The example is reproduced below.
A derivatives consultant, a former head of interest rate swaps trading at a major
London bank, is asked by a Spanish corporation to devise an overlay strategy to
“effectively defease” a large debt liability. That means that there are dedicated
assets to retire the debt even if both assets and the liability remain on the balance
sheet. The corporation currently has enough euro- denominated cash assets to
retire the bonds, but its bank advises that acquiring the securities via a tender
offer at this time will be prohibitively expensive.
The 10- year fixed- rate bonds are callable at par value in three years. This is
a one- time call option. If the issuer does not exercise the option, the bonds are
then non- callable for the remaining time to maturity. The corporation’s CFO
anticipates higher benchmark interest rates in the coming years. Therefore, the
strategy of investing the available funds for three years and then calling the debt
is questionable because the embedded call option might be “out of the money”
when the call date arrives. Moreover, it is likely that the cost to buy the bonds
on the open market at that time will still be prohibitive.
The corporation has considered a cash flow matching approach by buying a
corporate bond having the same credit rating and a call structure (call date and
call price) close to the corporation’s own debt liability. The bank working with
the CFO has been unable to identify an acceptable bond, however. Instead, the
bank suggests that the corporation buy a 10- year non- callable, fixed- rate corporate
bond and use a swaption to mimic the characteristics of the embedded call
option. The idea is to transform the callable bond (the liability) into a non- callable
security synthetically using the swaption. Then the newly purchased non- callable
bond “effectively” defeases the transformed “non- callable” debt liability.
To confirm the bank’s recommendation for the derivatives overlay, the CFO
turns to the derivatives consultant, asking if the corporation should (1) buy a
payer swaption, (2) buy a receiver swaption, (3) write a payer swaption, or (4)
write a receiver swaption. The time frames for the swaptions correspond to the
embedded call option. They are “3y7y” contracts, an option to enter a sevenyear
interest rate swap in three years. The CFO also asks the consultant about
the risks to the recommended swaption position.
1 Indicate the swaption position that the derivatives consultant should recommend to the corporation.
2 Indicate the risks in using the derivatives overlay.
Solution to 1:
The derivatives consultant should recommend that the corporation choose the
fourth option and write a receiver swaption—that is, an option that gives the
swaption buyer the right to enter into a swap to receive fixed and pay floating.
When the corporation issued the callable bond, it effectively bought the call
option, giving the corporation the flexibility to refinance at a lower cost of borrowed
funds if benchmark rates and/or the corporation’s credit spread narrows.
Writing the receiver swaption “sells” that call option, and the corporation captures
the value of the embedded call option by means of the premium received.
Suppose that market rates in three years are higher than the strike rate on the
swaption and the yield on the debt security. Then both options—the embedded
call option in the bond liability, as well as the swaption—expire out of the money.
The asset and liability both have seven years until maturity and are non- callable.
Suppose instead that market rates fall and bond prices go up. Both options
are now in the money. The corporation sells the seven- year bonds (the assets)
and uses the proceeds to call the debt liabilities at par value. The gain on that
transaction offsets the loss on closing out the swaption with the counterparty.
Is there an easy way to remember that reversing the call option of a callable bond is to write a receiver swaption? Some how this isn’t intuitive for me and I’m having trouble internalising this material.
What if a question asks about a putable bond?