Swaption

A swap commits you. Enter one today for a period starting in six months and you are locked in, whatever rates do in the meantime.

A swaption is the optional version. Pay a premium now for the right to enter that swap at a strike rate on a future date. If rates move against you, exercise and take the rate you locked. If they move in your favour, let it lapse, swap at the market instead, and the premium is all you lost.

The naming is the part that costs marks, because it is not intuitive:

• a call swaption gives the right to enter a swap receiving fixed and paying floating — the holder is a receiver
• a put swaption gives the right to enter a swap paying fixed and receiving floating — the holder is a payer

Swaptions are OTC instruments. The exchange-traded interest rate options market in India offers premium-style European calls and puts on government securities; swaptions sit on the OTC side of the comparison table along with caps, floors, collars and structured products.

A swaption is insurance on a rate, and it behaves like every other option in the paper: the buyer's loss is capped at the premium, the buyer's gain is not capped, and the seller's position is the mirror image.

The decision at expiry is a comparison of two rates. A payer swaption holder — someone who wants to pay fixed, typically a borrower — exercises when the market swap rate is above his strike, because the strike is the cheaper rate to pay. A receiver swaption holder exercises when the market rate is below his strike, because the strike is the richer rate to receive.

The workbook groups the whole family of OTC interest rate options together: a cap is a series of interest rate call options, paying out whenever the underlying rate exceeds the strike; a floor is a series of puts, paying out when it falls below; a collar buys a cap and sells a floor on the same rate, tenor and notional; and a reverse collar does the opposite. A swaption differs from all of these in that it delivers an entire swap rather than a single period's payment.

Payer swaption (put)    : right to PAY fixed at the strike, receive floating
                          exercise when market swap rate > strike

Receiver swaption (call): right to RECEIVE fixed at the strike, pay floating
                          exercise when market swap rate < strike

Maximum loss to the buyer  = premium paid
Maximum gain to the seller = premium received

Annual benefit on exercise = Notional × | Market rate − Strike rate |

A borrower buying protection. A manufacturer will raise Rs 100 crore of 5-year floating-rate debt in six months and fears rates rising before it prices. It buys a payer (put) swaption: the right, in six months, to enter a 5-year swap paying fixed at 7.00%. The premium is 40 basis points of notional, paid upfront:

Premium = Rs 100 crore × 0.40% = Rs 40,00,000

Case 1 — rates rise. The 5-year swap rate at expiry is 7.60%. Exercise.

Saving = Rs 100 crore × (7.60% − 7.00%) = Rs 60,00,000 a year

Rs 60 lakh a year for five years, against a Rs 40 lakh premium paid once. Discounted at the market rate the saving is worth far more than the premium, and the company pays 7.00% on a book that would otherwise have cost 7.60%.

Case 2 — rates fall. The 5-year swap rate at expiry is 6.50%. Let it lapse and swap at the market:

Loss    = the premium, Rs 40,00,000, and nothing more
Outcome = pays 6.50%, not the 7.00% strike

The company captured the fall and kept its downside to a known Rs 40 lakh. That asymmetry is what the premium bought — the same asymmetric risk exposure that defines every option in the paper.

Case 3 — it had bought the swap instead. A plain forward-starting swap at 7.00% costs nothing upfront and obliges. In Case 2 the company would be paying 7.00% against a 6.50% market:

Opportunity cost = Rs 100 crore × 0.50% = Rs 50,00,000 a year

Rs 50 lakh a year, every year, against the Rs 40 lakh the option cost once. That comparison is the whole argument for paying a premium.

Chapter 2, section 2.2.4, defines the swaption at the end of the swaps material: an option on a swap, giving the right but not the obligation to enter an interest rate swap, with the call-as-receiver and put-as-payer convention spelled out. The section 2.5 product grid places swaptions in the option column alongside interest rate and bond options. Chapter 4, section 4.10, lists swaptions among the OTC products that are not available on Indian exchanges, which offer premium-style European calls and puts instead.

Questions are definitional and directional: what a swaption is an option on, which of call and put gives the right to pay fixed, and whether swaptions trade on an exchange in India.

• Call means receiver, put means payer. A call swaption receives fixed; a put swaption pays fixed. The mapping is counter-intuitive and it is exactly what gets asked.
• A swaption delivers a swap, not a cash flow. Exercise puts you into a multi-year contract, unlike a cap or floor which settles period by period.
• The buyer's loss is capped at the premium; the seller's is not. The seller receives the premium and carries the open-ended obligation.
• Swaptions are OTC, not exchange traded in India. Exchange traded interest rate options are premium-style European calls and puts on GOI securities.
• A cap is a strip of calls and a floor a strip of puts. A swaption is a single option on a whole swap and belongs to a different row of the table.
• Do not confuse the strike rate with the current swap rate. The strike is agreed when the swaption is bought; the exercise decision compares it with the market rate at expiry.