Stock Market Guide to Option Swaps
Option swaps are more commonly known by the acronym “swaption”. The concept is relatively simple, in that by participating in a swaption, a trader has acquired the option to enter an interest rate swap. They key factor is that the trader is not obligated to enter into the swap, but he does have the right to do so should he so desire.
There are two basic types of swaptions: a “Payer Swaption” and a “Receiver Swaption”. In effect, both types of swaption are essentially different sides of the same coin. As such, a payer swaption enables the trader to pay the fixed rate leg of the interest rate swap, and receive the floating, or variable rate leg. Conversely, a receiver swaption grants the trader the right to enter into an interest rate swap contract where they would receive the fixed interest rate leg and pay the floating rate leg.
Both parties to the option swap agree on certain set terms, including length of the option period, the term of the swap, amortization terms, notational amount, strike rate and, lastly, the frequency of settlement. Like most other types of options, swaptions allow traders to hedge against downside risk while taking advantage of upside benefits as they arise. Time, however, is a fixed factor, and if the trader does not exercise his right to enter into the interest rate swap by the maturity date, the option swap contract will expire with no residual value. However, if the strike rate becomes more favorable than the current or prevailing market swap rate, the trader will likely exercise the option swap contract under the terms of the swaption agreement.
Thus, the trader enjoys the benefits of a favorable strike rate when market conditions are right, yet also has the flexibility to exercise his option and enter into the interest rate swap contract when rates are lower and a profit can be realized on the difference. The reverse applies if the holder of the swaption received the fixed rate leg under the terms of the option swap agreement.