Swaption 1

Swaption
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:
• A payer swaption gives the owner of the swaption the right to enter into a swap where they pay the fixed leg and
receive the floating leg.
• A receiver swaption gives the owner of the swaption the right to enter into a swap in which they will receive the
fixed leg, and pay the floating leg.
The buyer and seller of the swaption agree on:
• the premium (price) of the swaption
• the strike rate (equal to the fixed rate of the underlying swap)
• length of the option period (which usually ends two business days prior to the start date of the underlying swap),
• the term of the underlying swap,
• notional amount,
• amortization, if any
• frequency of settlement of payments on the underlying swap = basis point spread

The swaption market

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. Major investment and commercial banks such as JP Morgan Chase, Bank of America
Securities and Citigroup 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 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 over-the-counter (OTC), i.e., not traded on any exchange. Legally, a swaption is an
agreement between the two counterparties to exchange the required payments. The counterparties are exposed to
each others' failure to make scheduled payments on the underlying swap, although this exposure is typically
mitigated through the use of "collateral agreements" whereby margin is posted to cover the anticipated future
exposure.
Swaption 2

Properties
Unlike ordinary swaps, a swaption not only hedges the buyer against downside risk, but it also enables the buyer to
take advantage of any upside benefits. Like any other option, if the swaption is not exercised by maturity, it expires
worthless.
If the strike rate of the swaption is more favorable than the prevailing market swap rate, then the swaption will be
exercised as detailed in the swaption agreement.
• It is designed to give the holder the benefit of the agreed-upon strike rate if the market rates are higher, with the
flexibility to enter into the current market swap rate if they are lower.
• The converse is true if the holder of the swaption receives the fixed rate under the swap agreement.
Investors can also use swaptions to trade the volatility of the underlying swap rate.

An example
Joe is in Mexico and is aware of an upcoming election. Joe has some variable rate bonds that are paying very well,
but would like to hedge against the risk of political upheaval. Dave is in the UK, and rates are low and constant.
Dave would like some extra money and thinks that political change will not affect the rates too significantly. In this
case, Joe would wish to purchase a swaption from Dave.
Joe and Dave engage in a swap; Joe obtains fixed cash flows from the UK bond and Dave obtains the variable rate
bonds. They agree on terms that set the swap as even money (present valued) for both of them. However, they do not
do the swap yet because Joe's debt is about to expire, he plans to reinvest, and he wants to do the swap only if the
variable rates drop below a threshold (at which point his income decreases; he wants to lock in profits). In order to
lock in the profits, Joe is willing to arrange the option on slightly favorable terms with Dave. Dave wants the higher
temporary cash flow and is willing to accept the small risk that the variable rates may drop.
In this case, the swaption can be exercised and both people may still make a profit, depending on the timing and
amounts involved. At the very least, both parties either reduced or enhanced their risks/rewards as they desired.

Another example
Doug's Tractor Company needs to engage in a swap for the following reason: They have too much risk. They have a
five-year adjustable rate business loan that they have used to purchase machines to make tractors. They have just
agreed to sell ten tractors to Jimbob's Tractor Dealership at the rate of two per year for five years (they have trouble
selling the tractors, etc.). The price for the tractors is set in the contract and cannot be renegotiated.
The problem is that if the interest rates rise, Doug has to pay high interest payments, and he loses money on the
transaction. He needs to lock in an interest rate, even if it is slightly above the current rate.
Across town, Stanley's Tire Co. has a mortgage on their offices that he cannot pay off due to taxes and various legal
problems concerning ownership of the property. However, he is locked into a higher long-term rate mortgage loan.
He wants to reduce his rates.
Each of them makes a prediction about short-term rates. Stanley thinks that short-term rates will remain low, and
wants to pay less. Doug thinks that they will exceed than Stanley's fixed rate. However, Doug needs to do the swap
only if the rates rise that high. Stanley agrees to a swaption. Both are making a bet, and it should help them manage
risk better.
Swaption 3

Swaption styles
There are three styles of Swaptions. Each style reflects a different timeframe in which the option can be exercised.
• American swaption, in which the owner is allowed to enter the swap on any day that falls within a range of two
dates.
• European swaption, in which the owner is allowed to enter the swap only on the maturity date.
• Bermudan swaption, in which the owner is allowed to enter the swap only on certain dates that fall within a range
of the start (roll) date and end date.

