Call Swaption

  

It sounds like the name of the dashing options trader who becomes Archie's rival for a four-episode arc on Riverdale. But, no, a call swaption is a clever name that only finance people could come up with to refer to a combination of an interest rate swap and an option.

This strategy involves a player (usually a bank or large corporation) who wants to have the ability to hedge against falling interest rates. Borrowers who have a floating interest rate can swap with another party to a fixed rate to make costs more predictable. Or they can take advantage of lower interest rates and swap a fixed interest rate for a floating one. The option part comes in because it gives the holder the right to enter into a swap agreement as the floating rate payer and the fixed rate receiver.

A strike price of the option is established, (the price at which action will be taken), an expiration date, and the fixed and floating rates. Once the strike price is reached, the fixed interest rate can be swapped for a floating interest rate.

If this sounds like a lot of gibberish, an example here might be helpful. Let's say Knowitall University is watching the market closely and expects interest rates to fall. They have a large amount of fixed interest rate debt and want to hedge, so they can take advantage of the falling interest rates. So they enter into a call swaption to convert its fixed rate debt to a floating rate for the duration of five years. Now they can pay a variable interest rate on their debt (which they hope means the rate will go lower). If interest rates rise, they will lose out.

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