Swaptions, as the name suggests, are options on swaps, specifically the right to enter into a swap as either the payer or receiver of the fixed leg.
Swaptions therefore, give traders the opportunity to express a view on or to hedge against movements in longer rates.
For example, tenure year swaps, like with caps and flaws, the terminology in swaptions does not use the call and put language, but rather we talk about payer swaptions and receiver swaptions.
A payer swap option gives the holder the right to pay fixed on an underlying swap, and the receive swap option gives the right to receive fixed.
To illustrate with an example, if you are the owner of a one year, 10 year payer swap option, then in one year on the expiry day, you have the right to pay fixed on a 10 year swap.
Note. Swaptions use the same X year, Y year date format as forward starting swaps with the first number being the time to expiry and the second the tenor of the underlying swap.
Please note that swaps and swaptions use a different date convention from caps and floors, which might seem confusing at first, but does usefully allow practitioners to distinguish between the two types of options by observing the date terminology being used? For example, if someone was to ask for a price on a five year tenure at the money straddle, they would be requesting a swap option quote.
The equivalent in caps and floors would be a five by 15 at the money straddle.
A pay a swap option will generate a positive payoff in the event the underlying swap finishes higher than the strike.
Hence, a payer can be thought of as a call option on the swap rate, which might be a useful way of picturing it.
Likewise, a receiver swap option can be thought of as a put option on the swap rate.
The equation on screen shows the payoff of a payer swap option.
If the swap is higher than the strike on expiry, the amount is multiplied by the pvo, one of the underlying swap, because the differential in fixed rates is carried over the life of the swap.
