Hi guys, I can’t figure out how swaption works. I’ve read a lot of posts but I’m still confused about some definitions.
This is an example from the textbook Level 3 Book 2 page 326.
This contract is called a receiver swaption. The cost is a known amount paid upfront. Suppose that the strike rate on the swaption is 3.50%. Given that the current 30-year swap fixed rate is assumed to be 4.16%, this receiver swaption is out of the money. The swap rate would have to fall by 66 bps (= 4.16% – 3.50%) for the swap contract to have intrinsic value. Suppose that the swaption premium is 100 bps.
When the expiration date arrives, the plan exercises the swaption if 30-year swap rates are below 3.50%. The plan could “take delivery” of the swap and receive what has become an above-market fixed rate for payment of the three-month MRR. Or, the plan could close out the swap with the counterparty to capture the present value of the annuity based on the difference between the contractual fixed rate of 3.50% and the fixed rate in the swap market, multiplied by the notional principal. This gain partially offsets the loss incurred on the higher value for the pension plan liabilities. If 30-year swap rates are equal to or above 3.50% at expiration, the plan lets the swaption expire.
Please correct me if I’m wrong:
strike rate 3.5% is always tied to the fix leg
current swap rate refers to the fixed rate in swap, and it is changing constantly in the swap market
pay floating rate is equivalent to pay MRR, and this floating rate has nothing to do with current swap rate and strike rate
a receiver swaption is usually used by a bond issuer who tries to pay the coupon using the fixed rate received
in this example, if the swap rate is larger than 3.5%, do not exercise the option because the current swap rate is over 3.5%, net return = current swap rate - MRR - premium; if the swap rate is less than 3.5%, exercise the option, net return = 3.5% (strike rate) - MRR - premium.
Thanks.
Correct: the strike rate will be the fixed rate on the swap if you exercise the option.
Correct.
So far, so good.
That’s a bit of an overstatement. As you recall from Level II, the swap fixed rate is calculated using the existing spot curve, so the current MRR does have something to do with the current swap rate and the strike rate. However, once you’ve entered into the swap or the swaption (i.e., signed the contract), then a change in the MRR will not affect your swap’s or swaption’s fixed rate; it’s fixed.
There are two parties to a receiver swaption: the buyer and the seller (writer). Remember, in a receiver swaption, the buyer has the option to enter into a swap to receive the fixed rate and pay the floating rate; should the buyer exercise the option, the writer has the obligation to enter into a swap to pay the fixed rate and receive the floating rate.
You might buy a receiver swaption in the expectation (hope) that future interest rates will be lower than those implied by the spot curve, and you might sell (write) a receiver swaption in the expectation (hope) that they’ll be higher. Should the issuer of fixed rate bonds believe that interest rates will fall, she might buy a receiver swaption: if rates fall, she can exercise the option and effectively convert the fixed rate bonds to floating rate bonds. Should she believe that interest rates will rise, she might sell a receiver swaption; if rates rise, the buyer will not exercise the option, so she keeps the premium.
