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Aswaption (a portmanteau of "swap" and "option") is anoption granting its owner the right but not the obligation to enter into an underlyingswap on specified terms at a future date. In practice the term is most commonly used for options oninterest rate swaps, where the holder has the right to enter into a fixed-for-floating interest rate swap.
Swaptions are tradedover the counter between institutions and are used bybanks,insurance companies,corporations and others to manageinterest rate risk or to take speculative positions on future interest rates.[1] The basic contract may give the right to pay fixed and receive floating (a "payer" swaption) or to receive fixed and pay floating (a "receiver" swaption), and can be structured with various exercise styles (European, Bermudan or American) and either physical or cash settlement.[2][3]
Swaption valuation typically relies on option pricing models such as theBlack model or interest rate models implemented on a lattice or tree to describe the evolution of future interest rates.[4]
In an interest rate context, a swaption is an option on a fixed-for-floatinginterest rate swap. The terms of the underlying swap are agreed when the option is traded, while the decision to exercise is made later at the option expiry date.
There are two types of swaption contracts (analogous to put and call options):[2]
A "straddle" refers to a combination of a receiver and a payer option on the same underlying swap.
The buyer and seller of the swaption agree on:
There are two possiblesettlement conventions. Swaptions can be settled physically (i.e., at expiry the swap is entered between the two parties) or cash-settled, where the value of the swap at expiry is paid according to a market-standard formula.
The participants in the swaption market[3] are predominantly large corporations, banks, financial institutions and hedge funds. End users such as corporations and banks typically use swaptions to manageinterest rate risk arising from their core business or from their financing arrangements. For example, a corporation wanting protection from rising interest rates might buy a payer swaption. A bank that holds a mortgage portfolio might buy a receiver swaption to protect against lower interest rates that might lead to early prepayment of the mortgages. A hedge fund believing that interest rates will not rise by more than a certain amount might sell a payer swaption aiming to make money by collecting the premium.Investment banks make markets in swaptions in the major currencies, and these banks trade amongst themselves in the swaption interbank market. The market-making banks typically manage large portfolios of swaptions that they have written with various counterparties. A significant investment in technology and human capital is required to properly monitor and risk-manage the resulting exposure. Swaption markets exist in most of the major currencies in the world, the largest markets being in U.S. dollars, euro, sterling and Japanese yen.
The swaption market is primarilyover-the-counter (OTC), i.e., not cleared or traded on an exchange.[5] Legally, a swaption is a contract granting a party the right to enter an agreement with another counterparty to exchange the required payments. The owner ("buyer") of the swaption is exposed to a failure by the "seller" to enter the swap upon expiry (or to pay the agreed payoff in the case of a cash-settled swaption). Often this exposure is mitigated through the use of collateral agreements whereby variation margin is posted to cover the anticipated future exposure.
There are three main styles that define the exercise of the swaption:
Exotic desks may be willing to create customised types of swaptions, analogous toexotic options. These can involve bespoke exercise rules, or a non-constant swap notional.
The valuation of swaptions is complicated in that theat-the-money level is the forward swap rate, being theforward rate that would apply between the maturity of the option—time m—and the tenor of the underlying swap such that the swap, at time m, would have an "NPV" of zero; seeswap valuation. Moneyness, therefore, is determined based on whether the strike rate is higher, lower, or at the same level as the forward swap rate.
Addressing this,quantitative analysts value swaptions by constructing complexlattice-basedterm structure andshort-rate models that describe the movement of interest rates over time.[1][4] However, a standard practice, particularly amongsttraders, to whomspeed of calculation is more important, is to value European swaptions using theBlack model. ForAmerican- andBermudan-styled options, where exercise is permitted prior to maturity, only the lattice based approach is applicable.
Because most swaptions are tradedover the counter, each party is exposed tocounterparty credit risk if the other party defaults while the position has positive value.[3] The size and direction of the exposure change over time as interest rates and implied volatilities move, so swaption portfolios are an important source ofmarket risk and can create significant funding needs when collateral must be posted.
Counterparty risk on non-cleared swaptions is usually mitigated throughcollateral arrangements documented in a credit support annex to anISDA master agreement. Under these agreements the parties agree to exchangeinitial margin and variation margin to cover current and potential future exposure, subject to thresholds and minimum transfer amounts.[6] International standards developed by theBasel Committee on Banking Supervision and theInternational Organization of Securities Commissions set minimum margin requirements for many non-centrally cleared derivatives, including interest rate options, in order to reduce systemic risk and to discourage the build up of large uncollateralised bilateral exposures.[6]
Following the2007–2008 financial crisis, theG20 reform agenda required that standardised OTC derivatives be traded on organised platforms where appropriate, cleared through acentral counterparty and reported to trade repositories.[6] In response, many jurisdictions introduced rules that mandate central clearing for standardised interest rate swaps and related products and that require margin for non-centrally cleared derivatives.[7][8] Interest rate swaps have therefore migrated heavily into central clearing, while more customised contracts such as many swaptions continue to trade bilaterally and remain subject to the non-cleared margin rules.[5][7]