Swaption question-Finquiz Test 1

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maxmeomeo

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I cant get my head around this, can anyone help explain in simplest term
  1. In order to remove the call feature from their callable issue?
    A. Purchasing a receiver swaption with an exercise rate of 15%. B. Selling a receiver swaption with an exercise rate of 10.5%. C. Buying a payer swaption with an exercise rate of 19.5%.
You can ignore the rate.
As far as Im concerned, as the investor have callable bond, meaning they are at loss when interest rate delince ( bond issuer will call back), Hence to hedge they should buy a receiver swaption = right to get fixed from a swap (benefit when interest declines). Where am I wrong here?
 
Without the full question, I have no idea who they’re talking about - you’ve assumed it’s the investor, but it might not be.
If they’re talking from the issuer’s perspective, the issuer could sell a receiver swaption at the the current fixed rate of the bond. That way, if interest rates go up, he’s still stuck paying 10.5% on the orignally issued bond. If interest rates go down, the issuer will call the bond and re-issue a floating rate bond. this way, the issuer would be paying 10.5% to the swap counterparty, receiving a floating rate, and forwarding the floating rate to the investors of the newly issued floating bond. Either way, the issuer is paying 10.5%. In other words, the answer is B for the issuer of the bond, although you picked A, which is correct from the perspective of the investor in the bond, but the percentages make no sense, which makes me wonder what the question actually is.
Again, you should include the FULL QUESTION if you are going to post. correct grammar wouldn’t hurt either.
 
^^^^^Correct
An easy way of thinking about it is that a receiver swaption is like a call option, where if rates rise you can exercise the swaption to receive a higher rate. The issuer is already long a call option as it is embedded in the bond, so to remove it you can sell a receiver swaption.
 
Sorry guys here is the full question
  1. X-Tech issued a ten-year callable bond with a face value of €55 million to support its expansion strategy. X-Tech has agreed to pay a coupon rate of 15% annually, of which 4.5% is the estimated credit premium. The finance department at the firm regularly monitors the interest rate environment to determine the risk of their debt portfolio. During a recent examination, X-Tech determined that interest rates were expected to fall in the euro zone. Knowing that such a scenario can prove to be unfavorable for their bond position, the firm decided to remove the call feature from their bond issue. Ramos asked Smith how X-Tech can synthetically achieve this objective.
  1. Which of the following would best achieve X-Tech’s objective of removing the call feature from their callable issue?
    A. Purchasing a receiver swaption with an exercise rate of 15%. B. Selling a receiver swaption with an exercise rate of 10.5%. C. Buying a payer swaption with an exercise rate of 19.5%.
 
I’m confused. If they’re the issuer, and the interest rates are going down, why do they want to remove the call feature? The call feature would allow them to call the issue, then get another debt instrument at the new lower interests.
am i missing something?
 
That is one big concern of mine, at first I though the question ask from the perspective of investors. But after reread it, I realize it ask from issuer perspective. So why do they want to hedge from declining interest rate?
 
Quote:
A callable bond is a bond in which the issuer has the right to retire it early. The issuer has considerable flexibility to take advantage of declining interest rates. This feature is like a call option on the bond. As interest rates fall, bond prices rise. By calling the bond, the issuer essentially buys back the bond at predetermined terms, making it equivalent to exercising a call option to buy the bond. The issuer pays for this right by paying a higher coupon rate on the bond.
In some cases, the issuer of a callable bond may find that it no longer expects interest rates to fall sufficiently over the remaining life of the bond to justify calling the bond. Then it would feel that it is not likely to use the call feature, but it is still paying the higher coupon rate for the call feature. A swaption can be used to effec- tively sell the embedded call. This strategy involves synthetically removing the call from callable debt by selling a receiver swaption.33 A receiver swaption (receive fixed) becomes more valuable as rates decline, thus balancing the short call. In effect, the call feature is sold for cash.
(Institute 486)
Click to expand...
 
Hi Cpk123, long time no see your nick ;) Being a charterholder and you are still passionate with the exam huh?
Thanks a lot for your post. It helps enlightening this concept :)
 
cpk123 wrote:
Quote:
In some cases, the issuer of a callable bond may find that it no longer expects interest rates to fall sufficiently over the remaining life of the bond to justify calling the bond. …..
(Institute 486)
Click to expand...
Click to expand...
the question says: During a recent examination, X-Tech determined that interest rates were expected to fall in the euro zone..
 
but they want to still remove the call option.
if interest rates are falling - the bond price rise may not be sufficiently offset by the “cumulative” additional coupon payments made by the issuer. (this is what they mean by fall sufficiently over remaining life to …. )
To be eligible for a call option - you are paying a higher interest rate on your coupons. and now in a falling rate environment - you might be able to issue a higher priced bond at a lower coupon.
 
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