A swaption is an option on a swap. Commodity swaption structures are a variant of the commodity swap structure considered above. They are based on the principle that any scheme should aim to cope only with exceptional and not normal price movements, either because large shocks to prices have disproportionate effects (Collier and Gunning, 1996; Dehn, 2004) or simply to limit activity.
A floating-for-fixed swaption may either be a call (the right to swap into floating from fixed) or a put (the right to swap into fixed from floating). We shall consider symmetric collar-type structures in which the borrowing country is long a set of outof- the-money calls and short an equal number of out-of-the-money puts. Because both sets of options are out-of-the-money, debt service payments will be unaffected for moderate variations in the commodity price11.
The swaption repayment scheme corresponding to the swap scheme in equation (3) may be expressed as
The middle row of equation (4) shows that in the band in which the commodity price is within ± ? % of P0, debt service payments are unchanged from those under the standard currency loan. If the price falls short of (1- ? ) P0, debt service is reduced in relation to the proportion ? of this shortfall. Correspondingly, at prices above (1+ ? )P0 , debt service is increased in relation to the proportion ? of the excess. This may be expressed more succinctly as
Equations (4) and (5) makes explicit that the original loan for $A has been modified by adding a short position of calls on $ ? A in the floating rate loan with strike price (1+? ) P0 and a long position of puts on $?A in the floating rate loan with strike price (1-? ) P0. These repayments are illustrated for a simple example
in Figure 1, which also illustrates a simple swap-based scheme.
11 Commodity swaption-based schemes are reminiscent of band stabilization schemes operated in the buffer stock commodity stabilization schemes operated in tin (until 1985) and natural rubber (until 1999) – see Gilbert (1987, 1996).
By Prof. Christopher L. Gilbert, Prof. Alexandra Tabova
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