A swaption is an option granting its owner the right but not the obligation to enter into an underlying swap. Although options can be traded on a variety of swaps, the term "swaption" typically refers to options on interest rate swaps.
There are two types of swaption contracts (analogous to put and call options):
In addition, 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 possible settlement 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 are predominantly large corporations, banks, financial institutions and hedge funds. End users such as corporations and banks typically use swaptions to manage interest 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 primarily over-the-counter (OTC), i.e., not cleared or traded on an exchange. 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 to exotic options. These can involve bespoke exercise rules, or a non-constant swap notional.
Compare: Bond option § Valuation
The valuation of swaptions is complicated in that the at-the-money level is the forward swap rate, being the forward 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; see swap 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 complex lattice-based term structure and short-rate models that describe the movement of interest rates over time. However, a standard practice, particularly amongst traders, to whom speed of calculation is more important, is to value European swaptions using the Black model. For American- and Bermudan- styled options, where exercise is permitted prior to maturity, only the lattice based approach is applicable.