Bermudan Swaption: 1.0 Scenario
Bermudan Swaption: 1.0 Scenario
Bermudan Swaption: 1.0 Scenario
Overview
3.0 Examples
Two examples will be given to demonstrate the use of a Bermudan swaption.
3.1 Example 1
The pricing below shows the comparison between a vanilla swaption and Bermudan
hedge strategy for a floating rate borrower.
Suppose you enter into a vanilla swaption today with expiry in one year that gives
the right to pay fixed for the subsequent 4 years with quarterly rolls at 6.75%.
Regardless of the track of interest rates between now and one year’s time, you must
wait until then to enter into the underlying swap agreement. If rates start rising
before the exercise date on the swaption, you would like to have the opportunity to
lock in early.
If however, you had purchased a Bermudan swaption, exercisable say at the end of
each quarter, you would have the right to exercise the swaption on the pre-specified
dates and pay fixed at 6.75% until the same expiry date.
3.2 Example 2
This example shows how a fixed rate payer may unwind a hedge position without
incurring a break cost.
Suppose you have floating rate borrowings, which are currently hedged, via an
interest rate swap. You have put this hedge in place to protect against rate rises,
but you believe you may be in a position to pay down the debt early due to the
potential sale of a business asset. If this occurs you will wish to unwind your
interest rate cover and repay the floating rate loan. You do not want to be exposed
to the possibility of incurring a break cost on the swap in this event.
The solution is to purchase a Bermudan receiver swaption. This gives you the right
but not the obligation to receive fixed on any rollover date, into a swap which has
the same parameters as your swap hedge. In the event that you exercise this
option, you will effectively cancel the hedge at the original rate without incurring a
break cost.
6.0 Conclusion
Bermudan swaptions can be used to hedge interest rate exposure effectively
especially during uncertain times. It gives the purchaser the flexibility to exercise
on pre-specified dates before the maturity date of the swaption for extended cover.
They also enable existing swaps to be cancelled for no break cost.
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