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Swaptions are options that grant the owner a right to enter into an underlying swap, but do not require the owner to actually engage in the swap process. Generally, the use of the identification of a swaption is reserved to refer to options that involve interest rate swaps.
There are essentially two types of swaption strategies that are in common use. The first is referred to as a payer swaption. This form of swaption provides the owner of the option with the ability to enter into the swap and pay a fixed leg while receiving a floating leg. This approach is sometimes referred to as a fixed-rate payer swaption.
A second approach to the concept of a swaption is the receiver method. This approach is the opposite of the payer swaption. With this type of call swaption, the owner can enter into a swap situation where he or she will receive a fixed leg and pay a floating leg.
Regardless of the type of swaption involved, there are several points that the buyer and the seller both agree to as part of the transaction. First, both the strike rate and the premium are considered fixed. Next, the length of the option period is set, based on terms that are acceptable to both parties. Often this is in the range of two business days prior to the start date of the underlying wrap for the swaption. If amortization is involved in the options, then the two parties agree to the mode of calculation involved. Last, the seller and buyer come to terms on the frequency of payments associated with the underlying swap.
A swaption does not usually involve the single investor. Instead, it is more common for investors who deal in swaption transactions to be large corporations, banks or brokerage firms, and possibly hedge funds. The use of the swaption has a fair amount of attraction, since the strategy can be used to manage the amount of interest rate risk associated with banks and other types of financial institutions. There are swaption markets in most of the major currency markets around the world, especially the ones associated with the United States dollar, the Euro and the Japanese yen.
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