The example on page 487 (Swap strategies) describes how CHEMID (a company which issued a 8 % fixed rate callable bond) tries to remove the call by selling receiver swaption (which swaption shall be considered identical with a call).
At the beginning, the example states that the company pays coupon of 8 %. I would assume that after removing the call feature, the company will pay lower coupon (less expensive without the call feature). At the end of the example, however, the conclusion is, that after all CHEMID pays effectively 8 %, equivalent to non callable bond. How come that the rate of callable bond is equal to the that of non callable? Is it because of the change in market rate?
Am I erroniously understanding something here? Advices and clear explanation on this will be much appreciated!
You are confusing coupon with yield. Without the call option, the price of the bind should increase since the call benefits the issuer, the investor is short the call. With the call, the yield on the bond shoud be higher than an equivalent noncallable bond. I didnt read the example but what I infer from your question is that you think the coupon should change but it will not, only the price of the bond without the call option of the issuer. Hope that helps some.
I think it is referring to tbe rate/yield. I dont see how an issuer can suddenly change the coupon it is contractually obligated to pay on a bond. I am open to others opinions, I just dont see how they can change their coupon payment.
The issuer issues the bond at higher cupon (compared to non callable bond). This is how he attracts investors (in spite of his ability to call the bond at any time).
I am with SWAPTION11 on this. I did not read the example but I would think they are referring to the Yield as the borrower needs to compensante the invester for the embeded option and therefore it needs to be higher that comparable option free bonds.My guess it may be just the fact that at the issue the coupon was ~ yield.
Higher coupons will be benificial either if you think that interest will rise so reinvestment will be favorable or if you are interested in matching cash flows.
if an invester is attracted by high coupons, it will be the case wethere the bond is callable or not. Actually callable bonds offer protection to the lender agains a decline in interest rate
I read the example and it seems poorly worded, my explanation is correct but also poorly worded. The basic take away is that the issuer sells bonds for a rate slightly higher than what his credit rating should receive, given the fact that he holds an option of value and the investor does not. Fast forward, he decides to sell the call option he holds by selling a receiver swaption to another party. The premium paid to him monetizes the option that he was holding so it represents a cash payment to him similar to what he would have received on top of the bond funds had he issued the bond without the call option attached. This lowers the effective rate he is paying, but leaves the coupons unchanged and his investors do not know or care what he just did. The third party paying the premium makes the bond proceeds similar to that of a non callable bond with the samd credit rating. His option to call the bind at a lower rate will be offset by his obligation to pay fixed on the swaption. Short callable bond + short fixed receiver swaption = short noncallable bond.
Are those sentences you wrote listed anywhere? If I own a callable bond, the issuer is long the option and I an short the option. callable bond + option value = non callable bond so lets give them values, 990 + 10 = 1000. So if I issue the callable bond and get 990 instead of an equivalent non callable bond, then later sell the call option (fixed receiver swaption) I kept for 10, I now have 1000 for a callable bond without the option, the same as a non callable bond. Does that make sense? It is a bit simplified but I believe it is correct in theory.
Long callable bond + Long receiver swaption = long noncallable bond
Why? Because when you own a callable bond you have effectively sold a call option to the issuer, which has value when interest rates decline (because they’ll call the bond back) and it is a negative value to you the investor. You need to purchase an option to offset this, which would be a receiver swaption, because you receive fixed and pay floating, which also has value when interest rates decline because you continue to receive the high fixed and pay the lower floating, so it has positive value to you. This offsets your short call option position embedded in your long callable bond position.
In your example, the opposite positions would be true. Here the issuer is short the callable bond (obviously) and has effectively bought a call option from the investor, so he is long the option. To offset this call option which is worthless if interest rates don’t decrease and is an added cost since he has to compensate the investor for the option, through intial higher coupon or whatevs, he would enter a short receiver swaption to offset this. The short receiver swaption gives the long the option to enter into a pay floating, receive fixed swap which only has value if interest rates decline. So if the issuer believes interest rates will stay the same or increase, he can offset the added cost of his long call position (worthless under those interest rate conditions) embedded in the callable bond, by collecting the premium from selling the swaption.
I think I got that right. Anyone who has passed the exam can confirm?
We were discussing the same point, but from different perspective:
From the issuer’s perspective: long callable bond + short receiver swaption = long noncallable bond
From the investor’s perspective: long callable bond + long receiver swaption = long noncallable bond
I understand the logic behind the swaption. My initial question was more on the coupon amount and whether one shall expect to change when removing the call option. From what you wrote, I understand that it will not, as the benefit of removing the option to the issuer (as in the example) comes in the form of premium from the shorted swaption. In anticipation of changing interest rates, the investor can decide whether to keep the option or short it to offset the call option position. Is my understanding correct?
concept: you issue a callable bond for which you pay premium interest rate. Let’s PV the coupons and say we committed to a $55k on a 20mn bond.
Our intention of issuing such a bond is that we might refinance it for a lower rates expecting interest rates to fall. However, that likelyhood is decimated.
So in order for us to remove it, we want to receive the $55k. So let’s sell an option which will expire in the money only when interest rates fall such as what a call option does.
So let’s see can we sell a call option on a bond? We likely receive less prem. how about a swap?
a swap would switch fixed with floating (libor) interest payments. When interest rates fall, a receiver swap will be priced higher because you would rather pay low coupons and received fixed. The likely hood of exercising this swap is more in a low interest environment. So you want to short this – receive prem for this. So sell receiver swaption on a notional that pays you $55k. This feature is as likely to be exercised as a call but you recieved your call prem upfront.
So effectively you did away with the call option but actually you did not change anything with you existing callable issue.
@jpbcologne, The investor can decide to keep exposure to the option because remember he is short the option, and he offsets this exposure by purchasing a receiver swaption.
The owner of the bond is irrelevant but in your case the issuer would be short everything. When you issue a bond you are short the bond and the investor is long the bond.