Exhibit 14 and the text that explains it just hurts my head. Looking at prior questions regarding this topic on Analyst Forum, most people asked about why a receiver swaption is like a call option on a bond. That part I sort of got. But there seems to be something missing in the explanation of the Chemical Industries (CHEMIND) example, or maybe I’m just too dense for this one.
Before selling the receiver swaption, CH pays 8% fixed to their bondholders (let’s call this Situation A). After selling the receiver swaption, if it expires out-of-the-money (Situation B), they continue paying 8% to the bondholders and nothing to the swap dealer. If it expires in-the-money (situation C), they have a netted outflow to the dealer of (0.055 - Market Rate) and an outflow to the bondholders due to the resissue of (Market Rate + 0.025), which combines to a total netted outflow of 8%.
Since Situations B and C have turned out exactly the same and the only outcome difference between them and Situation A is the fact that A lacks the $425,000 premium at the beginning, I’m left assuming that this premium amount is MAGICALLY the PV of the difference between the payment stream of $800,000 interest payments and what the interest payments would have been if the bonds hadn’t been callable in the first place.
First, is that a correct interpretation of the $425,000 (minus the “magically”)? Second, if that is correct, do I need to understand how and why $425,000 is the correct value? Third, if the 8% represents LIBOR par rate + credit spread as indicated in the text, which of those would be less if the bonds weren’t callable?