To eliminate this exposure, the companies would enter into a swaption to offset the underlying swap. This can be done two ways using either a cancelable or extendible swap.
A cancelable swap provides the right to cancel the swap at a given point in the future. An example would be a swap with a tenor of 5 years that can be cancelled after year three. This can be broken into two components. The first is a vanilla five year swap paying floating and receiving fixed. The second component is a payers swaption exercisable into a two year swap three years from today. The result is that when the original bond is called, the swaption is exercised and the cash flows for the original swap and that from the swaption offset one another. If the bond isn't called, the swaption is left to expire.
Another way to obtain a similar result is to use an extendible swap. The components are a three year pay floating / receive fixed swap and a receivers swaption whereby the holder can exercise into a two year swap, three years from today. In this case, exercising the swaption extends the swap to from three years to five years. This would be done if the bond was not called. If the bond was called, the swaption would not be exercised. Extendible and cancelable swaps are used in conjunction with related debt issues or when the user is indifferent to swaps of different tenors. In the latter case, swaptions are sold to obtain the premium which is then used to offset other financing charges.
Swaptions are also used in the engineering of structured notes in order to obtain the contingent payoff profiles requested by the investors. These can be identified in some cases where the cash flows change from fixed to floating or vice versa at some level of interest rates. By reverse engineering a structured note into all of its components, one can calculate its market price or amend the structure's payoff profile.
Finally, financial institutions or corporations may look at their balance sheet and identify contingent interest rate risk that they have or would like to have. By using swaptions, the asset / liability mix can often be altered to obtain the desired risk profile.