Liability driven - yield curve view Reading 23 / BB. 7.

CFA Level III
#1

Could someone explain to me (in simple language) the answer on BB7. Fixed Income Reading 23.

Question: what is the manager’s interest rate view when choosing the receive fix swap?

The pension plan manager can choose among:

  • a receive fixed swap with a 3.8% strike

  • a swaption collar (buy payer swaption with 3.6% strike + write receiver swaption with 4.25% strike)

  • and buy a receiver swaption with 3.6% strike.

Clear that his view is that the rate will be below 3.8% hence he chooses the receive fixed swap.

BUT: The answer says, the purchased receiver swaption will be preferred only if the swap rate is expected to be above 4.25%.

WHY? What do we do with a receiver swaption @ 3.6% when the swap rate is > 4.25%?

#2

Anyone?

#3

If rates are rising above 4.25%, swaption collar and receive fixed swap are going to cost you dearly as long as rates are rising. Only for receive swaption we have a floor on the losses - the option premium paid. When rates rise above 4.25% at expiration, we let the option expire OTM.

#4

Yes, clear if rates increase receive fixed is a bad choice, swaption collar again.

And yes, agree receiver swaption will expire OTM. We will receive (high) market rates instead. But in that case why the heck did we buy it at all? We paid a premium for nothing.

#5

For hoping that rates are going down past X, so we will exercise the option in the money, without having to worry about the possibility of a rate increase.

#6

The answer in the example explicitely says: “the purchased receiver swaption will be preferred only if the swap rate is expected to be above 4.25%.”

Why would we prefer buying a swaption and then hoping it expires OTM?