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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