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Dear Johan,
June 2018 asked to explain what swaption meant and how to use in the scenario given in the question. While I do understand the theoretical point of a swaption I am failing to understand how to apply it to the scenario.
can you please help me to understand what it meant by the use of a 1 x 4 swaption at an interest rate of 5% to demonstrate how a swaption might fulfil the requirements of Hickamore Co’s finance director.
Below is a link to the question paper and it is the last requirement of question 4.
https://www.accaglobal.com/content/dam/acca/global/PDF-students/acca/p4/exampapers/p4-2018-jun-q.pdf
Thanking you in advance for your time.
Kind regards,
JJYou are happy in principle with what a swaption is.
The “1 x 4” in the description of the swaption simply means that they have the right to exercise it (and therefore swap from floating to fixed rate) at any time from 1 to 4 years from now.
So if interest rates stay below 5% during the next 4 years, then they will not swap but will stay borrowing at floating rate, however if rates go higher, then they will exercise the option and end up paying 5% – so they are capping the interest rate at 5%.
However, whether or not they do end up exercising the option, they will have had to pay a premium.
On the information provided, that is all that is required for this part of the question (plus explaining a bit more about what the swaption is), and I cannot imagine the examiner ever expecting any more detail on swaptions in future exams 🙂
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