Third Party Contribution
May 31, 2005
A few months back a large European financial institution BA AG, chose to raise funds through a EUR callable fixed rate perpetual bond. The issuer engaged a big commercial bank, AB Bank, to lead manage the issue.
The issuer also wanted to ensure that the interest rate on it's liabilities matched those on it's assets. AB Bank suggested the following structure to the client and also raised the funds. The fixed rate bond was a perpetual non-call 3 year structure, i.e. it could not be called within the first three years of the issue, but it could be at the 3rd anniversary and annually hereafter.
Additionally the Bank suggested to the issuer that the following needs to be done to match interest rate on its assets and liabilities:
- Swap the bond into a floating rate
Realize the value of the option by selling it
The Bank therefore entered into a 30 year interest rate swap with the client (issuer of the bond). The Bank paid the client the fixed rate and received Euribor plus a margin. In addition, the Bank bought a 30 year receiver Bermudan swaption from the client, exercisable in 3 years time and every year thereafter.
In effect the Bank was buying the embedded optionality, and paying for it through reducing the margin it was receiving on the swap.
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