A swap in a layman's term denotes “exchange” of something. In financial markets however, a swap is a derivative contract that facilitates exchange of financial instruments between two counterparties. Generally swaps are designed to facilitate exchange of cash flows or liabilities originating from two different financial instruments.
An option is also a derivative instrument enabling the holder or buyer the right to buy or sell the underlying asset but not the obligation to do so. And the writer or seller of option contract is under obligation to sell or buy the underlying asset if the holder or buyer chooses to exercise the option.
A Swaption is a hybrid derivative of swap contract and options contract. A swaption therefore possesses components of both swap and options. Like a regular swap there is an exchange of cash flows or liabilities, sometimes the underlying can even include physical swap of FX or commodities. And, since swaps are customised or non-standard contracts they are often traded on OTC (over-the-counter) markets.
The trading characteristic of swaptions is generally closer to options than to swaps. Therefore, it would also comprise components that are essential to an option contract viz; expiration date, strike price and exercise style like America, European or Bermuda.
A swaption can be further classified into Payer swaption and Receiver swaption. A Payer swaption enables the buyer to enter into a swap contract and obtain the right to receive the floating rate and pay the fixed rate. A Receiver swaption confers the right to enter into a swap contract and obtain the right to receive fixed rate and pay the floating rate. The holder of Payers option benefits from rise in floating rates and the Receiver swaption holder benefits from the falling of floating rates.
And since the swaption is also an OTC derivative instrument the pricing also tends to be crucial and is a bit more difficult than pricing a regular exchange traded options contract. As described earlier that trading characteristics of swaptions are closer to options as against swaps, the components that affect option premium are equally influential on pricing of swaptions. The increase in floating rate of interest or increase in volatility of interest rates would lead to eventual increase in option premium. Longer the time till expiry, higher the extrinsic value and therefore more expensive option price. And, if the strike interest rate is closer to real interest rate again higher would be option premium. This would be akin to Strike price being closer to current market price of the underlying asset, thus making the strike At-the-Money which tend to be considerably more expensive and extremely sensitive to Theta.
Receiver swaption are more commenly used by Oil refineries and Airlines industry. Both require oil as input and are often subjected not just to price fluctuation in crude oil but even in USD rates, in which the crude oil is predominantly traded. Accepting a fixed crude oil price enables the companies to establish a baseline for determining the cost of operations. Also in terms of pricing Crude oil tends to be more volatile and susceptible to price change with very wide trading range. Comparatively in USD despite being volatile is bound to trade in moderately narrow range as it also functions as reserve currency. Therefore, when oil prices rise the receiver swaption functions as an effective hedge and when the oil price settle below the strike price, the companies would not choose to exercise the option and instead buy the crude oil from open market at lesser rate and forgo the option premium.
Swaptions are highly customisable and offer the most amount of flexibility to counter parties but at the same time they are extremely difficult to price and execute and therefore not conducive for speculative trading, especially for novice traders and investors.