Swaption Question

CFA Level II
#1

Is there a cash payment at the expiration of a swaption? I had thought that it gave the owner the right to enter into a swap, but I just had a Qbank questions that stated the cash payment is equal to the PV of the swap cash flows. Will someone explain this?

#2

Good question. I was wondering whether payoffs of swaption are paid on each payment date or the PV of sum of all payments is paid at t=0.

#3

Taking a payer swaption as an example. There are four ways you can exit the swaption.

  1. You can either exercise the swaption -

that is, enter into a pay fixed (remember payer pays fixed) receieve floating swap.

  1. You can enter into offsetting positions-

that is, you can exercise the swaption, enter into a pay fixed recieve floating, and then immediately enter into another contract to recieve fixed and pay floating. (This way, you don’t have any exposure)

  1. You can enter into a net payment stream-

This is just like the first case, only this time, the payments are netted like a stream of annuity.

  1. You can recieve cash and run -

If you don’t like the idea of taking your payments like in third case above and you just want your cash right away, you can simply demand for the present value of the cashflows.

#4

good explanation bloodine, i always fins your posts straight to the poit :slight_smile: almost wink

could you take a look at my question in your My dumbed down Accounting for Pension Expense thread. I’ve been thinking over this since morning… would appreciate any help :slight_smile:

#5

Thanks bloodline. To clarify, the answer to the question used option 2 in the explanation, but this was never specified in the question. Won’t the type of exit affect the cash flows? Is there one that we should assume if it is not specified?