swaptions

CFA Level III Fixed Income
#1

RD 22, BB 8- I do not understand the logic behind writing swaption to get rid of the call feature

#2

the complete topic derivative overlay in fixed income is very badly written and explained

#3

I’ve been wrapping my head around this for a while and here’s what I’ve come up with:

  • if a bond is callable by a corp, it is the equivalent of a long call option for the corp (in this case the spanish corp)

  • purchased 10yr fixed bond to match non-callable outstanding bond but bond is callable

  • to defease, need to turn callable into non callable -> remove call feature

  • since corp is long a call option, the opposite is to be short a call option, in this case write a receiver swaption (the corp will pay fixed if the option is exercised)

here’s how it works methinks:

* rates go down so corp will call bond to refi at lower rates; simultaneously, if rates go down the long receiver swaption will be ITM and exercised, and the corp will pay fixed just like it would if it had not exercised.

#4

It’s easy. Call feature is profitable if rates decline. To remove it means net gain should be zero, how to do that? Write a receiver swaption that will be excercised by the long if rates decline = loss for the short. Call the bond (gain) + pay on the option (loss) is neutral, as if the bond was non-callable.