Swaption

Swaption is affected when an option is applied on a swap. Swaptions are not very desirable derivative instruments of investors. The article below reveals certain aspects of swaption. Also included in the article are forms of swaption. An option on a swap is called a Swaption.

Working of swaption
It is seldom that individuals invest in swaptions, however it is not uncommon for the swaption to be sold. For instance, a corporation issues debt as callable bonds and pays fixed rate of interest semiannually. The corporation as well may want to swap debt in to debt with a floating rate of interest. For this, the corporation opts for a swap of "fixed-forfloating" from the dealer of derivatives. The corporation now intends to liquidate the debt with the call feature; hence the corporation sells a swaption to the derivative dealer. There are instances when dealers of derivatives have swaptions sold to them.

Forms of swaptions
Two forms of swaptions are recognized. They are: Receiver swaption This form of swaption may be referred to a call pertaining to "receive fixed swap". This entitles the swaption holder for receiving "fixed on a swap". Payer swaption This swaption form may be addressed to a call pertaining to "pay-fixed swap". This entitles the holder of the swaption for paying "fixed on a swap".

Specification of a swaption
In specifying any swaption, usually the following are required:The tenor pertaining to the swap The Option's expiration date The underlying swap 's fixed rate.

Features of a swaption
A swaption may be either: Physically settled Cash settled

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 fiveyear interest rate swap to pay fixed versus three-month Libor on a notional amount of $5 million

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.