Question #62
Reading: Reading 31 Valuation of Contingent Claims
PDF File: Reading 31 Valuation of Contingent Claims.pdf
Page: 29
Status: Unattempted
Part of Context Group: Q62-64
First in Group
Shared Context
Question
Which of the following best describes how a payer swap could be replicated using interest rate swaptions?
Answer Choices:
A. The swap can be replicated by selling a payer swaption and buying a receiver swaption at the same strike
B. The swap can be replicated by buying a payer swaption and selling a receiver swaption at the same strike
C. The swap can be replicated by buying a payer swaption and selling a receiver swaption at different strikes
Explanation
The swap can be replicated by buying a payer swaption and selling a receiver swaption at
the same strikes.
Payer swaption is the right to enter the swap as the fixed-rate payer and receiver swaption
is the right to enter as fixed-rate receiver. Payer swaption increases in value when the
floating rate increases, similar to that for the pay-fixed party in an interest rate swap.
Receiver swaption increases in value when the floating rate decreases. To replicate the
negative value suffered by the pay-fixed interest rate party when floating rate decreases,
the swap can be replicated by selling a receiver swaption as the negative value increases
when rates fall.