The characteristics of derivative contracts, such as forwards, futures, options and swaps, can also be combined to form a new financial instrument. A swaption agreement is an example of such a tools. A swaption can be considered an option on a swap, and is therefore a derivative of a derivative.
A swaption is a combination of extremely popular financial instruments. The tool is appreciated by organisations as it provides a great way to hedge risk with a limited downside. Obviously, swaptions can also be applied to speculate, but that is not in scope of this book.
Even though generic derivatives are already relatively complex, in order to understand swaptions, one needs even more expertise and the ability to think in abstract terms. Not just the product is complicated, its valuation process also requires sophistication. It is quite challenging to price swaptions. Consequently, there is a lot of demand for quick and effective techniques to valuate swaption agreements.
A swaption contract concerns an option on a swap and, thus, a derivative on a derivative. Therefore, a swaption concerns a compound derivative. A swaption is not a swap yet, but the right to take a position in the swap underlying the overall agreement. This is why, upfront, a premium payment is required by the buyer, just as with outright options. Such an out-of-pocket expense gives the holder of the swaption a right, not an obligation, as he does not have to exercise his right, but it only advised to do so if preferred. Hence, it brings the swaption holder flexibility.
As with all derivative contracts, swaptions are legal agreements between two parties. The swaption contract specifications covers all terms and conditions. Therewith, it represents the details as negotiated by the counterparties. These specs include the following aspects:
- The strike price (or rate) (which is typically equal to the fixed price (or rate) of the underlying swap);
- Maturity (i.e. expiration date + time) (indicating the remaining lifetime (or validity period) of the option);
- The terms of the underlying swap (i.e. swap contract specifications);
- The notional amount (i.e. the underlying sum of the swap);
- Amortisation (if any);
- The settlement frequency on the underlying swap (i.e. periodic payments).
On the basis of these details the premium (price) of the swaption is negotiated.