Question on Payer/Receiver Swaptions

A payer / receiver swaption is similar to which of the following:

  1. call / put options on interest rates

  2. call / put options on fixed income securities

Should it be payer (receiver) swaption is similar to a call (put) option on interest rates or a put (call) option on fixed income securities.

i hate this topic. I am not bothering to understand it 100%

Yes you are right.

To answer these questions correctly:

  1. Think of a swap, where one party receives fixed and pays float (the other party pays fixed and receives float).

  2. A swaption is an option just like any call/putt option on stocks and bonds, except that the underlying is a swap.

  3. If you buy a receiver swaption, then you have the right to get into a swap at expiration or not. It’s up to you. If you do execrise your swaption, then you will be the RECEIVE fixed part, so that means you will pay float.

  4. A call on a bond is again just like any stock call option. If the bond price goes up, you win.So, if interest rates fall, you win, but you are *not* buying a call on interest rates, rather on the bond price itself.

  5. If the swap rate is fixed at 6%, it means if you buy it 3 months later, you will receive 6% interest and pay whatever is the floating rate is at that time. In order to be able to do that months from now, you need to buy a receiver swaption. Then sit back and wait.

  6. Let us say that the floating rate 3 months down is 3%. Your swaption says you can receive 6%, so that’s good, you would execrise it.

  7. How is that similiar to a call on a bond? Since interest rates dropped to 3%, the bond price must go up, so you win with your call on the bond.

That’s how they are similiar.

Great! At least I’m right on track on my understanding.

In summary, payer (pay fix rate) swaption is similar to call option on interest rates and put option on fixed income securities because as interest rates rises your option increase in value because:

a) Payer Swaption: current swap rate increases and you benefit from receiving a higher floating rate than fix

b) Call Option on Interest Rates: Interest rates increase, you receive the value due to differential rates

c) Put Option on Fixed Income: Interest rates increase, fixed income securities price drops and a put option increases in value.