What it means
An interest rate swap is an agreement in which two parties exchange interest payments, typically one paying a fixed rate and the other a floating rate that moves with the market. A swaption is an option on such a swap.
The buyer pays a premium and gets the right to start the swap on a future date at a rate fixed today. In the common convention, a put swaption is a payer swaption, meaning the holder has the right to pay the fixed rate and receive the floating rate.
This is similar to a put option on a bond, because it gains value when rates rise and bond prices fall. Some dealers use the opposite labelling, so the term sheet needs to state clearly which side pays fixed.
Companies use put swaptions to protect themselves against rising borrowing costs. A business with floating-rate debt can buy a payer swaption so that, if rates climb, it can lock in a lower fixed rate than the market then offers.
If rates stay low or fall, it lets the swaption expire and simply loses the premium. The advantage over entering a swap straight away is flexibility.
A swap commits both sides, while a swaption gives a choice. This is useful when the company is not sure whether it will actually need the borrowing, for example when it is bidding for a contract or waiting for board approval.
The price depends on several factors. These include the strike rate (the fixed rate in the swap), how long until the option expires, the length of the swap, current interest rates and the expected volatility of rates.
Higher volatility makes the swaption more expensive. A nuance is the exercise style.
A European swaption can be exercised only on its expiry date, a Bermudan swaption on a set of dates, and an American swaption at any time. Different styles are priced differently, and the choice should match when the company might actually need to act.
In practice
Real-world examples.
Example
A property developer has a $10,000,000 floating-rate loan and fears rates will rise. She buys a payer swaption that allows her to lock in 4.0% in a year. If the market rate reaches 5.0%, she exercises and saves 1.0% a year on the loan.
Example
A utility is bidding for a government contract and will need extra funding only if it wins. It buys a put swaption instead of entering a swap now. If it loses the bid, it lets the option expire and has lost only the premium, not a swap that it no longer needs.
Example
A bank trading desk sells put swaptions to corporate clients and earns premium income. It hedges the position by trading futures and swaps so that it does not carry large exposure if rates rise. The desk reviews the hedge daily because the sensitivity of the option changes as rates move.
Formula
Calculation
Payoff at exercise (per period) = notional x (prevailing swap rate - strike rate) if positive, otherwise zero
Suppose a company buys a put (payer) swaption on a $10,000,000 notional with a strike rate of 4.0% for a premium of $60,000. At expiry the market swap rate is 5.0%. The holder can pay 4.0% instead of 5.0%, a saving of 1.0% a year, which is 10,000,000 x 0.01 = $100,000 per year. Over a five-year swap that is $500,000 of undiscounted savings, compared with the $60,000 premium, so exercising is worthwhile.Case study
Seen in the real world.
Halcyon Shipping is an illustrative, fictional company with a $40,000,000 floating-rate loan and a plan to buy two new vessels in about a year. The finance director was worried that rates would rise before the purchases were confirmed, but she did not want to commit to a swap in case the deal fell through.
She bought a one-year put (payer) swaption on $40,000,000 with a strike of 4.5% for a premium of $240,000. Within the year, swap rates rose to 5.5%, and the vessel purchases went ahead. The company exercised and paid 4.5% fixed instead of 5.5%, saving 1.0% on $40,000,000, or $400,000 a year.
The illustrative lesson was that the swaption worked like insurance with a deadline. Had rates fallen or the purchases been cancelled, the company would have lost the $240,000 premium and nothing more.
Watch out
Common mistakes.
- Assuming a put swaption always means the holder receives fixed, when in the most common convention it is the right to pay fixed.
- Treating the premium as recoverable, when it is lost if the swaption expires out of the money.
- Forgetting to match the swaption's expiry and the underlying swap's length to the real exposure being hedged.
Questions
People also ask.
What is the difference between a swaption and a swap?
A swap is a binding agreement to exchange payments, while a swaption is an option to enter one, so the holder can walk away.
Is a put swaption the same as a payer swaption?
In the most common usage yes, but some dealers label them the other way round, so confirm which party pays fixed before trading.
Who sells swaptions?
Banks and dealers usually write them, charging a premium and hedging their own risk in the swap and futures markets.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%Related