Bermudan exercise

(a) Suppose you own a 1yr-into-5yr Bermudan receiver swaption with strike 6%. The underlying swap has quarterly payment dates, fixed versus three-month libor. The exercise dates are quarterly. In one year's time you must determine whether to exercise the first option to receive fixed on a five-year swap, based on the then current interest rate scenario. For each scenario A-F in Table 1 for interest rates in one year's time, determine the most appropriate response to the question ‘Should the first option be exercised?' from the following choices.

I Yes, the option should definitely be exercised.

II No, the option should definitely not be exercised.

III It depends upon current levels of other market variables such as European swaption prices.

(b) Suppose you are told volatilities are zero for all interest rate options, that is, all out of-the-money-forward options have zero value. Again answer the question ‘Should the first option be exercised?' for scenarios D, E and F in Table 2.