Swaptions

A swaption is a financial derivative that gives the holder the right, but not the obligation, to enter into an interest rate swap on a specified future date. In a swap, two parties typically exchange cash flows on a notional amount, with one side paying a fixed rate and the other paying a floating rate tied to a reference index. The terms of the anticipated swap, including notional, fixed rate, floating index, payment dates, and the swap start date, are fixed at the option’s inception.

There are two basic types: a payer swaption grants the right to pay the fixed rate and receive the floating rate, effectively allowing the holder to enter a swap that benefits when rates rise. A receiver swaption grants the right to receive the fixed rate and pay the floating rate, beneficial when rates fall or when the fixed leg is attractive. Exercise styles include European (exercise only at expiry), Bermudan (exercise on predefined dates), and American (exercise at any time before expiry); in practice, most traded swaptions are European or Bermudan.

Valuation depends on the forward swap rate, the fixed rate of the underlying swap, and the volatility of interest rates. European swaptions are commonly priced with Black-type models using the forward swap rate as the underlying, within a chosen interest-rate framework and discounting. More complex features, such as Bermudan exercise, may require lattice methods or Monte Carlo simulation. Credit risk can be treated separately or incorporated as a credit-adjustment in some models.

Uses and market: swaptions are primarily traded OTC and used to hedge exposure to interest-rate movements or to speculate. They can be cash-settled or physically settled by entering into the underlying swap, with collateral and clearing arrangements commonly used in modern markets.