A swaption, or a swap option, is an option to enter into a specific type of financial agreement known as an interest rate swap. The buyer of a swaption contracts the right, but not the obligation, to enter into an interest rate swap agreement with a counterparty. The types of swaptions available are determined by the type of financial agreement that the swaption grants the right to enter into.

There are three main types of swaptions – Bermuda, European, or American – which vary based on when, and how, the option can be exercised.

Bermudan swaptions are specific to a predetermined set of dates. The purchaser of the swaption can only exercise the option and enter into the swap agreement on a select number of predetermined dates.

In a European swaption, the purchaser is only allowed to exercise the option at expiration. This means that the option can only be exercised on the date the swaption is set to expire, and no other date.

The final type of swaption is American, which allows the option to be exercised on any day between the origination of the swap and its expiration date. American swaptions usually come with a short lockout period after origination which may determine when the option can actually be exercised.

Separate from the particular type of swaption, the purchaser is guarded against swings in the price and value of the underlying interest rate swap via a right to early termination. This allows the purchaser to terminate or default on the swap and avoid the full consequences of adverse agreement terms.

All together, swaptions are a valuable tool for buyers, who are looking to secure a position in an interest rate swap, but are not yet ready to commit to the agreement. By purchasing a swaption, buyers can protect their position by obtaining a certain level of hedging against price fluctuations, among other benefits.