R19 BB8 Writing a receiver swaption to effectively defease callable bond

CFA Level III Fixed Income
#1

This BB is not intuitive to me at all. Writing below out helped a little bit. Can someone else have a more concise way to make this concept more intuitive and memorable?

  1. 10 year callable bond is issued by a corporation.
  2. Higher bm rates are expected in the coming years - which makes callable bond unattractive from a corporation’s point of view.
  3. “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.” -> The callable bond is issued at higher yield to give the optionality for a corporation to call back their bonds to refinance at a lower rate. So if the bm rates are high, they are paying high coupons for the option that they will not exercise.
  4. The bank working with the CFO 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. -> Buying a bond = defeasing liability (callable bond); to make a non-callable bond to a callable bond, use a swaption
  5. The liability that the corporation currently has is a callable bond that pays out fixed coupon. The issuer bought an option to call back the bond. -> Then, to defease this bond, you need to sell/write an option that receives fixed coupon. This translates into writing a receiver swaption that received fixed, paying out floating.
  6. The corporation receives premium when writing a receiver swaption -> this equates to the value of the embedded option.
  7. If the market rates in three years are higher than the strike rate on the swaption and the yield on the debt security, the embedded call option in the callable bond liability expire out of the money. -> If the rates are higher, the right to call back at an attractive lower rate becomes worthless.
  8. Because the embedded option in the liability expires worthless (OTM), the opposite side of the transaction, for the writer of the receiver swaption, it also expires worthless.
  9. If the market rates fall and the bond price goes up, then the callable feature in the liability is in the money and the corporation will exercise this option. The corporation sells the seven year bonds and uses the proceeds to call the deb liabilities at par value.
  10. Therefore, the writer of the receiver swaption (receive fixed, pay float) will be in the money and need to close out the swaption position with the counterparty at a loss. This loss is offset by the proceeds made when the bond is called.
#2

Basically the company is short the bonds and long call option (they issued callable bonds) and might get screwed if interest rates rise

To effectively decease the debt they need to take the opposite side which is long bond and short call option - buying the non callable bonds effectively ‘covers’ the short bond part of thing, it cancels out

Next, remember that we still have the long call option - a long call benefits when interest rates fall and prices go up so we need a swaption that loses in the same scenario. The long party in a receiver swaption benefits when interest rates fall, meaning the writer loses - we write a receiver swaption which then offsets the long call option.

Now, if interest rates rise, the call option and receiver swaption are OTM. If interest rates fall, the call option and receiver swaption are ITM. The corporation then sells the straight bonds and use the proceeds to retire the liabilities. The gain is then used to offset the loss on the receiver swaption (because the long side would exercise)

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