Swaption Collar (Liability Driven Investing)

CFA Level III
#1

Guys, how does a Pension Fund improve its Portfolio BPV using Swaption Collar.

When there is Negative Duration Gap, it means the Asset BPV < Liability BPV; This is mostly true for Pension fund because they invest the largest portion of their portfolio in Equity which have lower Duration.

The curriculum has it that:

You buy a Receiver Swaption (Receiving Fixed Rate and Paying Floating Rate): Duration on the Received Fixed > Duration on Floating Payment = The Portfolio BPV is improved with Receiver Swaption, assuming interest rate is expected to decrease (when interest rate decreases, Liability BPV increases faster than Asset BPV due to the Liabilities higher Duration).

So, since we have the above scenario, how does using Swaption Collar help to solve this problem.

If we buy Receiver Swaption, we receive Fixed and pay Floating, which make sense, because we technically receive a payment with higher Duration and makes payment with lower Duration.

Now, we have to write (sell) a Payer Swaption to complete the Swaption Collar. This means we Pay the Fixed Rate and Receive the Floating Rate (or am I illusinating? lol…)

Buy Receiver Swaption = Received Fixed (higher duration) - Pay Floating (lower duration)

Sell Payer Swaption = -Pay Fixed (higher duration) + Receive Floating (lower duration)

This equation technically nets each other out. So, how does the portfolio BPV gets immunized or increases to mitigate the negative portfolio gap?

Using only the Receiver Swaption definitely make intuitive sense, but I am strugling to understand how Swaption Collar helps to maintain immunization and improve the Portfolio BPV.

Thank you scholars.

#2

I think it’s due to protection against falling interest rates, which can cause further duration gap.

Increasing r results in plan gains, but swaption collar loss would offset at least a part of it.

The result in both cases could be neutral, which is aim of the hedge.

#3

Hi,

Can you please give me the specific reference of the book?

Thanks

Regards,

Jahid

#4

Yeah this is so confusing to even read.

#5

If a pension fund only buys a receiver swaption, it protects itself against rate declines below the swap fixed rate. It retains full upside potential of rate increases that will cause a decrease in the value of liabilities more than that of the assets (assuming a duration gap). That’s positive for the funding ratio, but from an immunization perspective it’s not a perfect match.

By also selling a payer swaption, the fund gives up the upside potential of rate increases and thus it provides for better immunization. The portfolio will only fluctuate vs. liabilities between the strike rates. Remember that selling a payer swaption means the fund will receive fixed pay floating if the option buyer exercises the option, which is long duration for the fund.

#6

Exactly what I am trying to understand. So, if I issue a Payer Swaption, I will receive the Fixed Rate, or I will pay the Fixed Rate?

I think by issuing the Payer Swaption, I should be paying the fixed rate, which is not good for my portfolio.

However, if i will be receiving the fixed and pay floating, then it make sense to use Swaption Collar.

Thank you Moonborne, I was the one getting the interpretation of Payer Swaption wrong.

Thank you all. Its clear now.

#7

No problem, happy to help.

Just remember that the terminology is from the long perspective, so if we’re talking about a payer swaption the buyer of the option (long party) is going to pay (hence payer) the fixed rate if exercised. The pension fund is short payer so it receives the fixed rate and pays floating (long duration which improves immunization if rates increase).

#8

True, thank you.

#9

If you’re selling the payer swaption, the buyer of that swaption pays the fixed and receives the floating. So, since we’re selling the swaption, we receive the fixed and pay the floating. Thus, this also increases duration.