An option that allows the holder to take part in a private tax rate swap
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A call swaption, also known as a receiver swaption, is an option that allows the holder to take part in a private tax rate swap. All swaptions are conducted over-the-counter (OTC), meaning they are not standardized contracts. In order to participate in a call swaption – or any swaption – both the buyer and seller must agree to all of the terms within the swaption contract.
Call swaptions give holders the right – but not the obligation – to do an interest rate swap with the other party.
Call swaptions are also known as receiver swaptions because the holder receives a fixed interest rate payment.
Swaptions are similar to traditional options in that they have an expiration date, an expiration style, and a strike price.
The Basics of a Swaption
A swaption is just like an option in that it comes with an expiration date, an expiration style, a strike price, and the buyer pays the seller for the privilege. The strike price is actually a strike rate – the fixed rate that will be exchanged (swapped) for the floating rate.
In terms of expiration style, there are three commonly used standards:
Bermuda style – Establishes a series of dates that the option can be exercised
American style – The option can be exercised at any time prior to the expiration
European style – Allows the holder to exercise the option only on one specified date, either the option’s expiration date or just before the expiration date, which is also the start of the swap
Elements of a Swaption
Swaptions list a number of different elements that the buyer and seller must sign off on. They include:
When entering into a call swaption, the holder agrees to pay the floating rate and gets the right to receive the fixed rate. In effect, the buyer of a call swaption is looking to take the position of one paying the floating rate. The buyer benefits when the fixed rate is higher than the floating rate.
Swaptions are often “cash-settled” at expiration. The buyer and seller simply use an agreed-upon calculation formula to determine the value of the swap.
Who Trades Call Swaptions?
The main participants in the swaption market are financial institutions or large, multinational companies. They use swaptions to manage interest rate risk. For example, a bank or other financial institution that holds a lot of mortgages might want to hedge against falling interest rates that could result in many mortgages being paid off early. The bank would be looking to buy a receiver, or call, option.
Investment banks are active as market makers in the swaption market. They commonly own a portfolio of swaption contracts that they created with a number of counterparties. The banks will enter into call swaption or put swaption contracts themselves in order to manage their rate risk exposure. Whether they are looking to buy call or put swaptions depends on the nature of their existing swaption portfolio – whether it is over-balanced in favor of puts or of calls.
Call Swaptions vs. Put Swaptions
Call swaptions, as discussed above, afford holders the right, but not the obligation, to enter an interest rate swap. Call swaptions are also sometimes referred to as receiver swaptions because the holder receives the fixed interest rate as payment while paying the floating rate.
Put swaptions, on the other hand, enable holders to enter into a swap where they are able to pay the fixed interest rate and receive the floating rate. It is because of this that put swaptions are also known as payer swaptions. Put swaptions are designed for those individuals who are looking to receive floating interest rate payments in exchange for fixed-rate payments.
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