The Swaption Arbitrage

In November of 1989, General Electric Capital Corporation (GECC) issued $ 200 million
Aaa/AAA-rated 15-year notes, puttable after five years.
Co-lead managed by Solomon Brothers and Chase Securities, the issue was priced to yield
7,95 %, about 20 basis points (b.p.) over the five-year Treasury. Other relevant quotes are
shown in the accompanying exhibit:

Assumptions Used in Analysis

 Five-year Treasury 7.75 %

 GECC spread over five-year Treasury 20 b.p.
 Average five-year triple-A yield 8.30 %
 Average 15-year triple-A yield 8.90 %
 GECC savings over five-year yield 35 b.p.
 GECC savings over 15-year yield 95 b.p.
 Estimated cost of five-year payer swaption 6.65 %
 Estimated cost of five-year receiver swaption 2.54 %

The GECC issue could have been structured in four ways:

1. As a hedged 15-year issue
2. As a hedged five-year issue
3. As an unhedged five-year issue
4. As an unhedged 15-year issue

The 15-Year Straight Scenario

Buyers of the GECC notes received the right to sell the bonds back to GECC at par five
years from the date of issue. GECC could hedge the risk that the bonds would be put back
in five years by purchasing a five-year payer swaption on a 10-year interest rate swap at
7.95 %. This option gives the holder the right, five years hence, to pay a fixed rate of 7.95
% and receive LIBOR.
Suppose 10-year interest rates five years hence were 7.95 % or less for a triple A
investment. Bondholers would choose to leave the notes outstanding and GECC would
continue to pay 7.95 % for the remaining 10 years.
On the other hand, if the bondholder could receive more than 7.95 % for the new triple-A
10-year investment, he or she would put the bonds back to the issuer. GECC would then
refinance for 10 years at a floating rate and exercise the option to receive LIBOR and pay
7.95 % in a swap. Making the simplifying assumption that the refinancing was done at
LIBOR, GECC would still be paying a fixed rate of 7.95 % for the next ten years.

Put Option = Payer Swaption

The preceding two scenarios show that the option to put 15-year fixed-rate bonds back to
the issuer after five years is exactly the same as an option to enter a 10-year swap five years
hence as a fixed-rate payer. If the issue were hedged in this way, GECC would simply be
acting as a broker for this option.
The deal would be viable only if GECC received more for the put than it paid for the
swaption. At the time of GECC’s issue, the average yield on secondary market triple-A 15-
year paper was 8.90 %, 95 b.p. higher than the 7.95 % yield on the GECC notes. Thus,
GECC sold the option for 95 b.p. per annum (paid semiannually) for 15 years. The price
was the swaption premium, about 6.65 %, according to swaption brokers. By amortizing
the premium semiannually over 15 years at the bond rate, these two values can be
compared.

Application

Assume GECC paid a premium on the swaption of 6.65 %. Amortize the premium over the
life of the issue using a discount rate of 7.95 %.
According to this analysis, GECC would have paid ______ per annum over 15 years for a
swaption that was sold for _______ , a profit/loss of _______ per annum.
The Five-Year Straight Scenario

From this viewpoint, GECC sold five-year debt and gave investors the option to extend it
for 10 years. By looking at the GECC issue in this way, it is easy to see how the company
could create five-year financing by buying a receiver swaption to hedge the risk that
investors would opt to extend the bond.
The yield on the GECC issue was 7.95 %, 35 b.p. less than the 8.30 % average secondary
market yield on five-year triple-A paper. In this case GECC’s risk is that the 10-year rate
for triple-A paper in five years will fall below 7.95 %. Bondholders would then opt to hold
their notes, extending the financing beyond the five-year horizon (or else force GECC to
repurchase the notes in the market at a premium).
If the notes remain outstanding, GECC would exercise the swaption and receive 7.95 %
fixed for the remaining 10 years (precisely offsetting the coupon payments on the notes)
while paying LIBOR. This LIBOR liability could then easily be swapped into any rate basis
desired.
Under this scenario, GECC has locked in five-year financing at a cost of 7.95 % plus the
price of the receiver swaption. The swaption was quoted by a broker at 2.54 %. This must
be compared to the 35 b.p. per annum of savings obtained by issuing this structure.

Application

Amortize the quoted premium of 2.54 % over the five-year term using a discount rate of
7.95 %.
The issuer would be paying a premium worth the equivalent of ______ per annum while
achieving a savings of ______ per annum.
The maximum price GECC would pay for the swaption is _________________.

The Naked Put Strategy

If the 10-year triple-A rate in five years is 7.95 % or more, GECC has saved 35 b.p. over
straight five-year debt.
GECC does not lose if the rate falls below the 7.95 % threshold only if it falls far enough to
wipe out the 35 b.p. per annum saving. This is the break-even rate: the yield below which
the 10-year triple-A borrowing rate would have to be in five years to make the company a
loser.
To find this break-even rate, we first assume that GECC will buy back the notes in the
secondary market if the bondholders do not put them back. For GECC to be a loser, the
price paid must drive the five-year cost of funds above 8.30 % the cost GECC would have
achieved by issuing straight debt.

Application

At what price would GECC have to buy back the notes in five years for the borrowing cost
to be the same as if it had issued straight five-year debt?
If GECC redeemed the notes in five years at a price of ______, its five-year financing cost
would be exactly 8.30 % the same yield as if it had issued straight five-year debt.

Application
Where would the 10-year yield have to be in five years for GECC to break even?
The 10-year yield for triple-A paper in five years must be below _______% for GECC to
have been better off issuing straight five-year debt.

Completing the Circle

A final alternative is the possibility that GECC sought 15-year funding while leaving
unhedged the risk of the put being exercised. The risk in this case is that rates will rise, the
bonds will be put back, and GECC will have to refinance for 10 more years at a higher rate.
The question is how high the 10-year rate can be for GECC to be indifferent between the
puttable bond and straight 15-year debt.
This rate can be calculated by seeing how far the 10-year rate five years from now would
have to rise in order to wipe out the 95 b.p. per annum savings during the first five years.
Application

Fill in the following matrix, summarizing the conclusions regarding the GECC puttable
notes.

Scenario Rising / Falling Put Execised/ Break-even rate

rates not exercised on unhedged position

5-year financing ______ ______ ______

15-year financing ______ ______ ______