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.
Types of swaptions
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.
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:
The premium (price) of the swaption
Length of the option period (which usually ends two business days prior to the start date of the underlying swap),
The terms of the underlying swap, including:
- Notional amount (with amortization amounts, if any)
- The fixed rate (which equals the strike of the swaption)
- The frequency of observation for the floating leg of the swap (for example, 3 month Libor paid quarterly)
