Hedging callable bonds with swaptions

CFA Level III Fixed Income
#1

Hi,

Just don’t fully understand the need to write a payer swaption in the following case:

A bank has an outstanding 10 years fixed rate bond, callabe in 3 years (liability) and also enough cash to retire that debt. That option though is not advisable as per the excessive cost of a tender offer. The bank opts for acquiring a 10 years fixed rate corporate bond. And also writing a receiver swaption (in 3 years). But what’s the point?

Scenario A, rates go up: then both options will be OTM (the bank will not exercise the call option and the dealer will not do so with the swap option). The bank keeps the premium for writing the option.

Scenario B, rates go down: then the bank will sell its assets and with the proceeds will exercise the call option paying the par value on its own debt. Additionally, as the swaption bears an additional cost (the bank has to honor paying a fixed rate and receiving a variable which is lower), that is compensated with part of the proceeds from the selling.

So the question is, was doing all of that worthwile? in the end, the only “advantage” with the swaption is keeping the premium if rates go up. On the contrary, if rates go down, it carries an additional cost for the bank.

#2

Hi Josep,

You are right in the payoff structures in both scenarios A and B.

The point of doing the above transaction is to effectively defease the debt, without retiring it through tender and cash as it is too costly.

The corp bond offsets the debt and the swaption offsets the call option on the debt.

Regarding scenario B, the bank can enter a new IRS to offset the swaption it wrote which has been exercised. Net the bank will lose (swaption exercise rate X – the new 7 year swap rate which is < X) each period and transaction costs. However this is offset by the gain on the corp bond it sold, assuming it called the debt and hence no more need for the corp bond.

It could be worthwhile as the primary purpose is to effectively defease the debt for the 3 years, which brings along benefits such as assurance to credit and equity investors.