SS 17: Derivative Investments

Derivatives
Reading Assignments

Option Markets and Contracts

Swap Markets and Contracts
Interest Rate Derivative Instruments
Credit Default Swaps

Option Markets and Contracts

Options: Brush-Up
Similarities between options and forwards/futures:
Options allow the holder to buy/sell an underlying asset in
the future

Differences between options and forwards/futures:

Options are optional; exercising it is not mandatory for the
buyer
Purchasing an option means putting up cash upfront
Premium
Options can be both privately traded with risks similar to
forwards, as well as publicly traded with advantages similar
to futures
4

Options: Brush-Up
Term

Definition

Call Option

Option that gives the holder the right to buy an underlying asset in the
future

Put Option

Option that gives the holder the right to sell an underlying asset in the
future

European
Option

Option exercisable only at maturity; denoted as c0 and p0

American
Option

Option that can be exercised at or before maturity; denoted as C0 and P0

Exercise
Price

Denoted by X is the price at which the (call/put) option can be used

Strike Rate

Rate (or price) at which interest rate options can be exercised

Options Terminology: Brush - Up

In-the-money: For calls when S X > 0; for puts when X S > 0
At-the-money: When X and the market price of the underlying
asset are same

Out-of-Money: for calls when S X < 0; for puts when X S <

0

Put-Call Parity
Fiduciary Call: comprises of a Long European call and a zerocoupon bond with a face value of X
Fiduciary Call = c0 + X/(1 + r)T
Protects against downside losses
Protective Put: comprises of a Long European Put and the
Underlying Asset
Protective Put = p0 + S0
Also protects against downside losses

Put-Call Parity
Fiduciary Call Value
Long Call
Long Bond
Total

Value At Expiration, if X < ST Value At Expiration, if X ST

c0

ST - X

X/(1 +r)T

c0 + X/(1 +r)T

ST

Protective Put Value

Value At Expiration, if X < ST Value At Expiration, if X ST

Long Put

p0

X - ST

Long Asset

S0

ST

ST

p 0 + S0

ST

Total

Note that the pay-offs at expiration, for both Put and Call are
same
Therefore, we can say that Fiduciary Call = Protective Put
8

Put-Call Parity
c0 + X/(1 +r)T = p0 + S0
This is called the Put-Call Parity and expresses and equality
between put and call
Rearrange:
T

= + - X/(1 +r)
Instead of purchasing a call option, one could simply
Buy a Put
+ Buy Underlying Asset
Synthetic Call
+ Short the bond
9

Synthetic Options and Assets

Put-Call Parity allows us to make synthetic (or quasi) options
and assets
Advantages
1. Helps in pricing options
2. Allows to make arbitrage profits if mispricing exists
Option/Asset

Synthetic Equivalent

c0

= p0 + S0 - X/(1 +r)T

p0

= c0 - S0 + X/(1 +r)T

S0

= c0 - p0 + X/(1 +r)T

X(1 +r)T

= S0 - c0 + p0
10

Arbitrage: Example
An investor is considering a long call priced at AED 2.00 that will
expire in 3 months. The underlying is a stock of E-value Co. with
an exercise price of AED 2.98 that is currently selling for AED
3.25. A put on the same underlying asset is selling for AED 2.50
with the same X. The risk-free rate is 2.5%.
Explain the opportunity for Arbitrage

11

Arbitrage: Example
Solution
co + X/(1 + r)T
2 + 2.98/(1.025)0.25
4.96

= p 0 + S0
= 2.50 + 3.25
5.75

To exploit the mispricing, the investor should long cheaper

investment and short the expensive one
i.e., long fiduciary call and short the protective put to pocket AED
0.79 today
At expiration, both portfolios have the same pay-off

12

Binomial Model to Price Options for

Assets
Binomial Model allows us to price options by
changing the price of underlying stock in 2
directions: Up or Down
Size of up move = u; Size of down move = d = 1/u
Risk-Neutral probability of movement =

where =

1+

and d = 1 - u

and call option price is =

+ + 1
1+

13

Binomial Model to Price Options for

Assets
S+
C+ = Max (0, S+ X)
S
C=?

SC- = Max (0, S- X)

14

Binomial Model to Price Options for

Assets
S+

C+ = Weighted Avg (C++, C+-)

S++
C++ = Max(0, S++ X)

S+C+- = Max(0, S+- X)

S
C = Weighted Avg (C+, C- )

SC- = Weighted Avg (C+-, C--)

S-C-- = Max(0, S-- X)

15

Binomial Model: Example

Laila Aziz is interning at Furkan Asset Management. She is training
under Saeed Ahmed to learn how to price call options. They are
looking at a stock of Emaar currently trading at AED 3.00 and have
decided to use the 2-period binomial model in which the stock can
either go up by 10% or down by 9.1%. The exercise price of the option
is AED 2.98 and the risk-free rate is 5% per period.
Solution
1. Compute the Up & Down Factors, and Risk-Neutral probabilities
2. Compute the stock price at the end of each node (Left Right)
3. Compute the call price at expiration and work backwards (Right
Left)
16

