International Financial Management: An Analytical Framework, 2nd Edition by Pearson

FINANCIAL SWAPS 287

six-month LIBOR for a five-year period, starting from a certain date six months from

now. Suppose that, at the maturity of the option, the market swap rate is less than 7 per-

cent. The firm will then exercise the option and accordingly enter into a swap. The

firm, therefore, will be able to enter into a swap at more favourable terms because of

swaption.

Thus, the holder of a swaption can benefit from favourable interest rate movements

and, at the same time, protect itself from unfavourable interest rate movements, of course

at a cost. The seller of a swaption has an obligation to discharge the agreement according to

the stated terms, in return for the upfront premium paid by the buyer. Swaptions are also

different from ...