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OTC Derivatives
OTC Derivatives
OTC Derivatives
Contents
1.
2.
3.
4.
3.2
3.3
Note:
Important concepts are underlined
Important calculations / formulas are marked by
A derivative is an instrument or a contract whose value is derived from the value of underlying
assets. Derivatives can be traded over the counter (OTC) or through exchanges. OTC
derivatives are bilateral customized contracts that are traded between two entities while
exchange-traded derivatives are contracts traded via exchanges with clearing corporations,
mitigating counterparty risk. OTC derivatives include complex and innovative instruments that
can be used to manage risks associated with the underlying markets. But all transactions in
OTC markets are negotiated between two parties, which may result in liquidity and counterparty
risk. The counterparty risk is also termed as credit or default risk. According to the Bank for
International Settlements data, the notional amount outstanding (of OTC Derivatives) is
$614,674 billion at end-2009. The number was $595,738 billion and $547,983 billion at the end
of 2007 and 2008, respectively. In the global derivative markets, there is dominance in the OTC
markets, where 91% of the overall notional amount outstanding belongs to OTC markets
and 9% belongs to organized (exchange-traded) markets as of end-2008.
Year
Instruments
Location
1848
Commodity Forwards
Chicago
1900
Equity Forwards
USA
1972
Currency options
CME
1981
Currency SWAP
Parameters
Exchange traded
Instruments
No
1
and Swaps
2
Exchange Floor/Exchange
Platforms
Clearing and
Settlement
institutions such as
Banks/Independent Clearing
Corporation
4
Contract
Specifications
by the Exchange in
Settlement
Risks Involved
Operational Risk
7
Transparency
available on Exchange/broking
Bloomberg/Reuters provide
firms/regulators websites
Regulators
Intermediaries
Securities Exchange
Associations
Mainly Banks
10
11
Price
Major Market
Better; as traded on a
transparent exchange
Participants
12
Type of Trading
Individuals
Via Market Makers, Mostly Quote
Order Driven
Driven
8
13
Redressal
Via regulators
Traded
Mass participation
Mechanism
14
15
Nature of the
market
Derivatives Instruments play an important role in price discovery through futures and options
markets. Price discovery is defined as a process of determining a price of a specific stock,
currency or a commodity through market demand and supply forces. Since derivatives
instruments are settled at a future date, market prices of derivatives contracts reflect prices of
underlying instruments on the settlement date. Hence, the price may be higher or lower than the
current spot rate, reflecting the markets bullish or bearish perception about the future price of
the underlying. But, since OTC instruments are traded in a scattered manner, efficiency in price
discovery may be affected to a great extent. For example, currency swaps are traded between
two banks. Hence the traded price is known to the counterparties at the time of trade and may
not be informed to other market participants. However, some OTC instruments such as currency
forwards are traded via Reuters/Bloomberg platform, which create efficient price discovery as
traded rate and quotes are flashed on the trading terminal. Normally, efficient price discovery is
extremely challenging for instruments that are highly customized such as exotic options or
exotic swaps.
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spread quoted in the markets. Illiquid markets are one of the reasons of inefficiency in price
discovery.
OTC Derivatives can be classified on the basis of underlying (e.g. equity, interest rates,
currency, and commodity) or the risk-return profile (symmetric or asymmetric). Forwards have
symmetric risk-return payoff profile, while options have an asymmetric one. The table below
highlights various types of OTC Derivatives:
Instruments
Equity
based on Risk
Ret/Underlying
Forwards
Equity
Forwards
Options
Swaps
Equity
Options/Warrants
Equity Swaps
Interest rates
Currency
Forward
Rate Currency
Agreements
Forwards
(FRA)
Caps/ Floors
Currency
Options
Swaptions
Currency
Swaps
Commodity
Commodity
Forwards
Commodity
Options
Commodity
Swaps
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Dealers are mainly institutions who trade on their own accounts. These trades are known as
principal or proprietary trades. The risks associated with dealers positions are market, credit,
operational and liquidity risk. Dealers are essential for OTC derivatives markets as liquidity is
poor.
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participants and thus not all participants can trade by accepting bids and offers made by
other participants that are open to multiple participants in the facility or system.
Summary:
The objective of this unit was to provide you with some exposure to introduction to the OTC
Derivatives Markets. The unit covers how the OTC Derivatives market is unique compared with
exchange traded derivatives markets. It is followed by an explanation on price discovery and
liquidity parameters governing the OTC markets. Finally, it covers types of participants such as
brokers and dealers, types of OTC markets, and OTC models.
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A forward contract is a customized contract between two parties, where settlement takes place
on a specific date (maturity date/expiry date/expiration date) in future, with terms and conditions
(specifications) agreed upon today.
They are OTC bilateral contracts (between two parties) and hence are exposed to
counter party risk.
Each forward contract is custom designed in terms of price, underlying, quality, quantity,
maturity date and settlement type (delivery/cash), location and currency. The underling
can be equity, currency, interest rates or commodity. Quality is relevant only in case of
commodity forwards. Delivery settlement results in actual delivery of the underlying; in
cash settlement, the intermediary calculates the profit or loss on settlement date.
The traded price or bid-offer price is not easily available in the public domain.
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Default risk/counter party risk/credit risk: Either party will deviate from the obligation.
Transparency risk: The price and other specifications are normally not available to
the market at large (unlike equity markets where details are available to trading
participants).
Liquidity Risk: Liquidity is a function of how easily trader can buy/sell a product. It
depends upon:
No. of buyers for a product
No. of sellers for a product
Quantity available for buying
Quantity available for selling
As forwards are not traded on exchanges, liquidity is low and hence traders normally
find it difficult to buy/sell in forward markets.
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No Dealing Desk: In case of no dealing desk, market participants trade via STP (Straight
through processing) route or via ECN (Electronic communication networks). No Dealing desk
brokers provide access to interbank market via STP automated screen based trading terminal
where order from market participants get matched with the best available quotes in the
interbank market. In case of ECNs, all the existing participants can allowed to trade with other
participants. Brokers charge a commission in case of STP/ ECNs.
(Source: forexbrokers.com)
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Currency
Commodity
Equity
Standard Forwards
Standard Forwards
Forwards
Par Forwards
Flat Forwards
Non-Deliverable
Forwards
Value
Description
Trade date
Transaction date
Tenure
1 month
Value date
Base Currency
USD
Fixed currency
Second
Yen
Variable Currency
Currency
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Spot rate
$/yen 85/85.15
Settlement is t+2
Forward points
$/yen 0.55/0.60
Forward rate
$/yen
85.55/85.75
Quantity
$ 10000
Documentation
ISDA
Buyer
Bank HSBC
Seller
Exporter in USD
Settlement
Delivery
Par Forwards:
A Par Forward is series of forward contracts at single rate rather than at different rates based on
the tenure of the forward time periods.
Specification
Value
Description
Trade date
Transaction date
Tenure
1, 2,3 month
Value date
on
Day
Convention
(following/
preceding
19
Base Currency
USD
Fixed currency
Second Currency
Yen
Variable Currency
Spot rate
$/yen 85/85.15
Settlement is t+2
Forward points
$/yen 0.55/0.60 ( 1m )
$/yen 0.57/0.625 ( 2m )
$/yen 0.59/0.65 ( 3m )
Forward
rate
( $/yen 85.57/85.775
applicable )
Quantity
$ 10000
Documentation
ISDA
Buyer
Bank HSBC
Seller
Exporter in USD
Settlement
Delivery
Spot rate
45
1.3
1.4
1.5
1.4
1.5
45.5
45.8
46.5
47
48
59.15
64.12
69.75
65.8
72
( USD/INR )
Amt received in INR(millions)
( Standard forwards )
20
66.164
66.164
66.164
66.164
66.164
( Flat forwards )
Explanation: The flat forwards is equal to the average of standard forwards. Therefore, the
calculation is as follows: (59.15+64.12+69.75+65.8+72)/5 = 66.164 (INR in millions)
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2. Two offshore entities can hedge their risk and thus avoid any regulatory controlled
restrictions on currency trading in domestic markets.
# Example 2.3.2:
Suppose an FII wishes to sell Indian Rupees (INR) forward. The transaction is to hedge an
underlying investment exposure that is not eligible for currency forward coverage in the formal
or official INR market. The counterparty enters into a NDF with a dealer for US $ 1 m for a 6
month maturity at rate US $ 1 = Rs 45.
If the rate goes to $/INR = 43 then the FII pays (20 lacs/ Rs 43) = $ 45311 (loss)
If the rate goes to 47, then FII will receive (20 lacs/ Rs 47) = $ 42533 (profit)
Explanation: The difference between the exchange rates of Rs45 Rs43 is 2rupees per dollar.
Therefore, computation is as follows:
1. $1000000 @ Rs43 is Rs43000000
2. $1000000 @ Rs45 is Rs45000000
3. $1000000 @ Rs47 is Rs47000000
If the rate goes to $/INR = 43 then the FII will pay the difference between Rs45million and Rs43
million which is equal to Rs2million or Rs20lakhs.
