Swaption

A Swaption is a finanicial term meaning an option to engage in a swap. A swap is a contract in which the parties will exchange the cash flows associated with the items they are swapping. Swaps are usually done to exchange fixed rate cash flows with variable rate cash flows. However, swaps can be done to exchange two fixed rate cash flows, especially if they are somehow irregular or differently regular flows. Sometimes, the parties are doing the swap to reduce risk, and one of them doesn't want to actually do the swap unless some market condition is reached.

An example of this would be helpful, so here goes: Joe is in Zaire and he knows there's an election coming up. Joe has some variable rate bonds that are paying very well. But, he thinks it it won't last. Dave is in the U.K. and rates are low and constant. Dave has some sovereign UK bonds that he'd like a better rate on, and likes the political outlook in Zaire.

Joe and Dave engage in a swap; Joe gets fixed cash flows from the UK bond and Dave gets the variable rate bonds. They agree on terms that set the swap as even money (present valued) for both of them. However, they don't do the swap yet because Joe's debt is about to expire and he is going to reinvest, and he only wants to do the swap if the variable rates drop below a threshold (at which point his income goes down; he wants to lock in profits). In order to lock int he profits, he's willing to arrange the option on slightly favorable terms with Dave. Dave wants the higher temporary cash flow and if the variable rates go down (which he doesn't think will happen) and is willing to live with a little risk.

Everyone is happy; the swaption can be exercised and both people may still make a profit, depending on the timing and amounts involved. At the very least, both parties either reduced or enhanced their risks/rewards as they desired.

Here's another scenario:

Doug's Tractor Company needs to engage in a swap for the following reason: They have too much risk. They have a 5 year adjustable rate business loan that they've used to buy machines to make tractors. They've just agreed to sell 10 tractors to Jimbob's Tractor Dealership at the rate of 2 per year for 5 years (they don't sell fast, etc.). The price for the tractors is set in the contract and cannot be renegotiated.

The problem is, if the interest rates go up, Doug is hosed; he has to pay lots of money in interest payments, and he loses money on the transaction. He needs to lock in an interest rate, even if it's a little above the current rate.

Across town, Stanley's Tire Co. owns a mortgage on their offices, that he cannot pay off for tax reasons and due to various legal problems tying up ownership of the property. However, he's locked into a higher long-term rate mortgage. He wants to reduce his rates.

Both of them have an opinion about the way short term rates are going to go. Stanley thinks short term rates are going to stay low, and wants to pay less. Doug thinks they're going higher than Stanley's fixed rate. But Doug only needs to do the swap if the rates get that high. Stanley agrees to a swaption. both are making a bet, and it should help them manage risk better.