Firm X has a callable bond outstanding. The firm intends to synthetically convert the bond to a noncallable bond using a swaption. Which of the following is the most appropriate action for the firm to take?
Buy a receiver swaption.
Write a receiver swaption.
Write a payer swaption.
Please help me to understand why “Write a receiver swaption.” will be right here.
AS per the question, That means X expected the interest rate to increase, thus long position in floating will be more profitable thus fixed rate payer. X will sell swaption to pay fixed. C has to be right as per the explanation provided above. Please help where I am going wrong. Thanks
The basics: The call in the callable bond is an option to the firm, and the firm benefits from this option if interest rates were to decline (the firm would call the bonds and refinance at lower rates). The case: In order to offset or cancel this call option, a firm can write a call option (on interest rates in this case). By writing a receiver swaption, they are now obligated to pay a fixed rate if the swaption is exercised. So if rates go down, the party which bought the receiver swaption will want to exercise their option, while the firm would also exercise the call on their callable bonds, essentially cancelling each other out. To summarize: If rates go down - Call option by firm would be exercised - Receiver swaption by counterparty would be exercised (to earn a fixed rate in a declining interest rate environment) If rates go up - Call option by firm would not be exercised - Receiver swaption by counterparty would not be exercised (earning a floating rate in a rising interest rate environment is obviously more favourable)
Thanks for your prompt reply. It makes sense to me. My concept was right but was missing that by writing payer swaption, I am selling the right to the counterparty to pay fixed to me upon exercising the option. Since I am expecting rates to be increased so I want to long on the LIBOR.
