Call Swaption - Explained
What is a Call Swaption?
Written by J. Mance Gordon
Updated at April 23rd, 2024
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What is a Call Swaption?
A swap agreement refers to a contract that allows two individuals or parties exchange or swap financial instruments. This exchange is with the aim of attending to the different needs of both parties. In a call option, a call swaption gives its holder, usually a buyer the right to make a swap agreement with another party as the floating payer and the receiver of the fixed rate in the contract. A call swaption is also called a receiver swaption. Holders of a call swaption are not under any obligation to enter such agreements, rather, it is a right which they might choose to exercise or otherwise.
How Does a Call Swaption Work?
There are two types of swaptions, they are call swaption and put swaption. A call swaption is also a receiver swaption while a put swaption is a payer swaption. Swaptions are not standardized agreements or contracts, all swaptions are done over-the-counter (OTC). Just like options, there are certain terms that parties must agree to in a swaption. Swaptions also have their strike price, expiration date and other terms contained in the agreement such as the notional amount, fixed and floating rates. Also, expiration style for swaptions differ from place to place. We have the American, Bermudan and European styles which have different features.
Call Swaption Considerations
In a call swaption, the holder of the right needs to agree to be the floating rate payer and fixed rate receiver in the swap agreement. That means that the holder of this type of swaption exchanges its fixed-rate liability for a floating-rate liability. Hence, he pays a floating rate to the other party and receives a fixed rate from the same party. Buyers of call swaptions enter into an agreement with the aim of hedging against a potential decline in interest rates.
Put Swaptions
A put swaption is the opposite of a call swaption. In this swap agreement, the holder of a put swaption pays the fixed rate and receives a floating rate. Individuals or institutions that go for this swaption do so with the perception that the interest rate of the option will likely increase. Hence, they agree to pay the fixed rate to the call swaption holder in exchange for the likely profit they will realize when the floating interest rates increase.