''Company plans to borrow 20m in 2 yr. Loan will be a pay quarterly LIBOR for 3 yrs. Company purchases a payer swaption expiring in 2 yrs with an exercise rate of 5%. Assume LIBOR at the beginning of the settlement period is 6.5%. Cal. the net cash flow on the first settlement date if FS(2,5) is above the exercise rate. ‘’ 1) My 1st question is regarding timeline of swaption. When does investor decides if he wants to exercise the option? I think it should be at the beginning of loan period (end of 2nd yr) in above example. If that is the case, then FS(2,5) above should be compared at the beginning of loan period and not at 1st settlement date. By the language of the question, it looks we are comparing it on 1st settlement date… 2) My second doubt is regarding F(2,5) itself. When option expires and to decide whether to exercise option or not, investor should compare the prevailing ‘‘SWAP RATE’’ with exercise price rather than SWAPTION RATE [F(2,5)]. Please help.
Look at IR projection and type of loan. variable rate loan with IR going up call for payer swaption. Fixed rate loan with IR going down call for receiver swaption. Net CF = (swap FR+loan spread ) * NP*Dt/360 = (.05)*20,000,000*0.25=250,000
- hmm, good question… I would assume that we would exercise the option at the beginning of the loan period (in 2 years), not on settlement days… you got me thinking here… unless, swaption means - “make a decision at the first settlement date”)
Even if we assume we are comparing exercise rate on beginning of the loan, should not we be comparing it with a 3 year swap rate rather than F(2,5) swaption? I mean on loan date, we want to enter a swap not another swaption…
hs_1811 Wrote: ------------------------------------------------------- > Even if we assume we are comparing exercise rate > on beginning of the loan, should not we be > comparing it with a 3 year swap rate rather than > F(2,5) swaption? I mean on loan date, we want to > enter a swap not another swaption… Completely don’t understand what you are wondering. Here is just in case: - F(2,5) IS the current 3 year swap rate in 2 years time. - Excercise at start loan date, so you compare the strike swap rate you have agreed with the prevailing 3 year swap rate F(2,5). It is a good deal then you enter into the swap with the strike swap rate. What do I miss?
Oh my… F(2,5) is the notation for swap rate in 2 years not swaption. sorry for confusion guys… thats what happens to schweser student!! Schweser does not even mentions such notation. thanks