Alternatively, if the rates goes to $/INR = 47 then the FII will receive the difference between
Rs47million and Rs45million which is equal to Rs2million or Rs20lakhs.
# Example 2.3.3:
Assuming a counterparty wishes to sell Indian Rupees (Rs.) forward. The transaction is to
hedge an underlying investment exposure that is not eligible for currency forward coverage in
the formal or official Rs (Rupee) currency market. The counterparty enters into a NDF with a
dealer for US $ 1 m for a 6 month maturity at rate US $ 1 = Rs 40.
Solution:
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Rs Appreciates
Rs Depreciates
35
45
40,000,000
40,000,000
NDF 35,000,000
45,000,000
Rs
Amount
at
Settlement rate
Net Settlement
Counterparty
142,857
or
pays
US
$ Counterparty receives US $
Rs5000000 111,111
{40000000-35000000}
or
Rs5000000
{45000000-40000000}
Commodity forwards:
Standard Forward Contracts: They are simple outright purchase / sell of commodity at the future
date. They are similar in nature when compared to currency forwards except for the underlying
which is a commodity like gold, silver etc
Flat Contracts: A series of forward contracts structured at a constant price (weighted average
price). In a contango market (forward price is greater than the spot price, and increases with the
time), the weighted average price of the Flat contracts will be higher for near maturity contracts
as compared to standard forward contracts. Hence the cash flow from these contracts will be
higher in the near term which will match the higher project cost during the initial phase of any
project.
Spot Deferred Contracts: These contracts covers an option (to one of the parties) to defer the
settlement by a fixed tenure.
Equity Forwards:
These are forward contracts on equity stocks. In this case, two parties agree to exchange the
underlying stock (or index) at a future date at a price decided today.
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OTC Forwards serves various applications for hedgers and arbitrageur. In case of currency
markets, hedgers can be classified as importers or exporters. Most of the importers and
exporters are exposed to unfavorable price movements and need to hedge their underlying
exposure to the currency markets. Exporters such as software companies hedge their
remittances in USD by selling forwards (forward covers) to banks. Importers such as
manufacturing companies (e.g. purchase of machinery from the US) hedge their positions by
buying forward contracts (forward covers) from banks. Banks use spot and swap market to
hedge their exposure to importers and exporters. But the trading volumes of Currency Forwards
still form a smaller portion of the overall foreign exchange markets (refer to the table below). It
highlights that fact that the forward trading in 2007 was 362 billion out of the total trading of $
3.4 Trillion.
Arbitrageurs are risk averse participants who trade on the mispriced currencies. When the
market is imperfect, they buy in one market and simultaneously sell in the other market to earn
risk less profits. The possible arbitrage opportunities are mentioned below:
1. Spot and forwards
2. Forward and swaps
3. Forward and Futures
4. NDF and domestic forwards
5. NDF and Futures
6. NDF and Swaps
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Most of the arbitrageurs are Banks who trade in these markets to avail any arbitrage
opportunities.
Forward contracts are priced using Static replication strategy (the carry cost of model). The cost
of carry model considers the cost of financing, storing the asset, income of the asset. Pricing
forwards is by replicating forward position by financing a position in the underlying spot market.
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A. #F = S
where S
carrying it forward to time t. F is the todays forward price and S is todays spot rate. r
is the annual interest rate, t is the time.
B. #F = (S- I )
where S
and carrying it forward to time t. where I stands for the cash received by the owner of the
asset. If cash is received, the present value of the amount is reduced from the price of
the asset as the cost to buy the underlying asset reduces.
C. #F = S
where q stands for the dividend amount received. We assume here that
y is convenience yield.
In all the above cases, if the forward price is greater that the right hand side of the equation,
arbitrage opportunity exist. But before you try applying these equations for trading and pricing in
the market, read the assumptions mentioned above!!!
# Example 2.5.1:
Interest rates: 6% pa
Dividend: $ 2 per share (payable in one Installment)
Dividend payable on 27th August 2010
Forward Price:
Calculate Adjusted Spot rate
No of days: 148
Adjustable spot price: $100 - $1.95 = $98.05
# Example 2.5.2:
A. The Price of the underlying asset is $ 100. If the prevailing interest rate in the US market
is 1%. The price of the 6 m Forward contract will be F = S
, F = 100*
100.5013.
B. The face value of the underlying government bond is $ 1000 with a semiannual coupon
of 2%. The coupon is paid in three months. If the prevailing interest rates in the US
market are 3%. Income (I) is calculated as follows: (general forumale to calculate income
is 10*e-rt)10 *e(-0.03)*0.25 = 9.9252. (since the US market prevailing interest rate is 3% it is
converted to 0.03 and incorporated into the formulae, while 0.25 is the time period, since
coupon is paid every three months therefore 3/12 = 0.25)
C. The price of the 6 m Forward contract will be F = (S- I )
, F = (1000 9.9252)*
= 1005.038
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, 1000*
28
forward contract
On X Axis, we plot Market price of the underlying
Profit / loss
Market Price
Summary:
The objective of this unit was to provide you with some exposure to Forward markets. The unit
covers the designing of forward market specifications, trading alternatives, and Forward market
types. It is followed by types of forward derivatives markets such covers equity, commodity, fx
and interest rates as underlying. Finally, it covers major market participants such as hedgers,
speculators, arbitrageurs and the pricing techniques and payoff of forward contracts.
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FRA is a forward contract on interest rates between two parties to protect themselves against
future movement in interest rates. The buyer in a FRA wants to be shielded against increase in
interest rates while the seller wants to be protected from any decreases. But there is no
commitment to lend or borrow funds. The maximum exposure for either parties is the interest
rate differential between the contracted rate and settlement rate. All FRAs are settled in cash. If
the settlement rate > the agreed rate, the borrower will receive the difference from the lender or
vice versa.
Settlement amount = [(Settlement Rate - Agreed Rate) x contract run x principal amount]/
[(36000 or 36500) + (Settlement Rate x contract period)]
Where
Settlement Date is the start date of the loan or deposit upon which the FRA is based
Maturity Date is the date on which the FRA contract period ends
Fixing Date for most currencies two business days before the settlement date
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Settlement rate is the mean rate quoted by specified reference banks for the relevant
period and currency. For most currencies LIBOR shown on BBA site (British Bankers
Association)
Run is the Period or term of underlying investment or borrowing-----normally 90 or 180
days.
US$ FRA
Notional Amount
Trade Date
15-May-10
Effective Date
17-May-10
Settlement Date
17 August 2010
maturity Date
17-Nov-10
Parties
seller (Lender )
Party A
buyer (borrower)
Party B
Rates
5.75% pa payable semi-annually in accordance with the Fixed
Fixed rate
Floating Rate
year
Designated Maturity
Three months
spread
Nil
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15-Aug-10
Semi-annual money market basis calculated on an actual/360 day
year
count fraction
y year
FRAs are used to hedge short term exposure to interest rates on borrowings and deposits. Let
us look at the applications of FRA as hedging tool for future borrowings or future investment.
Requirement
Expectation
Interest rates may rise by the time the company borrows the money
Why FRA
Buyer
Seller
FRA Provider
FRA
Daycount
basis
and in a year
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# If in one month the settlement rate is 5.00%pa then the company will settle the difference in
favour of the FRA provider as follows:
[((6.50-5.00) x182 x1, 000,000)/ (36,000+ (5.00 x182))] =$ 7396.36
Requirement
Will have $1million to deposit in three months for a six month period
Expectation
Interest rates may fall by the time the company invest the money
Why FRA
seller
buyer
FRA Provider
FRA
Day
basis
count Actual / 365 ( day count convention is the no of days considered in a month
and in a year
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# If in one month the settlement rate is 12.00%pa then the company will settle the difference in
favour of the FRA provider as follows:
[((12-10) x182 X 952505.20)/ (36,500+ (12.00 x182))] =$ 8962.66
FRAs are quoted in rate terms as mentioned below. The lower rate (1.78 %) is the bid rate, rate
at which the dealer is prepared to buy a FRA and the rate at which the counterparty would sell a
FRA effectively locking the deposit rate. The higher rate (1.80%) is the offer (ask) rate, rate at
which the dealer is prepared to sell a FRA and the rate at which the counterparty would buy a
FRA effectively locking the borrowing rate.
FRA Quotations
Maturity (months )
Bid /Ask
1x4
1.78/80
3x5
1.91/93
4x6
2.01/02
5x7
2.15/17
6x8
2.29/31
1x4 in the first example refers to a contract on the 3 months rate in 1 months time. The first
number refers to the settlement date of the FRA in months from the effective date. The second
number refers to the maturity date from the effective date.
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The FRA rates are calculated from the currently prevailing yield curve. The yield curve is the
relation between the yields and maturity of bonds. Generally, yield curve is upward sloping
meaning, higher yields for longer maturities.
