How Does a Swap Option Work?

A swap option is a complicated financial instrument that allows two parties to trade cash flows based on a number of different arrangements. In most cases, the party electing a swap option, or swaption, sees an advantage in one market over another, called a comparative advantage. If another party has the opposite comparative advantage, the two can trade and have a mutually beneficial agreement.

Swap Option Example

The most common type of swap option is an interest swap. Typically, this means one party exchanges a fixed rate interest payment for a variable rate interest payment and visa versa. Imagine one party has a comparative advantage in a market for fixed rate loans, but the company actually wants a variable rate loan. The company can source the fixed rate loan. Then, the company, or individual in rare cases, can exchange the loan terms with another borrower who did just the opposite.

Swap Option Risks

Swap options were blamed for a large portion of the responsibility in the 2007 market crash. The options in themselves are not bad, but they are challenging to understand and often end up being traded again and again on secondary and futures markets. As a result, they can pose a systemic risk.