Forward Swaps, Swap Options, and the
Management of Callable Debt
Keith C. Brown
Donald J. Smith
Journal of Applied Corporate
Finance
2, 1990, pp. 59-71
Recent economic conditions have forced issuers of callable,
fixed-rate debt to reexamine the question of what to do when market interest
rates decline substantially prior to the bond’s call date. In this paper, we demonstrate how interest
rate swaps with forward start dates and options on these swaps can be used to
address this problem. Specifically, we
show that forward swaps and swap options can be used in two distinct ways: (i) to preserve a maximum debt refinancing rate until the
end of the call deferment period, or (ii) “monetize” the value of
the otherwise non-marketable European-style option embedded in the callable
bond issue. We further demonstrate that
while neither of these strategies is completely riskless,
both are able to effectively hedge the volatility associated with explicit
movements in the underlying term structure of interest rates.
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