Swaptions – an intuitive account from a trader’s lens

Swaptions as the name suggests are options on interest rate swaps, that give the buyer a right (but not the obligation) to buy or sell the underlying interest rate.They are among the more elegant products in the fixed income world as in addition to the standard applications of FX/equity options world it deals with the convex payoffs of the underlying rate products. Like all other options, if the right to buy or sell is exercised at maturity it’s a European style swaption, while an exercise any time until expiry makes it an American style swaption; former are the standard market format and traded more widely.

Starting simple – the two types of options that correspond with calls and puts on interest rates are payer and receiver swaptions. Drawing a parallel with bonds – a payer swaption that’s a play on higher rates is akin to a put option on bonds, as lower bond prices correspond with higher yields. In the same vein, being long a receiver swaption is equivalent to being long a call option on bonds. In fact, valuation of long a payer swaption at strike ‘K’ is mathematically (and even intuitively) the same as being long a put option on a bond with a coupon ‘K’ and a strike price of par.

Much like the underlying interest rate swap, the option on it can be used for both hedging and speculative purposes – banks and corporates can hedge interest rate risk on their future lending/borrowing commitments (at pre-agreed rates) via payer and receiver swaptions respectively. Depending on the pattern of cashflows being hedged for future, option strategies composed of the vanilla receiver/payer can accordingly be structured. Since the advent of liability-driven investing (LDI), fixed income portfolios of even the pension community have increased the usage of swaptions to manage their duration mismatches and hedge against unexpected future movement in interest rates.

Speculators on the other hand can bet not only on the direction of interest rates (across the various sectors of the yield curve) via swaptions, but also express more nuanced views like a bull or a bear steepener in a cost-effective manner.

Premium grid for swaptions across different option expiries and underlying swap tenors (in addition to the volatility of the implied forward yields) are governed by the duration of the underlying swap. Intuitively, this is true as a longer duration would imply a larger summation of discounted forward cash-flows (in the nature of annuities) and vice versa. Additionally, the level and shape of the discount curve would explain the degree of divergence between spot and forward premia.

Swaption liquidity i.e. ease/access of trading in a large scale is significantly larger for developed markets versus emerging markets. US dollars, Euro, Sterling, Yen, Aussie Dollar are some of the major swaption markets, with trading mostly conducted over-the-counter i.e. not cleared by exchanges yet.  

For a deeper dive into swaptions and related strategies please visit pandemonium.sg that breaks down the mathematical complexity of these options (and several other market concepts) and offers crystal-like clarity - referencing real-market events - to both existing and aspiring practitioners of finance.

About the Author:

Pandemonium is a leading platform dedicated to sharing practical experiences and insights on financial markets and its products. Spearheaded by Varda Pandey, a seasoned financial practitioner with over 15 years of markets experience, we break down all jargon and offer logical and intuitive understanding of market concepts. The uniqueness of our content comes from references to real world market events to better learn practical application of the material.