FRM Study notes
Dear Marina,
Land purchase costs
• The results of the tender will be known in 3 months' time. So, we would want a swaption that begins in 3 months to hedge the $75m purchase costs.
• The organisation wants to protect itself for 2 years (i.e. 1 year for planning and 1 year for building).
• The organisation wants to protect against rising interest rates, so would like to pay fixed (i.e. Payer swaption).
We know that, if we win the tender, we will purchase land costing $75m in 3 months' time. This land will eventually be sold at the completion of the construction phase in 2 years and 3 months' time. So, we can hedge this potential $75m payment with a payer swaption. The swaption can be entered into immediately, with a start date in 3 months' time (when the tender is announced). It then lasts for 2 years, which covers us for the duration of the planning and construction phases.
All of the above points to a 2 year Payer Swaption starting in 3 months' time for $75m. This has a strike of 6.75% and a premium of 0.55%.
Development costs
If successful with the tender, we know that we are going to build a $50m resort, or a $100m complex on the land. Planning would start in 3 months' time (when the tender is announced), and approval would be expected to take 12 months. It is only at this point that we know which construction project will proceed. Construction and sale will then take a further 12 months.
So, we can hedge the potential $50m or $100m construction with a payer swaption. This can be entered into immediately, to start in 15 months' time (when planning approval is received). We would hedge the higher amount of $100m, which would be sufficient to cover either project. The swaption would last for 1 year, being the duration of the construction and selling phase.
All of the above points to a 1 year Payer Swaption starting in 15 months' time for $100m. This has a strike of 6.65% and a premium of 0.65%.
Swaptions
A swaption can be the preferred
Land purchase costs
• The results of the tender will be known in 3 months' time. So, we would want a swaption that begins in 3 months to hedge the $75m purchase costs.
• The organisation wants to protect itself for 2 years (i.e. 1 year for planning and 1 year for building).
• The organisation wants to protect against rising interest rates, so would like to pay fixed (i.e. Payer swaption).
We know that, if we win the tender, we will purchase land costing $75m in 3 months' time. This land will eventually be sold at the completion of the construction phase in 2 years and 3 months' time. So, we can hedge this potential $75m payment with a payer swaption. The swaption can be entered into immediately, with a start date in 3 months' time (when the tender is announced). It then lasts for 2 years, which covers us for the duration of the planning and construction phases.
All of the above points to a 2 year Payer Swaption starting in 3 months' time for $75m. This has a strike of 6.75% and a premium of 0.55%.
Development costs
If successful with the tender, we know that we are going to build a $50m resort, or a $100m complex on the land. Planning would start in 3 months' time (when the tender is announced), and approval would be expected to take 12 months. It is only at this point that we know which construction project will proceed. Construction and sale will then take a further 12 months.
So, we can hedge the potential $50m or $100m construction with a payer swaption. This can be entered into immediately, to start in 15 months' time (when planning approval is received). We would hedge the higher amount of $100m, which would be sufficient to cover either project. The swaption would last for 1 year, being the duration of the construction and selling phase.
All of the above points to a 1 year Payer Swaption starting in 15 months' time for $100m. This has a strike of 6.65% and a premium of 0.65%.
Swaptions
A swaption can be the preferred