Optimal Choice between swap, swaption and a collar

Hi, can anyone explain when a swap , swaption, collar is optimal?

In reading 23, example 7 of LDI, it is mentioned that purchased receiver swaption will be preferred only if swap rate is expected to be somewhat above 4.25%, the strike rate on the written payer swaption. And if the view is that swap rate will exceed 3.8%, the swaption collar would be preferred.

Just to give you a background of the question in brief, it is mentioned that the manager is expecting the discount rates to go down. And 3 interest rate derivatives are available in the market -

  1. 3.8%, receive fixed swap

2.Receiver swaption of 3.6% + premium of 145 bps

  1. Collar of 3.6% receiver swaption and writing a 4.25% payer swaption.

Can’t wrap my head around the solution. Someone please help.

So I guess collar is preferred if rates are expected to go above 3.8%, since its a zero cost collar and we will have the option not to exercise the option and instead go to the market for a better rate and we are protected from the downside as well . (correct me , If I am wrong ).

But still can’t understand the logic behind the 4.25% rate for receiver swaption.

No your logic is wrong… What you describe is the logic for the swaption.

The collar is good for rate 3.8% or above but below the breakeven of the swaption and collar, which is approx 4.25%. If you keep the collar past the 4.25%, the payer swaption will be losing money continuously. Remember you are long a receiver swaption (good when rates drop) and short the payer swaption (bad when rates increase for the short). If rates increase, you have no choice because your counterparter will exercise that payer swaption.

Therefore, the receiver swaption by itself has the limited losses of the premium and is the best option for increasing rates past 4.25%, because u can ignore the option and take a market rate swap.

Perfect. Thank you so much.