Can anyone please explain how this exactly works? Here is my understanding but I don’t know whether is correct:
Callable debt does not appreciate much when rates drop because of the callable feature, so you want to get rid of it.
You sell a receiver swaption, so the buyer will exercise it and will receive fixed, while you will receive variable (low rates).
Don’t get it… thanks!
First, when you say “you want to get rid of it” – are you referring to you being the holder or you are the seller/writer of the bond? The callable feature is at disposal of the writer/company who writes the bond, not the holder. It is true that it will appreciate less than a non-callable bond due to negative convexity. Therefore, you want to hedge against a decrease in rates, receiving fixed. The receiver swaption would do this, and have incremental gain to the callable bond if rates decrease.
If you mean hedge a callable bond you’re holding, then you should buy a reciever swaption at the strike interest rate. You don’t hedge a short option by shorting a swaption.