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 [1]. A premium is paid for the right to swap for this option. It is used to hedge against the risk of decreasing interest rates [1]. 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 [2] trading since interest is often part of the trade.
Another way to look at a call swaption [3] is that it is a transaction which allows two entities to trade streams of cash flow [4] 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 [5]. 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 [6] 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.