Have You Heard of a Call Swaption?

by Investing School on March 10, 2012

Simply put, the term “call swaption” is an abbreviation of the term call swap option. It defines a process by which two parties can swap one financial instrument for another. An option makes the process voluntary, not mandatory, providing the buyer with a guaranteed rate of return if they exercise their option.

The buyer, in these transactions, has the right to receive a fixed interest rate. A premium is paid for the right to swap for this option. It is used to hedge against the risk of decreasing interest rates. The option to switch interest rates is particularly useful when rates are fluctuating since the rate that the buyer will receive is fixed. This is a common process in Forex trading since interest is often part of the trade.

Another way to look at a call swaption is that it is a transaction which allows two entities to trade streams of cash flow for one another. The streams are called the legs of the swap. Such swaps can involve either cash or collateral and the details are controlled by a previously determined agreement or contract. The buyer will pay a premium for the right to potentially make the swap at a future date.

While a call swaption offers the buyer some security with regards to interest rates connected to a specific purchase, there must be a calculation made to determine whether the premium will be offset by the fixed interest rate set in the agreement. Only by running the numbers will a buyer know if entering such an arrangement is useful, and at what point to exercise their option.

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