Yield
Maturity
Formula:
(1+ R1) (1+ F1) = (1+ R2)
Where R1 is the interest rate for the one year
Where R2 is the interest rate for the two years
F1 is the forward rate for between year 1 and 2
# Example 3.4.1:
Year
Interest rate
6%
8%
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Summary:
The objective of this unit was to provide you with some exposure to introduction and concept of
FRA. The unit covers how the FRAs are traded and how the settlement amount is calculated. It
is followed by the hedging examples for borrower as well as for lender. Finally it covers how it is
traded and priced in the market.
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4. INTRODUCTION TO SWAPS
In this example, Company A and B are the swap counterparties while bank arranges the swap
deal between these companies. Here the Company A agrees to pay fixed rate (say 6 %) to
company B. In return, company B agrees to pay floating rate (variable based on the benchmark,
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say Libor (London Interbank offer rate)) to Company A. They get into this agreement due to
various reasons which is explained in the following sections.
The First Swap transaction was traded in the year 1981between IBM and World Bank.
Prior to this, swaps were traded in form of parallel loans. Due to stringent foreign exchange
control, companies conducting business in a foreign country were unable to convert foreign
currency into domestic currency. To overcome this difficulty, the two companies based in
different countries, used to borrow domestic currency and lend the domestic currency to each
other. This arrangement was known as parallel loans. In case of parallel loans, the practical
difficulties faced by the market participants were default risk, accounting issues and arranging
the deal. As Swaps are arranged by banks, the default risk and arrangement issues are
managed by banks (popularly known as swap brokers/dealers). As Swaps are off balance sheet
transactions most of the accounting issues are also addressed.
A swap transaction is closed when the two parties agree to the specification of a swap deal. The
specification covers coupon rate, floating rate basis, day basis, the start date, the maturity date,
rollover dates, governing law and documentation details.
The transaction was between World Bank and IBM. The deal valued at $210 million for 10years
was brokered by Soloman Brothers. World Bank was planning to borrow Swiss Franc through a
mega size issue. Prior to this issue they had raised Swiss Franc from Swiss investors and
feared that they may have to pay a higher coupon to attract Swiss investors. At the same time
38
IBM was looking for dollar issue and had not accessed Swiss Market. In this scenario, they got
into a swap arrangement wherein it was agreed that IBM will raise Swiss franc as the effective
cost for IBM will be lower than that incurred by World Bank and in return, World Bank will raise
dollar. They swapped liabilities between them as both share a comparative advantage.
Instrument
Notional Value
2009
$ 342 trillions
2007
$ 310 Trillions
2007
Currency Swap
$ 240 Trillion
The Fees and other expenses charged by the arranger may be charged over the period of the
swap. The fees charged depend upon the credit risk (default risk) of the two parties involved,
the deal size and the tenure of the deal.
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Adjustment Swaps
Amortising Swaps
Discount Swaps
Equity Swaps
Flexible Swaps
Asset swaps
Forward Swaps
Interest Rate Swaps
CAT Swaps
Premium Swaps
CMT SWAPS
Commodity swaps
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The risks associated with swap transactions are substantial due the following reasons:
a. Volatile nature of interest rates,
b. Fluctuation in currency exchange rates,
c. The counterparties involved
d. Settlement procedures involved
1. Market Risk: The risk is mainly due to fluctuation in the floating interest rates. If the
floating rate ( e.g. LIBOR ) increases , the floating rate payer may default resulting in the
loss to the fixed payer ( unless necessary provisions are implemented by the swap
arranger )
2. Credit Risk: Risk of Loss arising due to default of the counterparty. The default may be
due to market risk
3. Liquidity Risk: If either partys inability to make payment on the settlement date, it will
create liquidity risk to the counterparty which may fail to meet its obligation. Many a
times, it results in systemic risk. Failure of one major institution to meet its commitment
may result in failure of other institutions thus creating systemic failures
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To manage these risks, the intermediaries need to create a risk infrastructure comprising of
A. Organization/ Resourcing
B. Risk Administration
C. Risk Management Systems
D. Risk Disclosures
Market Risk
Credit Risk
Liquidity Risk
Operational Risk
The bank will run the following risks while handling any derivative transaction.
A. Credit Risk
Pre-Settlement and Settlement Risk:
The Pre-settlement Risk (PSR) and settlement risk are associated with the counter party of the
SWAP transaction. The pre-settlement risk will be monitored during the life of the Derivative
contract however the settlement risk will be for the settlement date and to the extent of the
payment obligation of the Derivative transaction and may not be for the notional principal
amount (in case of interest rate swaps). The calculation of the PSR is based on the notional
principal amount and the tenor of the contract.
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The responsibility of the Risk Management department (RMD) is to confirm the calculation of
the PSR to the Dealing Room and to Treasury Back Office. Risk Management and Dealing
departments use Risk Metrics to calculate the amount to be blocked against the PSR limit for
the counter party. However if the limits are not available for a counter party, the dealer should
approach the RMD to get the necessary approval.
B. Regulatory Risks /Documentation Risk :There are certain requirements in the form of documentary evidence which bank needs to
ensure before and after conclusion of any derivative transactions. Any delay/ error in the
documentation may lead to regulatory actions and penalty imposed the transacting parties.
Some of the swaps transaction may have trading restrictions or may be under ban period.
Dealing in such instruments may be void and considered as illegal.
C. Appropriateness Risk :This risk is mainly related complex nature of the transactions. The counterparty may not be able
to understand the derivative Swaps and the risk behind these contracts due to the complex
nature of the transactions. In order to ensure the appropriateness risk effectively, the bank has
a policy to obtain the Risk Disclosure Statement covering this risk arising out of any Swap
transactions.
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D. Operational Risk: This risk is mainly associated with the processing of such deals. Operational risk can be
classified as system risk or human risk. The system risk can be system failure, internal reporting
failure. Human risk is defined as human fraud or error. The concerned back office personnel
should be properly trained to understand the nature and extent of the risks associated with
Swaps transactions as Swap may involve the unpredictable amount of future payment
obligations. Adherence to stringent reporting and auditing procedures can avoid human risk.
The bank has a policy to confirm certain new clauses or deletion in the schedule to ISDA master
Agreement with their Solicitors.
1. Credit risk
2. Basis risk
3. Mismatch risk
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Credit Risk
It arises because of failure of one of the counterparties to perform as per the contractual
agreement. Generally, in swaps, default will be restricted to the net amount receivable. Hence
default risk is less severe than bonds. Hence a bank which arranges swap does a check on
creditworthiness of counterparty before arranging a swap. Similarly, to compensate for credit
risk, a bank adjusts fixed rate by creating a swap spread. Swap spread is a spread over the
benchmark rate and reflects credit risk of counterparty.
Basis Risk
This risk arises only in case of Basis swaps. For example, consider a floating-to-floating interest
rate swap based on US LIBOR and EUR LIBOR. Assume that the swap dealer has to pay EUR
LIBOR and receive EUR LIBOR. Due to some market developments, if the existing relationship
between USD Libor and EUR Libor changes, the swap dealer may suffer a loss. This is the
basis risk for him.
Mismatch Risk
Usually, swap dealers offset their risk exposure in swap transactions by entering into counter
swap deals. Mismatch risk means that a swap dealer may find it difficult to offset his position
easily and may not get counter swap deals.
fixed interest rate. Usually, the swap dealer finds another party and enters into a counter swap
agreement to contain the interest rate risk.
1.
Dealer / Broker / parties involved should undertake more stringent credit analyses and
use greater care in selecting counter parties. Financially strong counterparty minimizes
the chances of default and facilitates the transfer of a swap, if need arises.
2. Master agreement stipulates that all swaps between two parties are cross defaulted to
each other i.e. Default on any one swap triggers suspension of payments on all other
swaps covered in the agreements. Such agreements normally assume frequent
transactions between the parties. They also are the most effective in reducing exposure
when a balance exists in swap positions between the two parties.
5. Net Settlement: Swaps are settled on the same day and on net basis. Net settlement is
defined as the difference in the payment obligation of the two parties involved.
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Credit default swaps can be defined as exchange of payment based on the underlying credit
event. The buyer (bond holder or lender) of this swap buys a protection from the seller (who is
normally a dealer) for a premium amount. The protection is linked to a credit event such as
failure to pay or payment default of interest/ principal amount of the bond or restructuring event.
If the event happens, the protection seller (dealer) will pay the total loss to the protection buyer.
The premium paid by the protection buyer will be a fixed percentage of the notional principal
amount (Example: 1.25 % per annum). The Bond / company on which the credit default swap is
based are known as Reference entity. Credit default swaps are designed to isolate the risk of
default on credit obligations. These instruments are referred to as credit default swaps or credit
default options.
Example:
An institution invests $ 100 m in a Bond Issue. The bond Issuer agrees to pay fixed coupon
every year to the institution. But the institution has a view that the issuer may default on
47
payment terms. Hence the institution purchases a protection from an insurance company and
agrees to pay premium every year to the insurance company. In return the insurance company
agrees to pay the institutions, the face value of the bond if the issuer defaults.
The essential elements of a credit default swap are:
i)
ii) The concept of credit event that triggers the payment to cover loss arising from default.
The settlement can take in one of the following forms.
