A swaption (also known as a European swaption) gives its owner the right but not the obligation to enter into an underlying swap (the terms and conditions of which are set on the trade date) on a specified date in the future. In return for this right, the buyer of the swaption pays a premium to the seller.
If the swaption is exercised, if the swaption’s delivery type was set to:
Cash settled, then the seller pays the buyer the current market value (or price) of the underlying swap based on the predefined fixed rate. The amount is paid on the start date of the underlying swap.
If you choose to cash settle a swaption or swaption strategy, by default the system uses the market default annuity method to calculate the market price. For most instruments, this is the IRR method, which calculates the market price using the market formula for cash settlement whereby the annuity is calculated using a flat yield curve equal to the forward swap rate. However, for a cash settled vanilla swaption or a swaption strategy on USD or JPY, the price is always calculated as if it was swap settled (according to the market default for these instruments).
For a vanilla swaption and swaption strategies whose default is the IRR method, you can instead choose to use the swap curve annuity method. For more information see Customizing the Vanilla Swaption & Swaption Strategies.
Swap settled, then the underlying swap is activated, i.e., the swap is entered into by the two parties, based on the predefined terms.
For information on an American swaption (where the owner can choose to enter the swap on any day that falls within a specified date range) see American Swaption; for information on a Bermudan swaption (where the owner can choose to enter the swap on a number of specified dates) see Bermudan Swaption.
When pricing a swaption in SDX Interest Rates the following must be specified:
The type of swaption, either payer or receiver.
A payer swaption gives the holder of the swaption the right to enter into a swap where they will pay the predefined fixed rate, i.e., the strike, and receive the floating rate. The holder of a payer swaption will only enter into this swap if the underlying swap rate is above the strike on the exercise date.
A receiver swaption gives the holder of the swaption the right to enter into a swap where they will receive the predefined fixed rate, i.e., the strike, and pay the floating rate. The holder of a receiver swaption will only enter into this swap if the underlying swap rate is lower than the strike on the exercise date.
The type of underlying swap, either a Vanilla Swap or a General Swap.
By default the underlying swap is a vanilla swap, but you can choose to set it to a general swap instead using the Vanilla <> General toggle button.
The advantage of using a general swap is that for the general swap’s floating leg, there is no dependency between the reference rate, the frequency of the fixing dates and the frequency of the payment dates. Therefore in a general swap, because the reference rate, fixing frequency and payment frequency are all independent of one another, you can choose, for example, a reference rate of 3m LIBOR, a semi-annual fixing frequency and a monthly payment frequency.
By contrast, in a vanilla swap, there is direct dependency between the reference rate and the frequency of the fixing and payment dates. So, for example, if the vanilla swap’s reference rate is based on 3m LIBOR, its fixing and payment frequency must be quarterly; similarly, if the reference rate is based on 1m LIBOR, the fixing and payment frequency must be monthly.
The expiry
This is the date on which the option to enter the swap can be exercised. This date is, in line with market convention, automatically set to two business days before the start of the swap.
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If you price a swaption on its expiry date, i.e., you define the expiry date to be the same as the trade date, you can see the value of the swaption on its expiry day before you exercise it. The result displayed will in effect be the value of the underlying. This will be zero if the option is out-of-the-money or an intrinsic value if it is in-the-money. |
For more information on defining a swaption’s expiry see Defining Dates for a Swaption.
Whether you are buying or selling the swaption.
For the underlying swap you must define:
Which reference rate index is to be used for the floating rate(s).
The fixed rate (or strike) for the underlying swap.
For many swaption instruments and strategies, different strike values can be specified for each payment period, see Manually Adjusting Values for Individual Coupons.
Duration of the swap
You enter this using the Start Date field (which defines the date on which the swap will start, if entered into) and the End Date field (which defines the date on which the swap will end, if entered into).
Notional principal on which the coupon (whether fixed or floating) is to be paid for the underlying swap. In the Swap Cash Flow Dates page, you can set the notional to vary from one coupon period to the next. For more information see Adjusting the Notional for Each Coupon.
Currency of the notional.
Payment schedule, i.e., how often the interest rate payments (for both the fixed and floating rates individually) are to be made on the underlying swap.
Settlement type if on the exercise date the swaption is in-the-money and exercised. You can choose between either of the following:
Cash settled: The seller pays the buyer the current market value of the underlying swap based on the predefined fixed rate.
Swap settled: The swap is entered into by the two parties, based on the predefined terms.
You do this using the Swap Settle <> Cash Settle button.
In addition, it is important to note that for a vanilla swaption or swaption strategy (except if it is on USD or JPY), the Swap Settle <> Cash Settle button also affects the pricing of the instrument. That is:
If you choose to enter into a cash settled vanilla swaption or swaption strategy, by default SD uses the IRR method (also known as par cash rate) to calculate the market price, although you can choose to use the swap curve annuity method instead.
For more information on how to set the default method used, see Customizing the Vanilla Swaption & Swaption Strategies.
For a cash settled vanilla swaption or swaption strategy on USD or JPY, the pricing is always calculated as if it was swap settled.
If you choose to enter into a swap settled vanilla swaption or swaption strategy, SD uses the standard market approach—in which the discount factors for the annuity are computed based on the discounting curve that is used for the pricing of the swaption (and that is set by the Collateralization dropdown list in the pricer itself).
So, if you toggle between the swap settle and cash settle settings, then the price of the vanilla swaption will be slightly different in each case; unless it is based on USD or JPY, in which case there is no difference in the pricing between the two settings, in line with current market convention for these two currencies.
You can also enter your own market volatility or market normal volatility and then re-calculate the Greeks and various values. See Market Vol and Market Normal Vol .
You can also choose to see the Pure DV01 result for this instrument. To enable this result for your user see Displaying the Pure DV01 Result for European Swaptions.
Advantages of a Swaption
A swaption hedges the buyer against downside risk, as well as letting the buyer take advantage of any upside benefits. That is, it gives the buyer the benefit of the agreed upon swap rate if it is more favorable than the current market rate, with the flexibility of being able to enter into a swap at the prevailing market swap rate if it is preferable.
Swaptions enable the purchaser of a:
Receiver swaption to hedge against falling interest rates.
Payer swaption to obtain protection against rising interest rates.
Example of a Payer Swaption
You are paying a floating rate on your loan. However, you are worried that in the next month floating rates will rise. Therefore, you can buy a payer swaption which would give you the right to swap your loan to a fixed rate in a month’s time. On expiry, if the swap rate has risen in the market above the chosen strike you will exercise the swap; if not, you will not exercise the swap.
Example of Receiver Swaption
You are receiving a floating rate on an investment and are concerned that the reference rate will fall and you will receive a lower coupon over the remaining period of the investment. You could thus buy a receiver swaption. If the rates do indeed fall, you could exercise the option and effectively switch this receipt to the fixed rate, regardless of future rates movements.