Payers swaption

A payers swaption grants the holder the right to enter into the underlying swap as the fixed-rate payer. 

The owner of a payer (receiver) swaption maturing at time To, has the right to enter at time To the underlying forward payer (receiver) swap settled in arreas (see e.g. Musiela and Rutkowski [61])... 

The buyer of this swaption has the right, one year from now, to enter into a 3-year swap as the fixed-rate payer, paying 4% p.a. against receiving 3-month EURIBOR, on a notional principal of 10 million. If 3-year swap rates on 29 March 20X4 were, say, 4.5%, it would be worthwhile for the owner to exercise the swaption, paying a fixed rate of only 4% when the market rate was 4.5%. 

A 3-year European-style payer s swaption into a 2-year swap, struck at the fixed rate of the vanilla swap. 

If 2-year rates rise sufficiently in 3-years time, the swaption will expire in-the-money, and the investor can exercise the payer s swaption, entering into a second swap as the fixed-rate payer at exactly the same rate as the original swap, for which the investor is the fixed-rate receiver. This second swap exactly offsets the first swap, effectively cancelling the original swap for the last two years of its life. 

This arrangement could be structured as in Exhibit 17.31. This shows the vanilla 5-year swap coupled with the payer s swaption. Unfortunately, the need for the investor to make an up-front payment of 1.29% to acquire the payer s swaption makes the arrangement somewhat untidy. 

A neat way round this problem is to reduce the fixed rate of the swap below the market s fair rate of 3.00%, and have the swap counterparty make an up-front payment to the investor to restore parity. Reducing the swap rate also means that the strike rate of the payer s swaption must also be reduced in line, which increases the up-front premium payable. 

The combination of the below-market swap and the payer s swaption therefore creates a cancellable swap. Erom the investor s viewpoint, he or she can now compare ... 

A bank or corporation may buy or sell an option on a swap, known as a swaption. The buyer of a swaption has the right, but not the obligation, to transact an interest rate swap during the life of the option. An option on a swap where the buyer is the fixed-rate payer is termed a call swaption one where the buyer becomes the floating-rate payer is aswaption. The writer of the swaption becomes the buyers counterparty in underlying the transaction. 

---