Cash settlement In cash settlement, the protection seller pays the protection buyer an
amount based on the change in price of a reference asset. The change in price is the
difference in the price of the reference asset at the time of entry into the credit default swap
and the price of the asset immediately following the credit event (default). If the underlying is
a loan amount, the total loan amount will be paid by the protection seller to protection buyer.
Physical settlement or delivery - In this case, the protection buyer delivers to the
protection seller an agreed asset (generally a bond or loan given by the reference entity)
following a credit event .The seller of protection purchases the (defaulted ) security at preagreed value (the face value of the credit default swap).
Fixed Payment This entails the protection seller paying the protection buyer a pre
agreed fixed amount in the event of default. The amount paid reflects an agreed estimate of
loss given default. This structure is also referred to as a binary or digital credit default swap.
Actual workout /recovery value This entails the protection seller paying the protection
buyer the full face value amount of the credit default swap if a credit event occurs. The
48
buyer of protection is required to collect and pay through to the seller of protection all actual
amounts recovered from the reference entity following the credit event.
Buyer of protection
Investor
Seller of Protection
Dealer
Buyer of Protection
Bond holder
Maturity
3 years
Reference Entity
ABC Company
Reference Entity's 10 year 8.50%coupon bond(Bankruptcy or
Reference Bond
insolvency event),
(Failure to pay or payment default above a nominated minimum
Credit Event
Default Payment
Payment on Default
protection buyer
49
# Example:
For example, producer gets into a swap arrangement with a consumer on a notional principal of
1000 barrels of crude oil. The producer agrees to sell crude oil on semi-annual basis at a predetermined price of Rs 1800/bbl. On the first settlement date, if the spot price of crude oil is Rs
2,000/bbl, consumer must pay (Rs 1800/bbl)*(1000 bbl) = Rs 1,800,000. But the consumer
receives (Rs 2,000/bbl)*(1000 bbl) =Rs 2,000,000. The net payment made by the producer is
Rs 200,000. If the spot rate goes down to Rs 1600/ bbl, then the consumer will pay Rs 200,000.
Similar to interest rate swaps, the principal is actually not exchanged, but the payments are
based on some notional principal amounts. The payment linked to equity index is calculated as
50
a percentage change in the equity index or stock price. The party to the transaction receives a
return if it is positive and has to pay if the return is negative. The return is calculated as the
percentage change in the index value. The party is required to make a payment (for example
linked to the interest rate index) to the counterparty. So when the equity index return is negative,
the party has to make two payments, one linked to interest rate index and other linked to
negative returns of the index. The dividend paid by the underlying stocks of the index may also
be paid to the party by the counterparty.
PARTY A
Returns
linked
to
Equity Index
PARTY B
Summary:
The objective of this unit was to provide you with some exposure to introduction to the Swaps
Markets. The unit covers how the different types of SWAPS like interest rate, currency swaps
and others such as Credit default swaps, Commodity swaps and Equity swaps. It also covers
the risks involved in swap transactions and management of those risks.
51
Interest rate Swap: A swap arrangement where interest payments based on the notional
principal amount is exchanged between two parties.
Interest
From
Floating
Fixed
Same
Floating
Floating
Same
Floating
Fixed
Different
Fixed
Fixed
Different
Floating
Floating
Different
Example
Swapping from floating rate loan into fixed
rate
Swapping the interest rate basis of a loan
from US$ 6month LIBOR to US$ 3 month
CP rates.
Swapping a US$ floating rate loan to a
fixed rate GBP loan
Swapping a fixed rate US$ loan to a fixed
rate Yen loan
Swapping floating rate US$LIBOR
to
Floating rate Yen LIBOR
1. Fixed to Floating Swap: In this swap, one party receives fixed & pays floating interest
rates to the other party, through the life of the swap at each reset date.
2. Floating to Floating Swap: In this kind of a swap, both the counter parties exchange
two different floating reference rates, on the reset date through the life of the swap.
52
Interest Rate Swap (IRS) is an exchange of cash flows between two counter parties at preset
specifications as mentioned in the section 4.4.1 The two parties are obliged to exchange
interest payment or receipts on an agreed notional principal at regular intervals (normally
3months or 6months), over an agreed period of time (normally 5 years) in order to reduce the
cost of financing.
In this case, one party desires fixed rate funding but has access to comparatively cheaper
floating rate funding but while other party desires floating rate funding but has access to
comparatively cheaper fixed rate funding. By entering into swaps with the swap dealer, both the
parties can obtain the form of financing they desire and simultaneously exploit their comparative
borrowing advantages.
53
2. Independently approach an institution in the debt market to receive fixed or floating rate
amount.
# Suppose Company A and Company B wants to borrow $ 100mn for 1 year and have been
offered the following rates
Fixed
Floating
12.1%
6m Libor +0.3
13.3%
6m Libor + 1%
Spread
1.2%
0.7%
Desired borrowing
obligation
Comparative advantage
in borrowing
Company A
Floating
Fixed
Company B
Fixed
Floating
So the two parties decide to enter into a swap agreement. The cost for A is LIBOR and that of B
is 13.1 %.
Explanation:
The upper part of the table provides the base data
This benefit of 0.5% will be shared by Company A 30bps. And by Company B 20 bps.
So for Company B the cost will be 13.3% - 20 bps. Which comes to 13.1%
For Company A it will be LIBOR + 0.3% - 30bps. And therefore it will be LIBOR only
54
In the case of Company B reverse is true that is it desires to borrow fixed but has
comparative advantage in floating as spread is low 0.7% compared to 1.2%
Now Company B will borrow floating LIBOR + 1% and lend to Company A at LIBOR and
incurs additional cost of 1%
55
#
Month
Party B receives $
Net Settlement
10,00,00,000*(0.
10,00,00,000*(0.11)
( beginning of
12)*(3/12)=
*(3/12)=
the 3m period )
$ 30,00,000
$ 27,50,000
0M
Libor
11%
Settled
Party A
after
receives $
3M
A $ 250,000
3M
10%
6M
10,00,00,000*(0.
10,00,00,000*(0.10)
12)*(3/12)=
*(3/12)
$ 30,00,000
$ 25,00,000
6M
14%
9M
10,00,00,000*(0.
10,00,00,000*(0.14)
12)*(3/12)=
*(3/12)
$ 30,00,000
$ 35,00,000
Bank
5,00,000
9M
15%
12M
10,00,00,000*(0.
10,00,00,000*(0.15)
12)*(3/12)=
*(3/12)
$ 30,00,000
$ 37,50,000
party
750,000
#
B. Floating to Floating Swap :
In this kind of a swap, both the parties (A and B) exchange cash flows linked to two floating rate
benchmark rates on the reset date through the life of the swap.
For example Bank A enters into a swap with a Party B, whereby, the Party B pays to the Party A
latest 91 Day T Bill cut-off, in exchange for the prevailing 3 month Commercial Paper Rate
minus 200 basis points (i.e. 2%), of a AAA rated corporate, for a notional principal of $ 10, 00,
00,000.The reset is done every 3 months though the life of the swap periods of 1 year.
56
Month 3: 91 day T bill cut-off is 9% & the latest CP rate of AAA rated corporate is 11.00% set in
month 0 and settled in month 3. The Party B has to pay the Party A 9%, and the Party A has to
pay the Party B 9% (11.00%-2.00%). Hence, no net payments exchanged.
Month 6: 91 Day T Bill cut-off is 10% & the latest CP rate of an AAA rated corporate is 12.50%,
--- set in month 3 and settled in month 6. The Party B has to pay the Party A 10% and the Party
A has to pay the party B 10.50 % (12.50%-2.00%). Hence, net payment will be made from the
Party
to
the
Party
of
0.50%
on
Rs
10,00,00,000/-
for
months
,i.e.
$10,00,00,000*0.0050*(3/12)= $ 1,25,000
Month 9: 91 Day T Bill cut-off is 9% & the latest CP rate of an AAA rated corporate is 10.50%
,set in month 6 and settled in month 9. The Party B has to pay the Party A 9%, and the Party A
has to pay the Party B 8.50% (10.50%-2.00%). Hence , net payment will be made from the
Party
to
Party
of
0.50%
on
Rs.10,00,00,000/-
for
months
i.e.
10,00,00,000*0.0050*(3/12) = $ 1,25,000.
Month 12: 91 Day T Bill cut-off is 8% & the latest CP rate of an AAA rated corporate is 10 .50%,
set in month 9 and settled in month 12. The Party B has to pay the Party A 8% and the Party A
has to pay the party B 8.50 %( 10.50%-2.00%). Hence, net payment will be made from the Party
A to Party B of 0.50% on Rs.10,00,00,000/- for 3 months , i.e. $ 10,00,00,000*0.005 *(3/12) = $
1,25,000.
57
Definition
Value
in most currencies )
Depending on market convention, October 5, 2010 ( As Oct 2 and 3 are
up to five business days from trade holidays)
Effective Date
Settlement Date
Effective Date
October 5, 2010
Fixed Payment
Fixed Coupon
depending
on
Payment Frequency
convention.
