Swaption

A payer swaption gives the right to enter a swap paying fixed and receiving floating; it gains value when rates rise. A receiver swaption gives the right to receive fixed and pay floating; it gains value when rates fall. Contracts specify the strike (the fixed rate of the underlying swap), the option expiry, the underlying swap tenor, notional and settlement method. Swaptions are described by expiry and tenor, so a “1y10y” is a one-year option on a ten-year swap. Exercise styles are European (single date), Bermudan (several dates) and American.

Funds use swaptions to hedge rate exposure with limited downside (the premium), to protect against callable-bond or mortgage prepayment risk, and to trade interest rate volatility. They are OTC contracts documented under an ISDA, with collateral exchanged under the Credit Support Annex.

How funds account for swaptions. The buyer records the premium paid as an asset at fair value; the seller records a liability. Valuation uses a normal (Bachelier) or lognormal (Black) model with inputs from the swaption volatility surface and the relevant discount and forward curves, so marks are usually Level 2 but can move to Level 3 for long-dated or bespoke structures. Daily mark-to-market changes are unrealized gains or losses.

Lifecycle events. At expiry the swaption is either exercised or lapses. On physical exercise, the option is closed and a new interest rate swap is booked at the strike rate, with the swaption’s carrying value rolled into the swap’s initial value. On cash settlement, the option is closed against a cash payment. A common error is letting an expired, out-of-the-money swaption remain on the books, or booking the exercised swap without removing the option. Independent price verification against counterparty marks is essential because model and volatility inputs can differ materially.

Example

A fund buys a 1y5y payer swaption at a 4.25% strike on USD 50M notional. If one year later the five-year swap rate is 4.75%, the fund exercises and enters a swap paying 4.25% fixed, below market, and books the swap at its positive fair value.