A company is engaged in a two-year swap with quarterly payments. It is paying 6 percent fixed and receiving Libor. It would like the flexibility to terminate the swap at any time prior to the end of the two-year period.
Assume 7% exercise rate. What is the payoff to the receiver swaption holder if: FS(t,2) ≥ 7 percent
The swaption is out-of-the-money and is not exercised. To terminate the existing swap, one would enter into a swap at the market rate. This swap would involve receiving the market rate FS(t,2), which is at least 7 percent, and paying Libor. The Libor payments offset, and the net effect is a net positive cash flow of FS(t,2) – 6 percent.
My thinking…if you are on the receiver end, you want to be the one receiving a higher fixed rate, no? So why would you not exercise if the prevailing fixed swap rate is higher than your own exercise rate?
Never mind! It:s because your initial receiver swaption has an exercise rate of 7%, which is below what you can get in the market now. Therefore you would not enter into that underlying swap at 7% receiving.