October 5, 2013
Day count
Pricing date
Trade Date
October 1, 2010
Floating Payment
US $ LIBOR of the designated Maturity
reset semi -annually plus the spread
payable semi-annually200 basis points
(Example: LIBOR + 2%) ( 1 basis point
Floating Index
Determination
58
source
Every April 5 and October 5 commencing
Payment frequency
index itself -
October 5, 2013
Semi
Day count *
-annual
money
market
basis
6 Months
Reset frequency
index itself
First coupon
* Day count: there are four types of day count convention: Actual / Actual, Actual / 360,
Actual / 365, 30/ 360
(years)
(%pa)
Spreads
(Basis
3.44/3.46
42/44
4.24/4.26
64/67
5.08/5.11
58/60
5.42/5.45
60/63
A plain vanilla swap is defined as fixed-for-floating interest rate swap and this type of swap is
commonly encountered structure hence named as plain vanilla.
59
This swap is widely used by corporates to hedge their underlying exposure of interest rate
sensitive assets/ liability. Assets result into receipt of fixed / floating interest or liabilities require
payment of fixed / floating interest.
Instrument
Swap
Forward contract
Rationale behind the Conversion of floating to fixed interest - Mainly for fixing up the future
transaction
Difference between the floating rate and Interest rate differential between
fixed rate due to net settlement
Obligation
Rate
Either
floating
or
fixed
rates
considered
Intermediaries
Broker or Dealer
Settlement
Mainly dealer
Rate
contract period )]
60
Summary:
The objective of this unit was to provide you with exposure to Interest rate Swaps. The unit
covers how the different types of interest rate swaps like Fixed for Floating, Floating for
Floating IRS. It is followed by the Understanding of vanilla IRS and what are its uses. Finally
it covers major differences between an IRS and a FRA.
61
6. CURRENCY SWAPS
Defining Structure of Currency swaps - Fixed for fixed, Fixed for Floating, Floating
for Floating
A currency swap is a swap transaction in which two parties agree to exchange their respective
currency and interest rate positions between a currency pair at the commencement and
completion of the transaction (which is in the future).
The amount to be swapped is established in one currency based on the prevailing spot
exchange rate. Periodic payments similar to interest rate swaps are made which are based on
fixed or floating rates.
a) Cross Currency Interest rate Swap is defined as swap involving two currencies & two types
of interest rates (i.e. one fixed & the other floating).
b) Fixed /Fixed currency swap include two currencies and both currencies are having fixed
interest rates.
c) Cross currency Basis swaps: This swap involving two currencies with floating rate exposure
for both currencies.
62
1. Arbitrage: Borrowing US dollars at 1% and swap the dollars with INR. Investing INR at 9
%. Converting it back to USD after few years.
2. Asset / Liability management: Asset Liability mismatch happens when a company has
more assets in one currency and more liabilities in other currency. Swaps can be used to
convert such mismatch.
3. Hedging currency exposure: An Indian Company may have an outstanding Yankee Bond
issue where it is paying US$ Libor. In case, it expects US interest rates to go up and Indian
interest rates to fall. It has to convert dollar liability into INR. The company may enter into a
swap with a financial Institution or a bank wishing to swap fixed German rate with floating
US rates. Naturally Indian company will be paying fixed German rate while swap party will
be paying US$ Libor. This hedge is complete for the Indian company.
Company A has an INR liability of over 600,000,000 on account of debt issue in the Indian
market. It would like to convert the liability into USD. This can be achieved by the company by
converting their INR liability into a USD liability through a Currency Swap transaction. At the
same time, company B has USD liability of 16,850,000 on account of floating rate loan. Since
the company is an India based company having its commitments as well as its assets in INR, it
desires to have and monitor its USD liability converted into INR.
63
Both the companies contact Bank H for fulfilling their requirements. This leads to conclusion of 2
separate deals between H Bank and both the companies.
a) Deal with A:
Bank H undertakes the INR liability of Rs. 600,000,000/- @ 35.6083 of Company A on swapping
its own USD liability of 16,850,000 through a currency swap deal for the period of 5 years. This
swap will also ensure the swapping of the interest liability of both the counter parties on the
respective loans along with repayment responsibility. In this case, Company A will take the
responsibility to pay USD Libor (i.e. floating rate) to Bank H while receiving the INR fixed rate of
15% from Bank H on the repayment dates as per schedule. Due to this deal, company A has
two benefits:
a) Company A has got its INR interest inflow fixed against outflow on account of
debenture issue.
b) Company A has also locked into INR rate of 15.00% for the whole period of loan of 5
years thus hedging against any future adverse movements in interest rates (it goes
without saying that any beneficial movement cannot be exploited by the corporate).
b) Deal With Company B: Company B enters into a Currency Swap transaction with bank H to
swap into INR
ensure Bank H taking over the responsibility of USD repayment of Corporate Bs USD loan.
Under this contract, Bank H has agreed to pay 6mth USD Libor to company B while
company B will pay INR interest @15.25%. this agreement will ensure the following for
company B:
Company B has fixed Borrowing cost exposure at 15.25% so as to hedge itself from any future
adverse movement in INR interest rate
64
This deal also ensures a stable & assured income to the bank. This income is accrued &
received by the bank due to difference between the INR interest Inflows & Outflows from the
corporate. In this case, income from Bank H is 0.25% (i.e. 15.25 -15.00) % on the outstanding
INR borrowing amount as on every interest repayment date for next 5 years.
Company B
Final
Exchange
US$ Lenders
(Re-
exchange at maturity
US $94million
Company B
Company A
A$100million
US $94million
A$100million
A$ Lenders
US$ Lenders
65
Terms
Definition
Value
date
on
which
October 5 2013
the October 5, 2010 ( As Oct 2 and 3
(typically 2 days )
Market
Exchange
Rate
Rate
on
semi-annual
equivalent
of
or
the
Premium or Discount
None
66
Fixed rates
Non-US currency
US$
Notional Principal
notional
principal
Fixed Coupon
Notional Amount
Every April 5 and October 5
annual
depending
market convention
2013
Semi-annual
bond
equivalent
Pricing date
Trade Date
October 1, 2010
Floating Payment
US currency
US$ LIBOR of the Designated
Maturity reset semi-annually plus
Floating Index
the Spread
Payment frequency
index
2013
67
(generally actual/360).
itself.
Current Market rate for the Based on the LIBOR Rate
First coupon
index
Principal Exchanges
Company A shall pay to Company B the AUD Notional Amount
Initial Exchange
Exchange at Maturity
6.4 Major Differences between the Interest rate and Currency Swaps:
Sr. No
Parameter
CURRENCY SWAPS
Underlying
Interest rate
Mainly Currency
Currency
Parties Involved
Interest rates
across
different
Principal Amt.
Principal
amount
68
Exchange
Risk
involved
Regulations
Credit Risk
Market Risk
amount is exchanged
10
Interest payment
Summary:
The objective of this unit was to provide you with some exposure to currency swaps. This
unit covers the Concept and board understanding of the currency swaps. This is followed by
defining the various structures of Currency swaps. The structures can be classified as Fixed
for fixed, Fixed for Floating, Floating for Floating. It also covers the differences between
interest rate swaps and currency swaps.
69
7. MECHANICS OF SWAPS
After studying this unit, you should be able to understand the:
Pricing of Swaps
A reset date or a fixing date is the date when the floating rate is reset.
70
Fixing Date is the date on which the reference rate of the swap is decided. This date is generally
two working dates prior the start dates, however this date can be decided mutually by both the
counter parties. This would give adequate time to both the counter parties to complete the
documentation & other formalities. In our above mentioned example, the fixing or reset dates
would be 2 working days before each start dates, i.e. on 30th March 2010, 29th June 2010, 29th
September 2010 & 30th December 2010. The maturity date of the swap is 1st April 2011.
Size & tenor of the transaction: The dealer in consultation with the two parties involved
decides the size and tenor of the transaction. However, generally no regulator keeps any
restriction on the minimum or maximum size of notional principal amounts of the swaps as well
as the tenor of the transaction. Norms with regard to size are expected to emerge in the market
with the development of the product.
7.1.1 Example:
An investor has a portfolio of longterm bonds. The investor is worried that the interest rates will
rise and cause a loss in capital value. Thus, the investor can become a fixed rate payer (i.e. a
floating rate receiver) -. Effectively, the fixed rate bonds have been converted into floating rate
bonds, the portfolios value being immunized from interest rate fluctuations. If the interest rates
rise, the value of the portfolio will fall, this will be offset by the gain in the value of the swap
position. Similarly, if the interest rates fall, the value of the portfolio will rise, this will be offset by
the loss in the value of the swap position. This is an asset swap.
7.1.2 Example:
A fall in interest rates will increase the value of the liabilities. Thus, the company can hedge
itself from interest rate risk by becoming a floating rate payer (i.e. a fixed rate receiver). As
interest rates fall, the floating ratepayer gains. The gain from the swap will offset the losses to
71
the insurer as its liabilities increase in value. A rise in interest rates will increase the value of the
liabilities is the borrowing on floating rate. Thus, the company can hedge itself from interest rate
risk by becoming a fixed rate payer (i.e. a floating rate receiver). As interest rates rise, the fixed
rate payer gains. The gain from the swap will offset the losses to the insurer as its liabilities
increase in value. This is a liability swap.
