HI,
If I have a callable bond and I want to convert it to a non-callable bond by using a swaption, I have to write a payer swaption. I find this not intuitive because if the payer swaption gets exercised, I have to pay floating and receive fixed. Thus wouldn’t¨t calling the bond and exercising the swaption result in floating rate note?
Thanks,
Gerhard
You should write a receiver swaption, not a payer. Why?
If rates decline you will call the bond and refinance at a lower rate (a gain). The buyer of the receiver swaption will excercise it since the new rate will be below the SFR. This is a loss for you.
The net result is that the callable bond with a short receiver swaption is economically equivalent to a non-callable bond.
If you, as an investor, hold a callable bond, you as an investor are short a call option (you have sold a call option to the issuer).
You`d want to buy a receiver SWAPTION to offset this, because,
as Moonborne has stated, an investor who bought a receiver SWAPTION would exercise it if rates fall thereby receiving a higher fixed rate and paying a lower floating interest rate. This helps to offset the short call, so the net result is a non-callable bond.
If a company has issued a callable bond, the company is long a call option (it has bought a call option). So it would want to write (sell) a receiver SWAPTION to offset it.