An option that allows the buyer to enter into a rate swap
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A put swaption, also referred to as a payer swaption, involves the buyer being given the opportunity to enter into a rate swap, acting as the floating-rate payer. The party selling the swaption is the floating rate receiver. Because it is an interest rate swap, it means that the buyer is paid the fixed interest rate.
Put swaptions are also known as payer swaptions because the buyer has the right to pay the seller the floating interest rate in return for the fixed interest rate.
Swaptions allow two parties to privately enter into an interest rate swap. The buyer has the opportunity to, but is not obligated to, engage in the swap.
Swaptions are particularly useful for major corporations trying to hedge against risks associated with outstanding debt.
What is a Swaption?
Before we go deeper, it’s important to understand what a swaption is, in general. A swaption is the right – with no obligation – to enter into an interest rate swap with a second party.
Swaptions are typically done over-the-counter (OTC), meaning they’re private, and only the buyer and seller see and must agree on the terms. Among the terms within the contract, the buyer and seller agree on:
The price of the swaption (or the premium)
How long the option period will last
Terms regarding the underlying swap, which involves the notional amount, the fixed rate (the strike price and how often the fixed leg must be paid on, how frequently the floating leg of the swap will be observed
There are three overall types of swaps: a receiver swaption (which can be likened to a call option), a payer swaption (which can be likened to a put option), and a straddle (which is a combination of the two).
Importance of Swaptions
While individuals can enter into swaptions, they are typically used by large businesses or corporations. The primary goal is to counteract rising interest rates on debts that have started to grow within the corporation’s balance sheet.
Put swaptions provide the buying party with the opportunity to pay the seller the fixed rate in return for the floating rate. When looking at the issue of debt, put swaptions are particularly useful because they allow the buyer to switch fixed interest on its debt for floating interest on its debt. It, in turn, enables both parties to ultimately hedge against any risks on their outstanding debt. The put swaption buyer enters into the swap believing interest rates will rise and uses the swaption to hedge against that risk.
The contract that the buyer and seller enter into specifies a date on which the difference between the rates must be settled. The settlement is usually done in cash, with the US dollar being a staple because of its ability to be converted.
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