Synthetically add/remove call option to bond with swaption

CFA Level III
#1

Just see on the notes that:

Synthetically add a call option to a non-callable bond, need to buy a receiver swaption.

Synthetically remove a call option to a callable bond, need to sell a receiver swaption.

Could anybody explain the logic behind?

Thanks a lot!

#2

which notes??? why don’t you look at the corresponding section in the text book.

you buy a receiver swaption - you receive fixed, pay floating. At this option will be exercised ONLY if the interest rate environment is higher than what you have currently.

Equate this to a call option on a bond. Call option on Bond will be exercised only if the rate is higher than the current rate environment. At that time - the issuer exercises the call - is paid a fixed higher rate.

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#3

The explanation I’d give myself here is the following :

Initial assumption : callable bonds pay HIGHER coupons than non-callable because we, investors, run the risk that the issue might call back by the issuer if the int. rates fall.

INVESTOR CASE :

let’s assume we invested in a non callable- bond because we expected interest rates to fall (given we want to have a long-term investment and avoid reinvestment risk, we deliberately gave up some extra-coupons we could have received if we had invested in callable bonds…). Later we realise that our choice hasn’t turned to be optimal given the current market conditions do not change OK? What we do?

We can still improve our current income by adding this “extra income” by going long on a receiver swaption (we synthetically added the callable feature);

ISSUER CASE

We issued a callable bond because we were afraid int. rates were about to fall. In fact int. rates do not fall and we pay higher coupons.

What we do?

We can still improve by loweing our current payments to investor by going short (sell) on a receiver swaption (we synthetically removed the callable feature); The premium (cash) we received partially offset the coupon payment we are exposed to.

Hope it makes sense

#4

I checked the CFAI materials again.

It says that (from the perspective of bond issuer(:

  1. add a call option to non-callable bond, buy a receiver swaption: pay floating and receive fixed, which as you call back the bond and reissure in a new rate.

  2. remove a call option from callable bond, sell a receiver swaption: pay fixed and and receive floating, which makes you keep paying fixed, as you did not call back the bond.

Moreover, the exercise rate should be the coupon rate minus the credit premium.

#5

That’s OK, it does sound rather reasonable either way?

The message is “use the swaption cash flow to add-on or partially offset the underlying cash of your Fix Income asset or liability.”

Sorry if I didn’t help

#6

Thank you Sunseeker!