ABSTRACT
The owner of a payer (receiver) Bermudan swaption has the right to exercise into an underlying payer (receiver) swap at some subset of its fixed side reset dates. A good source of revenue for banks is an arrangement popular with in-
vestors, in which they receive higher than usual fixed interest in exchange for giving the bank the right to cancel the deal if it does not suit. At the centre of the structure is a callable swap, which is a payer swap that can be cancelled at any of its reset dates. A callable swap in which the bank pays fixed, is thus equivalent to the bank owning a vanilla payer swap plus a receiver Bermudan, because if the bank exercises the Bermudan, it gets a receiver swap that offsets (cancels) the remainder of the payer swap. Roughly speaking, these sorts of deals are set up as follows. The investor
deposits funds with the bank which are safely invested and generate floating Libor back to the bank. The bank then sets up (with its exotic derivatives desk) a callable swap in which the exotics desk receives that floating Libor and pays a fixed coupon. But because the swap is cancellable, that is equivalent to the exotics desk getting a free receiver Bermudan, which is worth money. That free money is then in part used to increase the fixed coupon in the underlying payer swap, which goes back to the investor as enhanced yield. A moment’s thought reveals that such deals will tend to get cancelled if
Libor rates fall, because the payer swap is then getting more expensive for the exotics desk. So the investor takes a view and bets that interest rates will remain steady; if he is right, he receives enhanced coupon for the full duration of the deposit, if he is wrong, he gets his deposit back early and must find an alternative investment at probably lower rates. Different views for the consideration of the investor can be created by sub-
stituting exotic coupons for the fixed coupon. For example, a callable constant maturity spread swap might, instead of the fixed coupon, pay a constant coupon plus a positive multiple of the 2-year constant maturity swaprate less the 30-year constant maturity swaprate. The investor receives enhanced yield betting that long-term rates don’t fall relative to short-term rates (because in that case the exotics desk must pay increased coupon perhaps causing them to cancel). Receiver Bermudans are also often used to partially hedge fixed coupon
mortgaged backed securities (MBS); if rates drop and mortgagees refinance at a lower coupon, banks may still want to receive the original higher coupon.