Binomial Model: Example

Step 1: Up Down Factors
u = 1.10
d = 0.91
Step 1: Risk-Neutral Probabilities
u
= (1 + r d)/ (u d)
u
= (1 + 0.05 - 0.91)/ (1.10 0.91)
u
= 0.74
d
= 1 or 0.26

Step 2: Compute Stock price at each node (next slide)

Step 3: Compute call price at expiration and work backwards to compute
weighted average call price at each node (next 2 slides)
17

Binomial Model: Example

S+ =

C+ =

3(1.10) = 3.3
Weighted Avg (C++, C+-)

S++ = 3.3(1.10) = 3.63

C++ = Max(0, S++ X)
C++ = 3.63 2.98 = 0.65

S+- = 3.3(0.91) = 3
C+- = Max(0, S+- X)
C+- = 3 2.98 = 0.02

S = 3.00
C = Weighted Avg (C+, C- )

S- = 3(0.91) = 2.73
C- = Weighted Avg (C+-, C--)
S-- = 2.73(0.91) = 2.48
C-- = Max(0, S-- X)
C-- = 2.48 2.98 = 0
18

Binomial Model: Example

S+ =

3(1.10) = 3.3
Weighted Avg (C++, C+-)
C+ = [(0.74 x 0.65) + (0.26 x 0.02)]/1.05
C+ = 0.46

C+ =

S = 3.00
C = Weighted Avg (C+, C- )
C = [(0.74 x 0.46) + (0.26 x 0.01)]/1.05
C = 0.33
S- = 3(0.91) = 2.73
C- = Weighted Avg (C+-, C--)
C- = [(0.74 x 0.02) + (0.26 x 0)]/1.05
C- = 0.01

S++ = 3.3(1.10) = 3.63

C++ = Max(0, S++ X)
C++ = 3.63 2.98 = 0.65

S+- = 3.3(0.91) = 3
C+- = Max(0, S+- X)
C+- = 3 2.98 = 0.02

S-- = 2.73(0.91) = 2.48

C-- = Max(0, S-- X)
C+- = 2.48 2.98 = 0
19

Binomial Model to Price Options on

Interest Rates
The methodology is same except for 3 differences:
1. At terminal node, compute pay-off as Max(0, Rate X) (in
case of call options)
2. At expiration the pay-off does not happen until one
additional period, so the call value at expiration also needs
to be discounted using the relevant one-period interest. (Do
not use the risk-free rate)
3. Risk-Neutral Probability, is 0.5

20

Valuing Caps and Floors

The value of a cap (floor) is the sum of the values of the
individual caplets (floorlets)
E.g.: Pricing of a 2 period cap consists of 2 caplets:
1. 1 period call option; and
2. a 2 period call option

21

Valuing Caps and Floors: Example

Laila Aziz is looking at valuing a two-period cap with an exercise
rate of 5.50% per period and a notional principal of $1. Given the
following term structure, what is the value of the cap today?

7.46%
4.990%
5.34%

2.0%
3.44%

3.70%

22

Valuing Caps and Floors: Example

Solution
1. Value 2-period caplet

2.0%
C = [(0.5 x 0.0087)
+ (0.5 x 0)]/1.02
C = 0.0043

4.990%
C+ = [(0.5 x 0.0182) +
(0.5 x 0)]/1.0499
C+ = 0.0087

3.44%
C- = [(0.5 x 0) + (0.5 x
0)]/1.0344
C- = 0

7.46%
C++ = (0.0746 0.055)/1.0746)
C++ = 0.0182

5.34%
C+- = (0.0534 0.055)/1.0534)
C+- = 0

3.70%
C-- = (0.0370 0.055)/1.037)
C-- = 0

23

Valuing Caps and Floors: Example

Solution
2. Value 1-period caplet

2.0%
C = [(0.5 x 0) + (0.5
x 0)]/1.02
C= 0

4.990%
C+ = (0.0499 0.055)/1.0499)
C+ = 0
3.44%
C- = (0.0344 0.055)/1.0344)
C- = 0

Value of cap = 0.0043 + 0 = 0.0043

24

Options on Fixed Income Securities

To calculate the value of an option on a fixed-income security:
Step 1: Price the bond at each ending node in the interest rate
tree
Step 2: Calculate terminal value of option at each ending node
in tree
Step 3: Discount expected terminal option values back
through tree
Step 4: Risk-Neutral Probability, is 0.5

25

Options on Fixed Income Securities

At t=0, bond tenor = 3 years
Bond coupon = 6%

Interest rate=4.99%
Bond price=?
Option Value =?

Interest rate= 2.0%

Bond price=?
Option Value =?

Interest rate=5.34%
Bond price=?
Option Value =?

Interest rate=3.44%
Bond price=?
Option Value =?

T=0

Interest rate=7.46%
Bond price=?
Option Value =?

tT = 1

Interest rate=3.70%
Bond price=?
Option Value =?

T=2
26

Black-Scholes-Merton Option Pricing

Model: Assumptions
Black-Scholes-Merton (BSM) Option Pricing Model is based
on continuous time, as opposed to discrete time in the
Binomial Model
6 Assumptions as follows:
1.

