Swaption
An option giving the right to enter an interest rate swap at a future date at a rate fixed in advance, used by life insurers to hedge rate guarantees against falling rates.
A swaption is an option on an interest rate swap: for a premium paid up front, the buyer gets the right, but not the obligation, to enter a swap at a set date at an agreed fixed rate. A receiver swaption, which grants the right to receive the fixed rate, gains value when rates fall; a payer swaption, when they rise. For a life insurer, the appeal lies in the shape of the payoff: a rate or annuity guarantee costs nothing while rates stay high and becomes very expensive when they fall, an asymmetric profile that a plain swap replicates poorly, since it gains and loses symmetrically. The swaption replicates that convexity. Its limit is price: the premium depends on rate volatility, and it is highest precisely when the need for protection is most visible.
In 2003, Antoon Pelsser, an actuary at Nationale-Nederlanden, published in Insurance: Mathematics and Economics (volume 33, issue 2) a method for statically hedging UK guaranteed annuity options with a portfolio of plain vanilla swaptions. Tested on UK rates from 1980 to 2000, the period that had led Equitable Life to close, it proved an effective hedge and considerably cheaper than reserving up front.
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