Callable bond - Receiver swapation

CFA Level III Derivatives
#1

Schweser B4 pg 229, Last bullet point

Stage 1

It says ‘ The net is the company benefits from calling the bond but loses when the swapation is exercised and requires the company to pay fixed’.

AS I understand the case

  1. The bond is to be called in one year’s time

  2. Since the interest rates are falling low, the Receiver swapation is exercised

  3. As a result under the swapation, the long (receiver swapation) will receive fixed and pay the floating

  4. Over all

a. Original bond – Pay fixed (assumed)

b. Swapation: Receive fixed

c. Swapation: Pay floating

Stage 2:

Further it says ‘The company gains and loses the benefit of calling the bond and economically is in a position as if the bond had not been callable.

I could not follow the statement in stage 1, hence I am unable to understand the stage 2.

Can anyone kindly help me the understand the flows/implication.

Thank you in advance for your time.

#2

I dont have the whole example but it looks like the company called the bond because rates lowered to a favorable point so it is no longer obligated to pay at the fixed rate on that bond. Then if someone exercises a swaption which the company has sold, it is now obligated to pay the fixed again, only now it is receiving floating at a lower rate since a lower rate environment is the inly reason the company would call the bond. Basically, they are long the option on the callable bond but short the option on the swaption. Unless I misread your question it sounds like the options cancel each other out.

#3

Swaption11

Thank you for your time and interest

Below is the entire text.

[text removed by admin]

** I mis read this as buy and not as sell.

But even otherwise I am not clear on the conclusion I draw from the above.

I went through your response. I do not think what you mentioned (based ont he limited info) is happening ’ Unless I misread your question it sounds like the options cancel each other out.’

Thank you

#4

They own the option to call the bond and sold the option of the swaption for a fee. It looks like they are simply locked into a fixed rate payer no matter what happens with interest rates. If rates stay high, they continue to pay on the bond. If rates come down, they call the bond, get the swaption excercised so they are fixed rate payer, receive floating. It looks like they are just selling the option that they paid for when issuing the bonds by getting a lower price.