A swaption is an option granting its owner the right but not the obligation to enter into an underlying swap. Although options can be traded on a variety of swaps, the term "swaption" typically refers to options on interest rate swaps.
There are two types of swaption contracts:
- A payer swaption gives the owner of the swaption the right to enter into a swap where they pay the fixed leg and receive the floating leg.
- A receiver swaption gives the owner of the swaption the right to enter into a swap in which they will receive the fixed leg, and pay the floating leg.
The buyer and seller of the swaption agree on:
- the premium (price) of the swaption
- the strike rate (equal to the fixed rate of the underlying swap)
- length of the option period (which usually ends two business days prior to the start date of the underlying swap),
- the term of the underlying swap,
- notional amount,
- amortization, if any
- frequency of settlement of payments on the underlying swap = basis point spread
Read more about Swaption: The Swaption Market, Properties, Swaption Styles, Valuation, First Known Swaption