the question if from the CFAI book, Fixed Income, study session 11, reading 23, example 7, pg 84.
I’m confused about the answer to question 2 which is "Indicate the plan manager’s likely view on future 30-year swap fixed rates given the decision to choose the swap rather than the purchased receiver swaption or the swaption collar.
After some discussions with the rates desk at the commercial bank and a conversation with the bank’s strategy group, the plan manager instructs the QPAM to select the 3.80% receive-fixed interest rate swap. Moreover, the manager chooses a hedging ratio of 75%"
Background:The QPAM has negotiated three interest rate derivatives with the commercial bank. The first is a 30-year, 3.80% receive-fixed swap referencing three-month Libor. The second is a receiver swaption having a strike rate of 3.60%. The plan pays a premium of 145 bps upfront to buy the right to enter a 30-year swap as the fixed-rate receiver. The third is a swaption collar, the combination of buying the 3.60% receiver swaption and writing a 4.25% payer swaption. The premiums on the two swaptions offset, so this is a “zero-cost” collar.
The answer states: The plan manager’s likely view is that the 30-year swap rate will be less than 3.80%. Then the gain on the swap exceeds that of the purchased receiver swaption having a strike rate of 3.60%. If the view is that the swap rate will exceed 3.80%, the swaption collar would be preferred. The purchased receiver swaption will be preferred only if the swap rate is expected to be somewhat above 4.25%, the strike rate on the written payer swaption.
My understanding is buy the swap if rates are expected to be below 3.8%. Buy the receiver swaption when rates are expected to fall below 3.6% and buy the collar if you expect rates to fall but offset the premium of a receiver swaption by writing a payer swaption at a higher swap rate. The answer says “the purchased receive swaption is preferred if the swap rate is expected to be somewhat above 4.25%” This is the part I don’t understand, if rates go up you underhedge the liability, why would I purchase a receiver option when I expect rates to go up? Is it to protect against my uncertainty of rates falling (or my lack of confidence in rates rising) and therefore receiving a lower i/r on my assets whilst the value of my liabilities go up?
apologies for the long winded question, just wanted to provide context. the question was basically which strategy is optimal (with a swap based hedged)
receiver swap
receiver swaption
zero cost collar
going back to the text, it seems option 2 is optimal as rates rise above a certain point where the other two strategies are providing negative payoffs, beyond what was paid for the premium for the receiver swaption and due to larger payments on the swap based on higher floating rates.
but i think I guess the investor just want to hedge against falling rates and will not both with the collar if they think rates could rise about the SFR that creates a zero cost collar. I guess I found the answer, kind of
I was reading that a couple days ago and yes, it’s difficult to understand.
My take is you have to do 1 of the 3 options, so you take whichever is best - even though the best option would be to do nothing because doing nothing is not an option.
Ugh - I read that part and wasted a silly amount of time as well. Writing this out hopefully clarifies the strategies for others who come across this explanation later.
Just to recap the derivatives overlay options for immunizing the portfolio:
Receiver swap
Receiver swaption
Zero cost collar
What they’re saying is that if you had entered option 3 (net-zero cost collar) and swap rates turned out to be over 4.25%…the loss from fulfilling the short payer swap (in-the-money) position exceeds the loss of the “receiver swap only” option 2, which was the premium you would’ve paid to enter a swaption that expired worthless. Under this rate assumption, Option 2 is the least negative, and therefore the most cost-effective strategy to immunize your portfolio.
If rates were between 3.8% and 4.25%, option 3’s collar would expire worthlessly. However, its non-negative payout is still better than the other two loss-making options. Option 1, the outright swap suffers an outright position loss, receiving less than LIBOR, and Option 2, the receiver swaption, losses by the amount of premium paid. Here, the collar increases your plan assets’ BPV, reducing your duration gap and costing nothing, making it the best immunization strategy out of the three options.
Finally, if you believe rates will fall below 2.5%, then clearly the best strategy would be option 1, an outright long receiver swap, which allows you to immunize and profit at the same time (other two options would expire worthless and/or cost a premium). Don’t think a full explanation is warranted here if you read the text.