A swaption can be defined as a contract which gives the holder a right to do an interest-rate swap in the future, but does not obligate them to do so. This is essentially a swaption (swap+option). Swaptions may be used to manage risk in interest rate markets or to speculate with future interest rate movements.
A swaption offers the holder flexibility in deciding whether or to not enter into an interest rate swap. The underlying rate swap usually involves the exchange fixed and fluctuating interest rate payments during a predetermined time period. By holding a'swaption', the buyer gains the ability to protect itself against rate movements that could be adverse in the future.
There are two major types of exchanges: the call swaption, and the put swaption. A call exchange gives the owner the right of entry into a switch as the fixed rates payer. The terms, such as the nominal amount, maturity and date of exercise, are agreed on at the time that the swaption is purchased.
Swaptions can be used for many different purposes by participants on the market. As an example, swaptions may be used by companies to hedge future interest rate fluctuations. By buying a swaption a company is able to secure a fixed-interest rate on future loans or bonds, minimizing the risk in an environment of rising interest rates.
Swaptions may also be used to make money on interest rate movements that are anticipated. A trader that believes that rates will go up may opt to buy a put swaption so they can potentially receive the higher fix rate in future. If, on the other hand, a trader is anticipating falling interest rates, then they may purchase a put swaption so that they can benefit from receiving a lower fixed rate in the future.
Swaptions have certain risks, just like any other financial instruments. The possibility of an unfavorable change in interest rates, which could result in the swaption going out of money, is a significant risk. Also, swaptions come with counterparty risks because the fulfilment of the contracts depends on counterparty creditworthiness.
A swaption is versatile financial instrument providing the holder, but without the obligation of entering into an interest-rate swap. Market participants can use it to hedge their risk against future rate fluctuations or speculate on interest rates. But it is vital that anyone considering swaptions thoroughly evaluates the risks involved.