Swaption

Swaption is a type of an option that gives the buyer the right but not the obligation to enter into a swap contract on a specified future date. Swaptions are over the counter contracts, i.e. not traded on an exchange.

There are two types of swaption: a payer swaption and a receiver swaption. In a payer swaption, the buyer has the right but not the obligation, to pay a fixed rate and receive a floating rate in the underlying swap. In receiver swaption, the purchaser has the right but not the obligation to receive a fixed rate and pay a floating rate in the underlying swap.

Swaption can be used when there is uncertainty about whether interest rates will increase or decrease in the future. Instead of using an interest rate swap, a swaption can be used to protect against the risk of higher borrowing costs, but without being benefited from lower interest rate.