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Swaption
       
 
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Swaption

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Swaption
An Option to enter an Interest rate Swap. A payer swaption gives the purchaser the right to pay fixed, a receiver swaption gives the purchaser the right to receive fixed (pay floating). Apart from those in the sterling market, many swaptions are capital-market driven. Good-quality borrowers are able to issue puttable or callable bonds and use the swaptions market to reduce their financing costs. In the case of callable bonds, the issuer effectively buys an Option from the investor in return for a slightly higher Coupon, so that it may benefit if rates decline. Because many of these embedded options have traditionally been underpriced, good-quality borrowers have been able to monetise this anomaly by selling an equivalent swaption (a receiver swaption) to a bank at market rates. The profit from this Arbitrage lowers funding costs. If the swaption is exercised against the issuer, it calls the bonds (although the issuer would almost certainly have called the issue given the reduction in rates). In the case of puttable bonds, the borrower sells a swaption to the swaption market. The Premium gained lowers the funding cost at the Expense of leaving the borrower unsure of the maturity of the Debt.
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