Hi…I couldn’t think of better financial advisorsthan you guys! I have also taken L3 this year and been reading the site quite a bit. I work in the financial sector in a small country and we don’t use IRS/Swaptions…However now finding the need as our clients are looking for fixed rate foreign currency loan (around 8years tenor). We thus need to hedge… Our one correspondent bank has proposed a 4 year IRS, with a swaption for the remaining 4 years. They haven’t sent us their pricing yet…As I only know swaps in theory, I would really appreciate your advice. Do you think it’s the ideal hedging solution? I think it will be quite expensive. What other alternatives can we look at? Obviously the correpondent banks will give us solutions that are more ‘convenient’ for them than for us! Thanks!
No one can answer your question because it depends on the client and his situation.
when the client ‘needs’ Fixed rate forex loan… why not go all the way with IRS…by going into a swaption it seems taht client wants an exit startegy in 4 years…Thus you need to outline the client and its situation(aS suggested by Bacaladitos) as your problem structure is kind of contradictory IMHO
Thanks guys…in fact the situation is as follows: Am the bank (X) lending for around 8 years fixed rate USD to my client (Y)…Now having lent fixed rate, I need to hedge my exposure from increasing rates. Thus wish to do an interest rate swap for 8 years (long period) where I’ll receive the fixed payments…I have asked for a quote from an international bank (Z) and the latter proposed an IRS for 4 years with an option attached for the remaining 4 years whereby either party (Z and me) can let the option expire. My view is that I’ll still be left exposed to the risk after the 4 years if Z doesn’t exercise. Are there any other alternatives hedge the risk which is long term?
I’ve never heard of an option where either party can choose not to exercise!! For you to be hedged, you need to have a receiver swaption - you get the choice whether to exercise. Or just go plain vanilla and do an 8 yr swap. Does Y have a prepayment option? Is it a bullet?
Leila30 Wrote: ------------------------------------------------------- > Thanks guys…in fact the situation is as > follows: > > Am the bank (X) lending for around 8 years fixed > rate USD to my client (Y)…Now having lent fixed > rate, I need to hedge my exposure from increasing > rates. Thus wish to do an interest rate swap for 8 > years (long period) where I’ll receive the fixed > payments…I have asked for a quote from an > international bank (Z) and the latter proposed an > IRS for 4 years with an option attached for the > remaining 4 years whereby either party (Z and me) > can let the option expire. > > My view is that I’ll still be left exposed to the > risk after the 4 years if Z doesn’t exercise. > > Are there any other alternatives hedge the risk > which is long term? sorry but my be iam not getting teh point here: so u want to hedge for rising interest rates and the option u are considering is receiving fixed…wouldnt you be hurt if u have to pay floating in an increasing rate scenario…so cant quite get as to how you would hedge by entering into a receiving fixed IRS… shouldnt you be the floating rate receiver if you anticipate Interest rates to go up IMHO
^yea you want to pay fixed no? I suppose it would depend on your view of what ‘pay fixed’ rates will be in four years. If you think it will go up enough to make the option profitable (accounting for TVM) then by all means do it. Not sure what a reasonable forecast would be. As far as not matching your 8 year horizon, I suppose it’s a good idea if you think ‘pay fixed’ rates could go down by enough to cover the cost of the option (accounting for TVM). You can let it expire and pay fixed for the remaining 4 years at the low market rate. You’re assuming less risk by having the option to cover the last 4 years. The proposed structure all depends on the cost of the option and your view of pay fixed rates IMO. good luck forecasting those. But I’m not sure why you’d enter an option that requires the counterparty to exercise also. Disclaimer: I’m no expert in this field.
as a lending institution i guess a floor should be useful…
Sorry I meant payer swaption
Thanks a lot…Yes, I got it wrong…I would in fact need to be a floating rate receiver thus payer swaption. I also find that option that both parties can exercise strange…they call it a Bermudan option!
A Bermudan option can only be exercised by the buyer of the option!
A Bermudan option is one in which the buyer can exercise on several stated dates (so it is called Bermudan because it is between America and Europe). One question: Do they want you to pay for an option in which they have the right to exercise too? I supposse that kind of option will always be exercised by some party on the first date, given that both counterparties are acting in a financially optimal way, so it would not be really a swaption, but a swap.
i am not sure if iam getting the point…may be just too fatigued but does an option seller ever have a choice or ‘Option’ of exercizing an option…doesnt always the buyer has the choice exercizing or not…is it not why the buyer pays the seller a premium… again in my opinion only buyer should be able to xercize in case of an option… if you are certian as to the price rise for 8yrs(freaking long time for certainity) then go for IRS 8yrs… if certain for 4 yrs and then uncertain, then a swaption at 4yrs if completely uncretain then my frnd 8 yr swaption with qtry reset dates(qtr imo is good time frame to reset in uncertainity)…this kind of swaption should ive u good flex) i still think and would certainly want to know as to whats wrong with Floor here… my best regards to all
Well, I don’t think the question is about certainty, but convenience. There is no certainty about the future, but market data, and you will need the 8 y market data to value both the swap (i. e. set the fixed leg level) and the swaption. I think we all know at this point that a conventional option has a buyer and a seller and that it is the buyer who has the right to exercise.
Leila 30 by cost: a standalone swap will be chepaer than swap+swaption…if i believe tahts what u asked at the start
Reasons for swap+swaption instead of swap (just an example): Assume: -You have a floating rate loan - You want to pay fixed rates for the next 8 years - You are unsure if the fixed rate is low enough 1) 8y swap 8 years of known interest payments 2) 4 year swap + swaption (option of another 4 years at a known rate). That gives you 4 years fixed interest payments and an option of another 4 years. If rates go down: You don’t exercise and you enter new cheaper swap If rates go up: You exercise and pay strike rate Conclusion: A swap+swaption will cost you the premium, but you will pay the same or less in interest.
…the more i think about this structure the more it sounds like it’s set up to benefit from higher volatility of the swap rate. But I still can’t get my head around the fact that the counterparty needs to exercise the option also. Isn’t it true that by definitiion there will be one winner and one loser on the option contract? I can’t think of a circumstance when both would want to exercise. Someone please enlighten me.
An option where buyer and seller can both exercise is a future! By definition, one side will have a postive value, and will therefore exercise. Bermudan just means you can exercise on multiple predefined dates - as opposed to a european (only at expiry) and an american (at any time prior to expiry).
^a forward/future is where both MUST exercise (or offset), but it sounds like both can choose whether or not to exercise. If both don’t choose to exercise the contract expires without entering into the contract swap. In this case I don’t see any situation where both would choose to exercise. I must be getting the structure wrong…