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What is a Swap Option?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 08 October 2018
  • Copyright Protected:
    2003-2018
    Conjecture Corporation
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A swap option is a type of investment approach that makes it possible for the two parties involved in the deal to trade or swap the cash flows associated with a specific investment. This type of bilateral netting allows both parties to benefit from involvement with the investment, assuming that the specifics of the agreement between the two parties are balanced and serve to distribute both the potential gains and the volatility equitably. One of the more common examples of a swap option focuses on the trading of interest rates related to particular financial instruments.

Depending on the type of swap option involved, the structure of this type of investment deal can be somewhat complicated. With a swap that involves the sharing of interest rates, one of the two parties involved may choose to exchange a fixed rate interest payment for a corresponding variable interest payment, depending on what is happening in the marketplace. This type of situation is likely to occur when one investor is firmly established with investments in fixed rate loans, but wishes to participate in a deal involving a variable rate loan. Assuming that it is possible to find a partner with interest in a number of variable rate loans and a willingness to take a chance on a fixed rate loan, this type of swap may be quickly arranged.

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With a swap option, investors have the chance to broaden the range of their investments while still holding close to a core structure to a portfolio. The degree of benefit derived from this sort of arrangement will depend greatly on exactly how the two parties choose to draft the provisions that apply to the swap. Unless the terms are properly balanced, there is the potential for one party to receive considerably more benefit over time than the other party. For this reason, investors who consider this type of investment strategy must look closely at the debt instruments involved, the projected movement of interest rates that will apply over the course of the agreement, and the possibility of different events shifting the average rates in a direction that would be considered undesirable.

Engaging in a swap option requires keeping close watch over the investment, monitoring the marketplace regularly, and choosing the right type of commodities for the deal. The complexity of the process can be intimidating, especially to newer investors who are just beginning to understand how investment markets work and what can occur to change the direction of a market. For this reason, seeking professional advice from brokers and other financial experts before attempting to enter into any type of swap option is often a prudent decision.

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