7.1.3 Dealings and Quotations
Swap dealer/ market maker usually sets the floating rate equal to a benchmark/ index rate, free
from the margin actually payable in the cash market by the relevant counter parties. The floating
rate is thus, said to be quoted flat .after doing this, the fixed rate is set.
A quote of 15.65% - 15.85% against 3 month MIBOR means that the market maker:
a. Pays (bid) 15.65% fixed and receives INR 3 month MIBOR.
b. Receives (ask /offer ) 15.85% fixed and pays INR 3 month MIBOR
The floating rate benchmark used may be any transparent rate available in the market.
72
should be equal to the forward forward rates of the same reset dates through the tenor of the
swap. These forward rates can be arrived at by using interest rate futures contract as shown in
the example below.
Example:
Consider a company Melico Inc has borrowed $ 25M by issuing 5.5 % Bonds in April 2010. The
company expects that the interest rate will decrease in the future and hence approaches the
banks to swap fixed to floating rate, so that the company will pay amount based on floating rate
and bank will make fixed payment which in turn will be paid by the company to lenders.
Step 1:
Calculate Forward rates from spot interest rates. In practice, they are derived from Futures
contracts on Eurodollar CDs traded on exchanges such as CME. The prices of Eurodollar CD
futures enable us to arrive at implied forward rates.
Expiry
Price
Expiry
Price
Sep-10
97.83
Jun-12
96.555
Dec-10
97.735
Sep-12
96.37
Mar-11
97.695
Dec-12
96.195
Jun-11
97.475
Mar-13
96.055
Sep-11
97.235
Jun-13
95.935
Dec-11
97.005
Sep-13
95.815
Mar-12
96.765
Dec-13
95.7
Mar-14
95.615
73
Step 2:
Assume that current USD Libor rates are as follows. 3 m 2.5420, 6 m - 2.3825
Step 3:
Calculate the cash flows
The value of interest rate swap at inception to both the parties is Zero. Subsequently the swap
value changes due to change in interest rates. Valuation of interest rate swap involves arriving
at Present
Price
rate
future
Swap Period
rate
Begins
Ends
YrFrac
NP
CF
2.54%
01-Apr-10
30-Jun-10
0.2500
25000000 158750.00
Sep-10
97.8300
2.17%
1-Jul-10
30-Sep-10
0.2528
25000000 137131.94
Dec-10
97.7350
2.27%
01-Oct-10
31-Dec-10
0.2528
25000000 143135.42
Mar-11
97.6950
2.31%
1-Jan-11
31-Mar-11
0.2472
25000000 142461.81
Jun-11
97.4750
2.53%
01-Apr-11
30-Jun-11
0.2500
25000000 157812.50
Sep-11
97.2350
2.77%
1-Jul-11
30-Sep-11
0.2528
25000000 174732.64
Dec-11
97.0050
3.00%
01-Oct-11
31-Dec-11
0.2528
25000000 189267.36
Mar-12
96.7650
3.24%
1-Jan-12
31-Mar-12
0.2472
25000000 199940.97
Jun-12
96.5550
3.44%
01-Apr-12
30-Jun-12
0.2500
25000000 215312.50
Sep-12
96.3700
3.63%
1-Jul-12
30-Sep-12
0.2528
25000000 229395.83
Dec-12
96.1950
3.81%
01-Oct-12
31-Dec-12
0.2528
25000000 240454.86
Mar-13
96.0550
3.94%
1-Jan-13
31-Mar-13
0.2472
25000000 243822.92
Jun-13
95.9350
4.07%
01-Apr-13
30-Jun-13
0.2500
25000000 254062.50
Sep-13
95.8150
4.19%
1-Jul-13
30-Sep-13
0.2528
25000000 264468.75
Dec-13
95.7000
4.30%
01-Oct-13
31-Dec-13
0.2528
25000000 271736.11
Mar-14
95.6150
4.39%
1-Jan-14
31-Mar-14
0.2500
25000000 274062.50
74
In the above table, we are calculated the future cash flows for each quarter based on the
forward rate which is calculated from Futures price.
For Example : 2.17 % is calculated for the period ending September 2010 based on the
September Futures contract trading at 97.83 as ( 100- 97.83 ). Year Fraction is calculated
based on the difference between the respective quarters. In excel we can use the yearfrac ()
function.
Step 5:
Calculate the Present value of the cash flows. The discounting has to be done for each quarter
cash flow based on the respective discount rate
75
CF of December 2010/ (1+r1) (1+r2) where r1 is Forward rate year fraction of the first quarter
and r 2 is Forward rate * year fraction of the second quarter
CF
Forward. Rate
Period F R
Disc. F
PV of CF
30-Jun-10
158750.00
2.54%
0.6350%
0.99369
157748.3
30-Sep-10
137131.94
2.17%
0.5485%
0.98827
135523.27
31-Dec-10
143135.42
2.27%
0.5725%
0.98264
140651.03
31-Mar-11
142461.81
2.31%
0.5698%
0.97708
139195.91
30-Jun-11
157812.50
2.53%
0.6313%
0.97095
153227.44
30-Sep-11
174732.64
2.77%
0.6989%
0.96421
168478.44
31-Dec-11
189267.36
3.00%
0.7571%
0.95696
181121.7
31-Mar-12
199940.97
3.24%
0.7998%
0.94937
189817.85
30-Jun-12
215312.50
3.44%
0.8612%
0.94126
202665.65
30-Sep-12
229395.83
3.63%
0.9176%
0.93270
213958.52
31-Dec-12
240454.86
3.81%
0.9618%
0.92382
222136.77
31-Mar-13
243822.92
3.94%
0.9753%
0.91490
223072.64
30-Jun-13
254062.50
4.07%
1.0163%
0.90569
230102.37
30-Sep-13
264468.75
4.19%
1.0579%
0.89621
237019.86
31-Dec-13
271736.11
4.30%
1.0869%
0.88657
240914.34
76
31-Mar-14
274062.50
4.39%
1.0963%
0.87696
240342.11
3075976.2
3075976.2
3075976.2
Step 6: (Candidate should note that this example may be important from test point of view)
Calculate the SWAP rate (fixed rate)
To calculate the SWAP rate the PV of Fixed Cash flow = PV of Floating Cash Flow
Assume the SWAP rate is X%
PV of Fixed Cash flow = PV of Floating Cash Flow
PV of Fixed Cash flow = (X * NP * Year frac1)
(1+ r1)
(X * NP * Year frac1) +
(1+ r1)
(X * NP * Year frac2)
(1+ r2)
77
NP
Yr. Frac.
B*C*D
0.99369
25000000
0.2500
6210562.93
0.98827
25000000
0.2528
6245311.91
0.98264
25000000
0.2528
6209758.45
0.97708
25000000
0.2472
6038867.93
0.97095
25000000
0.2500
6068413.51
0.96421
25000000
0.2528
6093252.73
0.95696
25000000
0.2528
6047469.18
0.94937
25000000
0.2472
5867630.58
0.94126
25000000
0.2500
5882892.60
0.93270
25000000
0.2528
5894174.12
0.92382
25000000
0.2528
5838022.88
0.91490
25000000
0.2472
5654566.17
0.90569
25000000
0.2500
5660575.03
0.89621
25000000
0.2528
5663556.95
0.88657
25000000
0.2528
5602659.16
0.87696
25000000
0.2500
5481005.95
94458720.09
3.2564%
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Summary:
The objective of this unit was to provide you with some exposure to trading, pricing and risk
management of swaps transactions. It starts with the trading along with the specifications of
swap transactions. It was followed by the pricing example of Swap transaction. Finally it covers
the concept of risk management along with the process followed in risk management.
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80
Front office provide the trade information to the middle and back office. However all the
operations mentioned above are undertaken by the back office team.
Front office comprises
Traders,
Clients,
Sales Officials who are mainly involved in pre and post trade client servicing,
Compliance: This department looks in the regulatory and legal compliance with respect
to all the transaction undertaken by the trading organisation. It has to liaison with the
counterparties, regulators, legal experts to safeguard the trading organisation from any
potential legal and regulatory non- compliances.
Risk Management: This department management all the types of risk namely market
risk, credit risk, operational and liquidity risk.
Trade Support: This department provide support to the front and back office by providing
the trade enrichment data like static data and other related information.
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Customer Support: This department deals with the clients and provide with information
and necessary support for trading related activities.
Static/ reference data capturing : This function comprising of capturing data which
doesnt change frequently.
Cash Settlement : This function comprises of transfer cash from loss making parties to
profit making. This is known as mark to market settlement. Cash Settlement can also be
interms of delivery based derivatives where cash is transferred from buyer to seller.
Reconciliation : The process of checking the account held by the trading member and its
custodians.
Investigation : The process of checking the trading book and is followed after inspection.
