#54 “Baloo expects to enter a pay fixed position in a 4-year interest rate swap in six months. He asks Monk to explain how a swaption can be used to protect Springtree from an adverse change in interest rates.” Monk states: 1) Springtree should purchase a payer swaption (note: this is a correct statement) 2) The swaption fixes the rate that Springtree will pay on its swap (note: this is an incorrect statement) -------- Question 1) Why is the first statement correct? If Baloo must pay a fixed rate, that means Baloo has floating rate exposure. Shouldn’t Baloo enter into a receiver swaption to offset his fixed rate exposure? 2) why is statement #2 incorrect? Thanks

Payer swaption will give him the option to enter into a Pay-fixed swap if interest rates are favorable in 4 years time. and that is the position he wants to be in. It does not FIX his position. He gets an option. Right now - the strike on the Payer swaption is say 6%. In 4 years time, if the Swap had a fixed rate of say 5% - he can go ahead and enter into the Swap. If not he lets go, and takes a market based swap instead. Since it is an option to enter into a swap, he can either choose to go with the swap on the Swaption or a market swap which has a lower Pay fixed rate. This is why Statement 2 is incorrect.

cpk, don’t you mean “6 months” instead of “4 years” since that’s when the swaption expires?

What I don’t understand is: If Baloo expects to enter into a pay fixed swap in four months, and he is concerned abuot a change in interest rates, why would he enter into a pay fixed swaption? Baloo will be paying 5% fixed then enters a pay fixed, receive float swaption: Baloo will then 1) pay fixed and receive float ---- doesn’t it seem like he will be paying fixed twice? – Also, what do you mean “if interest rates are favorable?”

CFA.Rhythm Wrote: ------------------------------------------------------- > What I don’t understand is: > > If Baloo expects to enter into a pay fixed swap in > four months, and he is concerned abuot a change in > interest rates, why would he enter into a pay > fixed swaption? > > Baloo will be paying 5% fixed > > then enters a pay fixed, receive float swaption: > Baloo will then > 1) pay fixed and receive float > > ---- > > doesn’t it seem like he will be paying fixed > twice? > > – > > Also, what do you mean “if interest rates are > favorable?” He expects enter into a swap. He will not enter into both of them together. He can choose EITHER one of them. Either the swap or the swaption.

what mock exam is this in?! …not in my CFAI mock!

i dont understand statement one either. To CPK’s point, that would be correct if you determine the rate in four years, but the swaption rate that you fix in as the rate your paying will likely be set today, for entry in 4 years. If this is the case and rates decline, you are paying a higher fixed and receiving a lower float, double exposure, so i do not get why this is right.

You are forgetting it is an option to enter into a swap. if the rate > the fixed rate - you WILL NOT ENTER. you have a strike rate - which is the price on the swaption. As usual to enter into the option, you would pay the seller a premium. that is all you lose now. based on libor - prevailing 4 years from now if the rate happens to be lower than your strike on the swaption - you would opt not to go for the swaption, but enter and buy a new market swap at a lower fixed rate.

He’s got a payer swaption now e.g. at a rate of 5% - if the market swap rate in 6 months (expiry of the swaption) is 7%, he’ll have lower fixed payments by just exercising the swaption and paying fixed at 5% instead of 7% - if the market swap rate is 3% in 6 months, he’ll just let the swaption expire without exercising it and enter into a swap straight in the market at 3% instead of the 5%. Correct me if I’m wrong…

CFAtime Wrote: ------------------------------------------------------- > He’s got a payer swaption now e.g. at a rate of > 5% > > - if the market swap rate in 6 months (expiry of > the swaption) is 7%, he’ll have lower fixed > payments by just exercising the swaption and > paying fixed at 5% instead of 7% > > - if the market swap rate is 3% in 6 months, he’ll > just let the swaption expire without exercising it > and enter into a swap straight in the market at 3% > instead of the 5%. > > Correct me if I’m wrong… Yup, that is what cpk is trying to tell.

CFAtime - that looks right. CFA.Rhythm - i think the key distinction here is that he EXPECTS to enter into a pay fixed swap in 6 months. So, he wants to have the option of knowing the rate he can pay in 6 months by entering into a swaption. If the market rate in 6 months is lower than the swaption strike he lets the swaption expire and pays fixed at the lower market rate, otherwise he excersises the option.

a payer swaption is different from a swap it is a right to enter into a specific swap at some date in future as the fixed rate payer at a rate specified in the swaption. receiver swaption - the right to enter the swaption as a floating rate payer

“receiver swaption - the right to enter the swaption as a floating rate payer” More accurately it is the right to enter the swap as the fixed rate receiver . Given the intention is to profit immediately based on the differential beween the strike rate of the swaption and the market rate of the swap.

took me a while, but now I see it. He can choose a) to enter into a fixed payer interest rate swap or b) enter into a fixed rate payer swapTION — why not enter into a the swaption, right?

I think it’s more along the lines of he WILL enter into a fixed rate payer interest rate swap in 6 months. Either via the swaption or at spot. If he enters into a swaption today, he can enter into the fixed rate payer interest rate swap in six months by either excersising the swaption if it’s in the money, or by entering into a fixed rate payer swap at market if that is better than the swaption rate.

CFA.Rhythm Wrote: ------------------------------------------------------- > took me a while, but now I see it. > > He can choose > > a) to enter into a fixed payer interest rate swap > > or > > b) enter into a fixed rate payer swapTION > > — > > why not enter into a the swaption, right? That is why the first statement is correct and the second statement is wrong.

So, for the 2nd statement to be correct should it read as follows: “The swaption fixes the rate that Springtree will pay on its swap if exercised.”