Swaption - Wikipedia, the free encyclopediahttp://en.wikipedia.org/wiki/Swaption1 of 29/1/2005 6:53 PM
From Wikipedia, the free encyclopedia.A
is a financial instrument granting the owner an option to enter an interest rate swap. A swap is a contract inwhich the parties will exchange the cash flows associated with the items they are swapping. Swaps are usually done toexchange fixed rate cash flows with variable rate cash flows. However, swaps can be done to exchange two fixed rate cashflows, especially if they are somehow irregular or differently regular flows. Sometimes, he parties are doing the swap toreduce risk, and one of them doesn't want to actually do the swap unless some market condition is reached.Swaptions are now quotidian (or in market jargon "vanilla") instruments in today's financial markets. There is a liquidswaption market on the LIBOR rates of all the world's major currencies.
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There are three styles of Swaptions. Each style reflects a different timeframe in which the option can be exercised.American Swaption, in which the owner is allowed to enter the swap on any day that falls within a range of two dates.Bermudan Swaption, in which the owner is allowed to enter the swap on a sequence of dates.European Swaption, in which the owner is allowed to enter the swap on one specified date.
An example of this would be helpful, so here goes: Joe is in Zaire and he knows there's an election coming up. Joe hassome variable rate bonds that are paying very well. But, he thinks it won't last. Dave is in the U.K. and rates are low andconstant. Dave has some sovereign UK bonds that he'd like a better rate on, and likes the political outlook in Zaire.Joe and Dave engage in a swap; Joe gets fixed cash flows from the UK bond and Dave gets the variable rate bonds. Theyagree on terms that set the swap as even money (present valued) for both of them. However, they don't do the swap yetbecause Joe's debt is about to expire and he is going to reinvest, and he only wants to do the swap if the variable rates dropbelow a threshold (at which point his income goes down; he wants to lock in profits). In order to lock in the profits, he'swilling to arrange the option on slightly favorable terms with Dave. Dave wants the higher temporary cash flow and if thevariable rates go down (which he doesn't think will happen) and is willing to live with a little risk.Everyone is happy; the swaption can be exercised and both people may still make a profit, depending on the timing andamounts involved. At the very least, both parties either reduced or enhanced their risks/rewards as they desired.