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All trades must be recorded formally by the market participant. A Trade is captured
to update a trading position for a specific security within a trading book,
to update average price of the current trading position to enable the trader to calculate
trading profit or loss,
To allow trade detail to be sent through to the Back Office for trade processing and
settlement
To meet market & regulatory reporting requirements
To facilitate risk management
Traders use complex trading systems to facilitate trading & position management, trade
processing is usually done via Back Office processing systems.
TRADING
ORGANISATION
TRADE AFFIRMATION
FACILITY
TRADING
TRADING
ORGANISATION A
INSTITUTIONS
TRADE MATCHING
ORGANISATION B
FACILITY
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and its
counterparties:
If the trades are not matched, the middle office will investigate the trade discrepancies with the
counterparties. This is a time bound activity as the trade needs to be reported to the regulator
within the stipulated time. In UK, the stipulated time is 30 minutes.
4. New counterparty and security set-up within internal systems :
This is related to the updation of static information. The counterparty related data is provided by
third parties such as Alert of Omega. The securities related data is provided by Data vendors
like Reuters, Standard and Poors, Bloomberg etc
5. Production of the daily trading Profit and loss Account:
The daily P&L Account is essential to evaluate each trader or trading book performance on daily
basis. As most of the positions are marked to market on daily basis, the default risk is analysed
based on this account. As the financial markets are dynamic in nature, organizational
performance can be evaluated on daily basis after analyzing this report,
6. The reconciliation of trading positions
The reconciliation of trading positions (i.e. the quantity of specific securities within each
trading book) between the trading organizations books and records with the information in
the trading and settlement system.
85
However trade fails due to settlement failures. The settlement fails due to many reasons
namely:
1. Non-matching settlement instruction: The settlement instruments are generated by
the counterparties which may not match. The contents of settlement instructions are as
follows
!
From
To
Depot account The Broker 's account number over which the securities
no.
movement is to be effected
Nostro account The Broker 's account number over which the cash
no.
movement is to be effected
Trade reference
Deliver/receive
Settlement
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basis
Value date
Quantity
Security
reference
Settlement
currency
Net
value
Counterparty
depot
account number
Counterparty
nostro
account number
Transmission
time
The above instructions are generated by buyers broker as well as by sellers broker and
transferred to their respective custodians. The transaction may lead to settlement failure if the
instructions send to both the custodians do not match.
2. Insufficient Securities: The seller has insufficient securities to deliver (in case of short
forward or short call) and unable or unwilling to borrow securities to meet its shortfall.
The shortfall may result, for example, because the seller is awaiting delivery of a
purchase of securities, or because securities are out on loan and the seller has been
unable to recall them to meet its settlement obligations.
3. Insufficient Cash, collateral or credit line: The buyer having insufficient cash to settle
the cash leg of the trade because, for example, it is awaiting the funds from a previous
sale of securities or is experiencing a cash funding/ liquidity problem.
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4. Corporate actions. Securities are not available for delivery because the clearing
organisation has blocked delivery in respect of some corporate action or event.
For example1:
HDFC BANK does some transactions in USD, but banks in India will only handle payments in
INR. So HDFC BANK opens a USD account at foreign bank NEW YORK BANK, and instructs
all counter-parties to settle transactions in USD in its account at New York Bank". HDFC BANK
refers to this account as its nostro account. NEW YORK BANK calls this account as the vostro
account.
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Here an institution may transfer funds from one custodian in country to another custodian in
another country. This transaction is termed as Nostro Transaction.
From Nostro
Custodian S Brussels
To Nostro
Custodian H Hongkong
Currency
HKD
Amount
37,800,000
Value date
25th Oct
Nostro and Vostro payment and reconciliation are a part of the back office functions in any
securities trading organisation, bank, financial institution, investment management companies
etc. when securities are cleared and settled these accounts are used.
ISDA documentation is the ISDA Master Agreement ('Master Agreement'). Once the buyer and
seller sign this agreement, it governs all individual transactions entered into between these
parties. The two counterparties must negotiate with care and prudence while formulating the
agreement. The types of derivatives that may be documented under the Master Agreements are
rate swaps, basis swaps, forward rates, commodity swaps, commodity options, equity/equity
index swaps, equity/equity index options, bond options, interest rate options, foreign exchange,
caps, floors, collars, swaptions, currency swaps, cross currency swaps, currency options, credit
derivatives and combinations of the above.
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Each Agreement covers Standard terms (which may be customised by the two players) and the
schedule.
# ( below table is very important from exam point of view )
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Currencies
Securities
Security groups
The term static data implies that the information does not change .The majority of static
data items are static and not subject to change; however, certain aspects of static data are
subject to periodic change or updating. This activity is outsourced to third party data vendors
as mentioned in the previous section. The challenge for a trading company is to gather the
relevant data, Store it securely, update it when necessary and utilise it appropriately.
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Counterparties / Security
STOs need to hold static data relating to all their counterparties/ securities, to enable
automated enrichment of trades and subsequent actions, such as the production of trade
confirmations and settlement instructions containing the counterpartys custodian details.
Example of a bond
Example of an equity
plc
GBP
Ordinary Shares
XYZ Ord
BD007894839
SH00434930843
ISIN: XS 098765430
ISIN: GB82739289
Issued currency
EURO
GBP
Issued quantity
EURO 1,000,000,000.00
100,000,000
Security type
Bond
Equity
Security group
UK Equity
fixed rate
NA ( Not Applicable )
Coupon rate
8.25%
NA ( Not Applicable )
Coupon frequency
Annual
NA ( Not Applicable )
st
1 JAN
NA ( Not Applicable )
NA ( Not Applicable )
Maturity date
NA ( Not Applicable )
Maturity price
100%
NA ( Not Applicable )
5000.00
and
1.00
board lots
20,000.00
Credit rating
BBB
NA ( Not Applicable )
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Summary:
The objective of this unit was to provide you with some exposure to Trade Life Cycle of
structured products. It covers the process of settlement of OTC trade (trade life cycle) and
the role played by the front , middle and back office in a trading organization. It is followed
by the reasons for trade failure and role of Trade Support in Trade life cycle. It explains the
concept of Nostro and Vostro Accounts. Finally it covers the importance and regulatory
clauses of ISDA documentation along with the Importance and sources of Static data
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9. OTC OPTIONS
After studying this unit, you should be able to understand the:
Definition and concept of options, various terms related to options
Different types of OTC or Exotic options
Basic option strategies
Types of settlement mechanism in options
Valuation and pricing of OTC options
Applications of Options
OTC Options
Type
Exotic
Plain Vanilla
Regulations
Liquidity
Limited
Higher Liquidity
Execution
confidentially
trade
data
is
as
the
accessible
Operation risk
Settlement
Existence
due
to
clearing house
compared by
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Market Prices of the underlying instruments ( equity shares, index, fixed income
securities, Fx, Commodity )
Exchange Rate Floating (Flexos) - Payment to be made in the currency of the option
using the exchange rate at exercise.
2. Barrier Options
These options are designed to allow the investor to benefit from their expectation of share price
path movement, (e.g. the share will first go down and then Rocket up; or the shares going up
but never past 20).
There are several types of barriers:
A. Knockout - if the share price exceeds the barrier the option is blown out. In this
example the barrier is 20 and if the share price exceeds this barrier the option ceases.
Note the option price is dramatically reduced - therefore if the clients view (that the
share will go up but not as high as 20) is correct the investor will make a larger gain.
B. Knockin options only kick-in if their barriers are past. E.g. If the user believes the stock
will go down first and then go up he can reduce his option cost by purchasing a Down
and In Barrier Option - the option only kicks in if the stock first falls below 14.00 (it
must then go up to be In-the-money). Note if the stock just went up without first crossing
the barrier the option holder gets nothing.
3. Asian Options
These are popularly known as averaging option. In case of Asian options, the payout is
calculated based on the closing price. The closing price is based average price of the day/week
/ month instead of the last half an hour weighted average price as in case of a plain vanilla
option. The payout is determined by deducting the average from the strike. (Please refer to the
exchange traded derivatives section for plain vanilla options)
This option is far cheaper because the volatility of an average is lower than that of the price
itself.
The averaging feature protects the writer and holder from last minute sharp spikes or share
price movement, and reduces the possibility and impact of manipulation.
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Another alternative is to average the strike price instead of the share price. This gives the holder
the right to purchase the share at the average price (over the averaging time period.). At expiry
the holder can purchase the share at the average price over the averaging period.
The option may give the buyer the right to select the lowest of the stock as the strike price. Then
the profit for the buyer will be (Closing price of the Dec 2010 Lowest price of the stock (during
Oct dec).
If the current closing price is $ 85 and the lowest price during the period Oct Dec is $ 76, then
the buyer get $ 9.
5. Ladder Options
An option where the gains are locked in once the underlying reaches a predetermined price
levels or rungs, guaranteeing some profit even if the underlying security falls back below these
levels before the expiry of the option. For example, a ladder call option with an underlying price
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of $30 has a strike price of $35 and rungs at $40, $45 and $50. If the underlying price reaches
$43 then the gain locked in would be $5 (40-35), the underlying price reaches $48 then the gain
locked in would be $10 (45-35), even if the underlying price decreases below these levels
before the expiration date.
