CFA Level I · CFA Level I Exam · Forward Commitment and Contingent Claim Features and Instruments
A corporation holds a payer swaption that gives it the right to enter a pay-fixed, receive-floating swap at a fixed rate of 4.0%. At expiration, the market rate on comparable swaps is 5.0%. The corporation will most likely:
The corporation will exercise and pay 4.0%. A payer swaption lets the holder pay fixed at the strike. Since the market fixed rate of 5.0% exceeds the 4.0% strike, exercising gives a cheaper swap than the market offers, so it is in the money.
- Alet the swaption lapse
- Bexercise the swaption and pay a fixed rate of 4.0%Correct
- Cexercise the swaption and pay a fixed rate of 5.0%
Explanation
A payer swaption is a call option on the swap fixed rate. With market swap rates at 5.0% above the 4.0% strike, exercising lets the holder pay only 4.0%, which is valuable. Lapsing forgoes this gain, and paying 5.0% would ignore the contractual strike.
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