Swaptions are options on interest rate swaps. When a swap buyer enters into a swaption, the buyer pays an initial premium for the right to enter a swap. In case the buyer wants to increase duration, he or she would buy receiver swaption, giving the buyer the right to initiate a receive-fixed swap at a prespecified swap fixed rate (SFR). The swap fixed rate may also be called the swaption strike rate.
On this page, we discuss the basics of swaptions. In particular, we explain what determines the value of a swaption.
Swaptions are often used by investors who wish to increase or decrease the basis point value (BPV) of their assets. An investor who wishes to increase the BPV of the assets will enter into a receiver swaption. Similarly, an investor who would like to reduce the BPV of the assets would take the opposite side.
The advantage of a swaption is that the cost is limited to the initial premium paid but while retaining upside. That is, it does not completely hedge out the impact of interest rate changes on the portfolio’s value.
As time passes, we can compare the swap fixed rate for new swaps to the swap fixed rate of the swap we are holding. The new swap fixed rate will determine if the option has value:
- if the new SFR declines. In that case, the right to receive a now above-market SFR rate has positive value and effectively increases the BPV of the assets. The value of the swaption is part of the portfolio assets and increases the total portfolio value
- if the new SFR increases, the right to receive a now below-market SFR has no value. The swaption will not be exercised, and it would be allowed to expire worthless. The advantage, now, is that there is no further downside compared to a receive-fixed swap.
While the terminology can often be somewhat confusing, the important thing to remember is that the term receiver swaptions and payer swaptions both refer to the fixed side of an interest rate swap.
We briefly discussed how swaptions work. In particular, these are simple options on the fixed side of a swap where the swap fixed rate of the swaption serves as the strike price.