Derivatives Q

A German company issues a five-year noncallable bond with a face value of 40 million euros. The bond pays a coupon annually of 10 percent, of which 3 percent is estimated to be a credit premium. The company would like to make the bond callable in exactly two years.

1, Design a strategy using a European swaption that will achieve this goal. 2, What is the exercise rate?

  1. Buy a European receiver Swaption due in 2 years with annual swap payments for a 3 year period.

  2. Exercise rate = 10 - 3 = 7% annually.

Buy Receiver Swaption with X = 7?

Agreed, buy a 3 year receiver swaption with expiration in 2 yrs at 10-3=7% strike rate.

The company currently pay fixed rate. Why should they buy a receiver wpt to pay another fix rate at 7%? I think they should enter a swt as a pay float?

sorry, i am wrong, receiver swt pay float

Is there an example of this in the book? this looks foreign to me - at least how it is structured

Pg 522-523

Yes, Its right. Co has issued a non-callable 10% fixed liability bond…

Why the company would like to call had it been a callable bond? Coz interest rate go down substantially after issuance…Company doesnt wanna continue paying higher int rate on its bond

So enter a Receiver swaption having maturity of 2 yrs with a strike rate of 10-3 = 7%

If int rate goes down Co has a right to enter into Receive fixed-pay floating swap…>> Would receive 7% fixed which can be passed on for its bonds payment & pay low int rate as floating…