Swaptions buying payer versus writing receiver

Hi all,
Below is a question whose answer I don’t really agree with. 2
The answer is A but I chose B because my reasoning was that the option premium will shield some of the losses. The logic for A apparently is that with A the losses are known and there is no uncertain timing. I don’t understand this. When you buy a payer swaption and exercise it you pay fixed and receive float once exercised and this continues till the maturity of the swap. I.e. a 1y5y would be the option to get into a 5 year swap in 1 years time. If exercised in 1 year you get into a 5 year swap unless you choose to unwind etc. So what is the uncertain timing we’re talking about?

Adams states to Neeson, “For the Lawson and Wharton plans, we can consider one of three alternative strategies to manage the multiple liabilities associated with these plans. Whenever a plan’s surplus is less than 5%, we favor passive management strategies. We could also use a derivatives strategy, and I prefer derivatives strategies that protect the portfolio against an increase in interest rates but will not produce large losses if rates decrease.”

Which of the following strategies most likely meets Adams’ preferences?

  1. Buy a payer swaption.
  2. Write a receiver swaption.
  3. Enter into a pay fixed swap.

A is correct. Adams would most likely buy a payer swaption. Although all three choices would hedge against rising interest rates, the potential losses on a payer swaption if rates fell would be limited to the option premium and would not be potentially large with uncertain timing.

B is incorrect because the potential loss on writing a receiver swaption if rates fell would be contingent on the interest rate and would be uncertain until termination of the contract.

The comment about timing is odd; I’d ignore it.

The point is that if you sell a swaption, you’re at the mercy of the option holder. And, of course, they’ll exercise it when it’s most advantageous for them; i.e., when it’s most disadvantageous for you.

As a general rule, do not put your risk management decisions in the hands of someone whose interests don’t align with yours.

Thanks Bill

My pleasure.