6. Chooser options
These options give the holder the right to wait and choose whether the option is a Call or Put.
Clearly this allows the user to win if share goes up or down and therefore is more attractive than
a straight Option and consequently priced accordingly.
7. Compound Option
This is an option on an option. In this case, the holder has a Call option that expires 30th June
to purchase a Call option for 3.00 which will then give the holder the right to purchase the
shares at 16.00 on 31st December. The holder pays less up-front initially making this a highly
geared instrument. However, the over-all cost (including the first strike) will be higher.
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For example, a purchase is made of a binary cash-or-nothing call option on ABC INC at $100
with a binary payoff of $1000. Then, if at the future maturity date, the stock is trading at or above
$100, $1000 is received. If its stock is trading below $100, nothing is received.
9. Cliquet
A cliquet option or ratchet option is a series of consecutive forward start options. The first is
active immediately. The second becomes active when the first expires, etc. Each option is
struck at-the-money (market price = strike price) when it becomes active.
A cliquet is, therefore, a series of at-the-money options but where the total premium is
determined in advance. A cliquet can be thought of as a series of "pre-purchased" at-the-money
options. The payout on each option can either be paid at the final maturity, or at the end of each
reset period.
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Loss Potential
Long Call
Bullish
Limited
Short Call
Bearish
Unlimited
Long Put
Bearish
Limited
Unlimited
Short Put
Bullish
Long Call: Here the trader expects a bullish view on the underlying. As the market moves up,
the buyer makes profit
Short Call: Here the trader expects a bearish view on the underlying. As the market moves up,
the seller makes loss
Long Put: Here the trader expects a bearish view on the underlying. As the market moves
down, the buyer makes profit
Short Put: Here the trader expects a bullish view on the underlying. As the market moves
down, the seller makes loss
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CALL OPTIONS
Long
Call
Spot
290
300
310
320
330
340
350
360
370
380
390
Net P/L
-15
-15
-15
-15
-15
-15
-5
5
15
25
35
Strike: 340
1 Call Buy: Prem: 15
102
Spot
290
300
310
320
330
340
350
360
370
380
390
Short
Call
Net P/L
15
15
15
15
15
15
5
-5
-15
-25
-35
Spot
290
300
310
320
330
340
350
360
370
380
390
Long
Put
Net P/L
38
28
18
8
-2
-12
-12
-12
-12
-12
-12
Strike: 340
1 Call Sell: Prem: 15
Strike: 340
1 Put Buy: Prem: 12
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Spot
290
300
310
320
330
340
350
360
370
380
390
Short
Put
Net P/L
-38
-28
-18
-8
2
12
12
12
12
12
12
Strike: 340
1 Put Sell: Prem: 12
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Put Options:
Higher the strike price as compared to the market price, put premium will be higher as the buyer
will receive a higher price ( strike price ) to sell the underlying. Similarly lower the strike price as
compared to the market price, Put premium will be lower as the buyer will receive a lower price
(strike price) to sell the underlying.
Volatility: Volatility is a measure of how much the price fluctuates. The more volatile the price,
The greater the probability that the option will become of value to the buyer at some time,
Therefore the higher its value charged by the seller. Hence the price of call and put options will
increase as the volatility increases
105
The time to expiry: the longer the time to expiry, the greater the probability that it will become of
value to the buyer at some time, because the price has a longer time in which to fluctuate.
Therefore, as an option move closer to its expiration, if all other factors remain the same, it
loses value each day. This is known as time decay.
Interest rates: The premium represents the buyers expected profit when the option is
exercised, but is payable up-front and is therefore discounted to a present value. The rate of
interest therefore affects the premium to some extent. If the interest rises, the call premium will
increase and put premium will decrease.
OTC Options applications are similar to that of exchange trade options. Please refer the
application of exchange traded options.
Organisations
Derivatives Instruments
banks
Applications
mortgage lenders
fund managers
to hedge assets
commodities, FX
106
insurance companies
industrial companies
industrial companies
commodity and FX
derivatives
industrial companies
FX derivatives
to hedge borrowing
material producers
energy providers and raw
costs,
commodity and FX derivatives
material producers
farmers
and
businesses
farmers
and
agricultural agricultural
businesses
derivatives
transportation companies
transportation companies
commodity
derivatives
transportation companies
FX derivatives
governments
107
market at 59. Again, as it has already paid a premium of 3, the all-in rate achieved by the
company is 56 INR per euro.
# Example of Speculation:
A speculator believes that the price of gold will fall below $1200 per ounce, so he buys a gold
put option at a strike of $1200, for a premium cost of $55, with expiry in one month. After one
month, the spot price is $1000. He exercises the option to sell gold at $1200 and immediately
buys the gold in the market at $1000 for a $200 profit. This gives him an all-in gain of $145 after
taking into account the initial $55 premium cost of the option. If the price of gold had not fallen
below $1200 at expiry, his loss would have been limited to the $55 premium paid up-front.
Summary:
The objective of this unit was to provide you with some exposure to introduction to the OT
options. It covered the broad definition and concept of options followed by the various terms
related to options like strike price, maturity etc. The reader should read the exchange traded
writeup along with this writeup. It mainly covers the various different types of OTC or Exotic
options. It is followed by the basic option strategies like buying a call, buying a put, selling a call
and selling a put. Finally it covers the different types of settlement mechanism in options like
exercising or square up followed by valuation pricing and applications of OTC options
108
Floors are options that protect the lender from the fall in the interest rates by offering him a
minimum rate of interest. Here if the (floating) deposit rate is lower than the floor strike rate, the
buyer receives the difference. Whenever the (floating) deposit rate is higher than the floor strike
rate, nothing is paid or received. The settlement mechanics for a floor are analogous to those
for a cap.
109
Collars are contracts that incorporate both a cap and a floor. When a cap is purchased and a
floor is sold the structure is called a collar. Collars can be constructed so that the two premiums
- the premium paid to buy the cap and the premium received when a floor is sold net zero. This
is referred to as a zero-cost collar. A collar is also known as a cylinder or tunnel.
If the loan requirement rise and fall repeatedly, in line with seasonal borrowing requirements, a
rollercoaster swap can be considered whose notional principal amount will rise or fall
accordingly.
.
10.2.2 Overnight Index Swaps
An overnight index swap (OIS) is a specific kind of interest rate swap. Their main features
include:
1. These contracts involve the exchange of obligations for relatively short periods such as
from one week to around a year, while normal interest rate swap contracts are for long
periods such as one to thirty years
110
2. The floating reference rate in the OIS contract is overnight rate, while floating rate in the
interest rate swap contract is set less frequently with reference to a quarterly or semiannual interest rate.
In an OIS transaction, the counterparties agree to exchange the difference between the interest
accrued on the fixed OIS rate and the compounded floating amount on expiry of the contract.
Pay floating rate (daily compounded reference rate)
OIS receiver
OIS payer
Pay fixed OIS rate
For example, a bank raises money by issuing three month bank bills and lends the money on an
overnight basis to its customers. The banks customers would pay a floating overnight interest
rate while the bank would be paying its lenders a three month fixed interest rate. When market
interest rates fall significantly, the bank would have to continue paying its lender at the fixed
interest rate while the bank would receive the lower floating interest rate. The OIS transaction
facilitates protection against unfavourable shift in the overnight rate.
Example:
Bank X raises $1million by issuing three month banks bills. Bank X pays the bank bill holder a
fixed interest rate. Bank X lends its customers on an overnight basis. i.e. Bank Xs customers
pay floating overnight interest rate. Therefore, Bank X is exposed to unfavourable shift in the
overnight interest rate. Bank X enters into a three month OIS contract for $1million with PQR
Ltd. (OIS counterparty).
111
The floating leg of the OIS transaction offsets the floating interest rate payments received from
the customers.
The counterparties to a swaption must agree start date and maturity date as well as the specific
details of the swap. Swaptions may be European or American style.
112
As with many other OTC derivatives, ISDA (International Swaps and Derivatives Association)
has developed market trading standards and responsibilities for participants in the swaption
market.
# Example:
A company is planning to take a three-year floating rate loan which will start after two months. It
is also planning to swap this loan into a fixed rate loan.
The company is of the opinion that the swap rates will decline in two months time and so would
like to wait until then before arranging a swap. However, the swap rates may move the other
way also. In order to avoid any potential loss, it may buy a two months option to be a payer of
fixed rate three year swap at 6% against LIBOR. If after two months, the market rate of fixedfloating swap is less than 6% it will let the option expire. On the other hand, if the market rate is
more than 6%, it will exercise its option on swap at 6%.
Summary:
The objective of this unit was to provide you with some exposure to introduction to the other
type of OT derivatives products. It covers the interest rate Caps, Floors and Collars in terms of
concept, applications and examples. It is followed by the different instruments such as
amortizing, accreting swaps, Overnight Index Swaps, Swaptions.
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End of Document
114