Call Swaption: What it Means, How it Works

What is a Call Swaption?

A call swaption, or call swap option, gives the holder the right, but not the obligation, to enter into a swap agreement as the floating rate payer and fixed rate receiver. A call swaptions is also known as a receiver swaption.

How a Call Swaption works

Swaptions function as the option to swap one kind of interest rate payments for another. This provides a kind of risk protection against rising or falling rates depending on the kind of option acquired. Swaptions are similar to other options in that they have two types (receiver or payer), a strike price, expiration date, and expiration style. The buyer pays the seller a premium for the swaption.

Swaptions come in two main types: a call, or receiver, swaption and a put, or payer, swaption. Call swaptions give the buyer the right to become the floating rate payer while put swaptions give the buyer the right to become the fixed rate payer. These constructs allow call swaption buyers to take advantage of floating rate payments in markets with falling interest rates, and gives put swaption buyers the insurance against such markets.

Strike prices for swaptions are actually interest rate levels. Expiration dates may appear quarterly or monthly depending on the offering institution. Expiration styles include American, which allows exercise at any time, European, which allows exercise only at the swaption's expiration date, and Bermudan, which sets a series of defined exercise dates. The style is defined at the onset of the swaption contract.

Swaptions are over-the-counter contracts and are not standardized like equity options or futures contracts. Thus, the buyer and seller need to both agree to the price of the swaption, the time until expiration of the swaption, the notional amount, and the fixed and floating rates.

Call Swaption Considerations

The buyer of a call swaption expects interest rates to fall and desires to hedge against this possibility. As an example, consider an institution that has a large amount of fixed-rate debt and wishes to increase its exposure to falling interest rates. With a call swaption, the institution converts its fixed-rate liability to a floating-rate one for the duration of the swap. Thus, the receiver swaption can now plan to pay a floating rate on their balance sheet debt and receive the fixed rate from the put swaption position. If interest rates fall, the call swaption can benefit by paying lower interest. Neither position has a guaranteed profit and, if interest rates rise above the call swaption payer's fixed rate, they stand to lose from the adverse market move.

Put Swaptions

Put swaptions are the inverse position to call swaptions and are also called payer swaptions. A put swaption position believes interest rates may increase. In order to capitalize or hedge this possibility, the put swaption holder is willing to pay the fixed rate for the chance to profit from the fixed rate differential as the floating rate increases.