Swap

See: Swaption. Can we just say its an option to swap? Like that thing where the couples put their keys in a fish bowl as soon as they get to the party? Or maybe not.

Yeah. Like Microsoft is “microcomputer” and “software.” Or like “electrocution” is “electricity” and “execution.” Or like bromance is “brother” and “romance.” Which is...something totally different when dealing with gerbils.

Anyway, one day a guy was holding a swap, turned a corner, wasn't looking where he was going. Then blammo. He ran into an option. What came of it was a super-hybrid type of security... wherein a swap is tacked on to an option.

OK example time:

You want the ability to pay off your loan either in US dollars or in Euros, assuming they still exist when your loan comes due. That is, you have the option to swap the flavor of payments you are making for the hundred grand you borrowed. So how does that play out? Well, when the bond was issued, one dollar bought you one Euro. And the interest rate was 8%, so you paid 8 grand a year to rent that hundred for 10 years, at which point you’ll pay it all off.

Simple.

But after 5 years, the exchange rates have drifted massively. Magic fairy dust was sprinkled by wizards all over Europe. They beat back the 32-hour work week, corruption, unions and economic misery wrought by not being able to compete with China, Russia, and Africa.

And now, amazingly, the Euro is a much stronger currency than the US dollar. In fact, one Euro buys you two U.S. dollars. So if you, holding the swaption on the interest payment flavor of the 100 grand you borrowed... so choose, you can pay that 80 grand in Euros.

That is, instead of 80,000 dollars a year in interest. you can pay 40,000 Euros. It’s almost as if your interest rate was cut in half. And if you live in Europe and work in Europe and were paid in Euros, it really is like a Roman Holiday of interest rates.