I think I am getting quite familiar with swaptions, however I don’t understand the following: - " The short position in a payer swaption is not exposed to potential credit risk" You are seller of an option, if it is exercised you are receiver of fixed rate / payer of floating right? As a receiver of fixed rate, if the counterparty defaults while you pay, I thought that would mean there is credit risk. Thanks for letting me know where I am going wrong. -N
There’s credit risk in the swap and credit risk in the swaption. So once the swaption is exercised it doesn’t exist anymore and then there is a series of payments from the resulting swap. Those have credit risk. A short option position never has credit risk.
but as you are short the option, if you are exercised, you HAVE TO enter the swap as the other counterparty, which makes you exposed to credit risk, correct?
I think this is nearly a semantic point and I think you understand what’s going on, but in this weird way you have sold an option to take on credit risk. There’s no credit risk in the option, only in what you get after the option is exercised and done with.
I think I see the point, I have to keep it simple and remember that selling the payer swaption has nothing to do with credit risk while buying does, because in that case you expect to receive floating… Thanks for the help Joey!
Could they also mean at the beginning of the swap? I think we agree that there is no credit risk with the short side of the option with the option itself. But in order for the option to be exercised by the long it has to have value at expiration. So the if there is value to the long then the long has credit risk. The short has none because this is a zero sum game. If the long exericises and holds onto the swap the credit risk could shift back and forth between both parties in the swap depending on which side has value. But the long could also take the other side of the swap at option expiration and lock his profits. Does this sound right?
option seller pockets the premium at the beginning and then he may cause a credit hazard himself. i guess no option seller faces credit risk. the underlying (swap) itself may give rise to credit situations,though