Why on earth, for god’s sake does this equivalence hold?
Why do we need to be long a receiver swaption as well? This doesn’t fit in. Why being short a payer swaption is not enough to emulate the receive-fixed, pay-floating interest rate swap? After all, being short a payer swaption, we are obliged to pay floating interest rate and receive fixed interest rate? Being long a receiver swaption is not necessary as it is just a right (not obligation) to enter a receive-fixed, pay-floating interest rate swap.
I hope somebody can explain this to me or else I will stuarnate!
So am I: swaptions are options; specifically, options to enter into a swap.
You’re long the option: you own it, so you can exercise it when it’s favorable. It’s a receiver option, so it’s an option to enter into a swap to receive a specified fixed rate and pay the prevailing floating rate. There are many purposes, just as there are many purposes for owning a put option on GOOG. Two of them are:
You think that interest rates are going to fall, so you speculate by buying a receiver swaption. If they fall, you exercise the swaption and receive the fixed rate specified in the swaption while paying a lower floating rate and you make gobs of money.
You have a short position (pay fixed, receive floating) in a plain vanilla interest rate swap, and you’re worried that interest rates might fall; you hedge by buying a receiver swaption. If they fall, you exercise the swaption and receive the fixed rate specified in the swaption while paying a lower floating rate and you limit your loss.
Three things can happen in a receive fixed, pay floating swap:
The value of the swap is positive (i.e., floating rates have decreased) and you get paid some money
The value of the swap is zero (i.e., floating rates are (essentially) unchanged) and you get nothing and you pay nothing
The value of the swap is negative (i.e., floating rates have increased) and you have to pay some money
Three things can happen when you’re long a receiver swaption and short a payer swaption:
The value of the receiver swaption is positive and the value of the payer swaption is negative (i.e., floating rates have decreased): you exercise your swaption (and the owner of the payer swaption doesn’t exercise it) and you get paid some money
The value of both swaptions is zero (i.e., floating rates are (essentially) unchanged): neither party exercises its swaption and you get nothing and you pay nothing
The value of the receiver swaption is negative and the value of the payer swaption is positive (i.e., floating rates have increased): the owner of the payer swaption exercises it (and you don’t exercise yours) and you have to pay some money
Correct. Whether the net result is favorable or unfavorable to you.
Correct. Whether the net result is favorable or unfavorable to you.
Not quite correct.
You have that obligation _ only when the holder of that option chooses to exercise it _.
And that option holder will presumably exercise the option only when it is favorable to him, which is to say _ only when it is unfavorable to you _: when interest rates have increased.
Not quite correct.
You have that obligation _ only when the holder of that option chooses to exercise it _.
And that option holder will presumably exercise the option only when it is favorable to him, which is to say _ only when it is unfavorable to you _: when interest rates have increased.
No, they’re not.
With the swap, you have potential upside (when interest rates decrease) and potential downside (when interest rates increase).
With the short payer swaption you have only potential downside (when interest rates increase).
To get the upside when interest rates decrease: you’ll exercise it when it’s favorable to you.