What is a Swaption?

A swaption is an option on an interest rate swap. The buyer of a swaption has the right, but not an obligation, to enter into an interest rate swap with predefined terms at the expiration of the option. In exchange for a premium payment, the buyer can lock in either a fixed or variable interest rate. Thus, if the buyer believes that interest rates will rise, he can enter into a swaption agreement, which he can later convert into an interest rate swap if interest rates do indeed go up.

A swaption can be a risky endeavor for the swaption seller, since the seller is taking on a potentially substantial risk in exchange for a premium.

Users of Swaptions

Swaptions are primarily entered into by larger business enterprises, such as banks, hedge funds, and corporations. Corporations are primarily interested in mitigating their risk of incurring increasing interest costs over time.