Valuation
The valuation of swaptions is complicated in that the result depends on several factors: the time to expiration, the
length of underlying swap, and the moneyness of the swaption. Here the at-the-money level is the forward swap rate,
the forward rate that would apply between the maturity of the option (t) and the tenor of the underlying swap (T)
such that the swap, at time t, has an "NPV" of zero; see swap valuation. For an at-the-money swaption, the strike rate
equals the forward swap rate, and moneyness, therefore, is determined based on whether the strike rate is higher,
lower, or at the same level as the forward swap rate.
Given these complications, quantitative analysts attempt to determine relative value between different swaptions, in
some cases by constructing complex 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, where, for this purpose, the underlier is treated as a forward
contract on a swap. Here:
• The forward price is the forward swap rate.
• The volatility is typically "read-off" a two dimensional grid of at-the-money volatilities as observed from prices in
the Interbank swaption market. On this grid, one axis is the time to expiration and the other is the length of the
underlying swap. Adjustments may then be made for moneyness; see Implied volatility surface under Volatility
smile.

First known swaption

The first known swaption was constructed and executed by William Lawton in 1983. Lawton was the Head Trader
for Fixed Income Derivatives at First Interstate Bank in Los Angeles at that time. Lawton worked with First
Interstate's Treasury Options Desk to adapt the concept of an interest rate swap and an options contract. The
swaption was for a period of one year. First Interstate, for a premium, sold a Los Angeles based savings and loan the
right to enter into a five-year interest rate swap to pay fixed versus three-month Libor on a notional amount of $5
million. Lawton was later hired by Mr. Chen Yuan of the People's Bank of China to modernize China's central bank,
which included training China's central bank staff in using and managing derivatives such as interest rate swaps and
swaptions.
Swaption 4

References
• Damiano Brigo, Fabio Mercurio (2001). Interest Rate Models - Theory and Practice with Smile, Inflation and
Credit (2nd ed. 2006 ed.). Springer Verlag. ISBN 978-3-540-22149-4.

External links
• Longstaff, Francis A., Pedro Santa-Clara, and Eduardo S. Schwartz. The Relative Valuation of Caps and
Swaptions: Theory and Empirical Evidence [1].
• Blanco, Carlos, Josh Gray and Marc Hazzard. Alternative Valuation Methods for Swaptions: The Devil is in the
Details [2].
• Interest Rate Risk - Models: Similarities and Differences [3].
• Basic Fixed Income Derivative Hedging [4]. Financial-edu.com.
• Risk Sensitivities using Analytical Models [5]. Thiruspace.com. Interactive chart that displays risk sensitivities.

References
[1] http:/ / personal. anderson. ucla. edu/ francis. longstaff/ 4-00. pdf
[2] http:/ / www. fea. com/ resources/ pdf/ swaptions. pdf
[3] http:/ / www. financewise. com/ public/ edit/ riskm/ interestrate/ interestraterisk00-modelsp. htm
[4] http:/ / www. financial-edu. com/ basic-fixed-income-derivative-hedging. php
[5] http:/ / www. derivatics. com/ GammaImpact. aspx
Article Sources and Contributors 5

Article Sources and Contributors

Swaption  Source: http://en.wikipedia.org/w/index.php?oldid=412866692  Contributors: Berkeley222, Borracho, Bovineone, CarbonCopy, Charles Matthews, Colonies Chris, D32, Danpak,
Dm63, Edward, Enchanter, Fenice, Finnancier, Fintor, Garylhewitt, GraemeL, Gregalton, Hadal, Hu12, Jerryseinfeld, Jni, Joseph Solis in Australia, Justanyone, Ksb-finances, Leifern, Michael
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