A swaption which activates or comes into life when the swap coupon crosses a threshold level or “barrier”. It comes in two kinds: knock-out swaption and knock-in swaption. The barrier is usually determined as a reference rate equal to that specified in the underlying swap. The barrier rate can be higher or lower than the swaption rate, depending on an investor’s views on interest rate. Insofar as the existence of barrier swaptions is just a matter of probability, not surety, premiums on barrier swaptions usually exceed premiums on ordinary swaptions.
Issuers of structured notes are principal users of “embedded” barrier swaptions. To lower their funding costs, issuers purchase the swaptions from investors and sell them in the derivatives market at a profit. For example, a firm would like to hedge the interest rate risk associated with a nearing note issue. If seven-year interest rates after one year are currently 6%. The firm may buy a one-year option to pay a fixed rate of 8.5% on a seven-year swap. At the same time, it could embed in it a knock-in barrier at 7%, if it believes that a rise of more than 1% in interest rate would herald additional increases.
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