Swaps and swaptions are among the most sophisticated derivatives trades, even for experienced investors. Unlike options and futures, swaps are not traded on exchanges; they are purely an over-the-counter financial product. If your company wishes to hedge risk using swaps—or even to profit from swaps speculation—it is important to carefully understand the markets and risks first. Talking to a Priori derivatives lawyer may help you to decide whether or not swaps are the right choice for your company.
Understanding Swaps and Swaptions
Like futures and options, swaps and swaptions are derivatives contracts that can be traded between two parties. Instead of trading responsibilities in relation to a single underlying stream, however, swaps trade two different cashflow streams.
A swap is a trade of two derivative cashflow streams. Basically, parties agree to exchange one stream, or “leg,” of cashflow against another leg. Generally, one leg of a swap is fixed, while another is variable, based on a benchmark interest rate, floating currency exchange rate, or index price. By trading swapping the fixed and variable legs, traders can hedge risks or speculate on the changing value of the underlying asset.
Swaptions, or swap options, are essentially exactly as they sound: they are options contracts on swaps. Essentially, a swaption gives the buyer the right but not the obligation to enter into an underlying swap during a fixed period of time for a certain price. There are three basic types of swaptions:
Payer Swaption. This gives the owner of the swaption the right to enter into a swap where they trade the fixed leg to receive the floating leg.
Receiver Swaption. This gives the owner of the swaption the right to enter into a swap where they trade the floating leg to receive the fixed leg.
Straddle Swaption. This is a combination of the payer and receiver swaptions. Basically, the owner of the swaption is betting on a large move in the value of the underlying in either direction, so they purchase both a put and call option. Only if there is little movement, the owner of the swaption makes no profit.
While options can be traded on any kind of swap, the term “swaption” is almost exclusively used to refer to swaps with an interest rate component.
What’s the Difference Between Swaps and Swaptions?
The basic mechanism for profiting with swaps and swaptions is the same. The only difference is that a swap contract is an actual agreement to trade the derivatives, while a swaption simply is a contract to purchase the right to enter into a swap contract during the indicated period. The easiest way to think about swaps and swaptions is that a swap is an immediate trade, while a swaption is the right to enter a trade at some point in the future.
Types of Swaps
There are many types of swaps and swaptions conducted through contracts on the swaps market. The following are the most common:
Interest Rate Swaps. Interest rate swaps are the most common types of swaps. In these swaps, legs exchanged are interest rate obligations on a financial instrument (such as a bond, for example) based on a notional principal amount. The principal amount is not traded—just the interest rate payments. Interest rate swaps are commonly used to hedge exposure to floating rate debt, i.e. to effectively limit the extent to which a fluctuation in the floating rate could impact payments.
Currency Swaps. In currency swaps, parties exchange interest and principal payments on debt denominated in different currencies, therefore hedging on a change in the value of the currency, not the interest rate itself.
Commodity Swaps. In commodity swaps, parties exchange for a floating commodity price, such as in the trade of crude oil.
Debt-Equity Swaps. In debt-equity swaps, fixed rate instruments like debt, for example, bonds, are exchanged for non-fixed instruments, such as stocks.
Total Return Swaps. In total return swaps, the total return from an asset is exchanged for a fixed interest rate. This allows the party holding the fixed interest rate leg to have exposure to the underlying without needing the capital to hold it.
Who can trade in swaps?
While technically anyone can trade in swaps, retail investors do not usually engage in swaps. Instead, swaps are over-the-counter contracts conducted between businesses or financial institutions.