Asset prices follows a lognormal distribution, i.e. log of the return

follows a normal distribution
Log returns = continuously compounded returns

2.

Risk-Free Rate is known and stays constant

Poses problems when pricing options for bonds and interest rates
27

Black-Scholes-Merton Option Pricing

Model: Assumptions
3. Asset Volatility is known and stays constant
Volatility = standard deviation of lognormal return
Reality: volatility is not known and needs to be estimated; also keeps
changing
4. No taxes or transaction costs
Unrealistic, assumption may be relaxed but complicates model
5. No cash flows on the underlying
Unrealistic, stocks have dividends, bonds have coupons, commodities
have cost-of-carry; assumption can be relaxed by adjusting for PV of
cash flows
6. Model prices only European options
Misprices American options that should be priced using the Binomial
Model

28

Black-Scholes-Merton Option Pricing

Model: Inputs
c = S0 N d1
cT

p = Xer

Where,

cT
r
Xe
N

1 N d2

d1 =

d2

S0 1 N d1

ln S0 X + rc + 2 2

d2 = d1 T
T = time to maturity
S0 = asset price
X
= exercise price
rc
= continuously compounded risk free rate
N(d1) and N(d2) = cumulative normal probability
= the annualized standard deviation of the continuously compounded return on
the stock
29

Black-Scholes-Merton Option Pricing

Model: Inputs
Greek

Input

Call Option Price Put Option Price

Delta

Asset Price (S)

+
Delta > 0

Delta < 0

Rho

Risk-Free Rate (r)

+
Rho > 0

Rho < 0

Theta

Time to Expiration
(measured as time value
decay) (T)

+
Theta < 0

+ (mostly)
Theta < 0

Vega

Volatility ()

+
Vega > 0

+
Vega > 0

Exercise Price

+
30

Delta
Delta measures sensitivity of option price to asset price, just like
market beta or bond duration
(Discrete) Delta = in option price / in underlying asset price
(Continuous) Call delta = N(d1) and Put delta = N(d1) 1
Call deltas range from 0 to 1:
Far out-of-the-money: Delta approaches 0
Far in-the-money: Delta approaches 1
Put deltas range from 1 to 0:
Far out-of-the-money: Delta approaches 0
Far in-the-money: Delta approaches 1
Put delta = Call delta 1
31

Delta
Call payoff at
expiration

Payoff $
Call payoff prior
to expiration

Delta = slope of the

curve prior-toexpiration
Stock price $

Out of money

Exercise
Price

In the money

32

Delta Hedging
Discrete time: Delta Call = C1C0 = C
S1 S0

Delta hedging or Dynamic hedging since delta keeps on

changing so position needs to be continuously hedged
dynamically
For calls: Delta-neutral Hedge = long asset + short calls
Value of the portfolio does not change when the stock
price changes

No. of options = No. of shares

Call Delta

33

Hedged Portfolios
Hedged portfolio is comprised of long asset units and short calls
such that its value remains the same whether the asset price moves
up or down
Hedged Portfolio Value = (No. of Asset Units * Asset Value) Call
Value
H = nS c
+

Since the portfolio is hedged, H = H or nS - c = nS - c

+

Therefore, n = c - c /(S - S )
(No. of asset units to hedge the portfolio = Diff. in call prices/Diff. in
asset prices)

34

Hedged Portfolio Summary

Calls
Delta or the hedgeratio
No. of shares to keep
the hedged portfolio

Delta =

+
+

Puts

Delta =

+
+

No. of shares = No. of options x Delta

If the option is
overpriced

Short call + Buy shares

Sell put + Short stock

If the option is
underpriced

Buy call + Short shares

Buy put + Buy stock

35

Hedged Portfolios: Example

Returning to our Emaar stock example where Laila Aziz and
Saeed Ahmed were valuing call options on a stock of Emaar
currently trading at AED 3.00. Use the 2-period binomial tree
information previously and determine the number of shares at
each node that would be required to construct a hedge using 50
calls.

36

Hedged Portfolios: Example

Solution
n = c+ - c-/(S+ - S-)
At S=3

n = (0.46 - 0.01)/(3.3-2.73)

Asset Units/Call

Asset Units/50 calls

0.78

39.19

At S+ =3.3 n = (0.65 - 0.02)/(3.63-3)

1.00

50.00

At S- =2.73 n = (0.02 - 0)/(3-2.48)

0.04

1.92

Check, at period 1:
H+ = nS+ - c+
H+

= (39.19 x 3.3) - (0.46 x 50)

Portfolio Value
= 106.19

H- = nS- - cH+

= (39.19 x 2.73) - (0.01 x 50)

= 106.19
37

Hedged Portfolios: Example

If the option were actually trading at the option price in the
formula, the portfolio would earn the risk-free rate
i.e. the portfolio has been hedged against risk

38

Gamma
Delta is not a linear relationship, but a curved one, i.e.,
when the underlying price changes by a large amount,
delta hedging is not useful
Gamma describes the curve or the deltas sensitivity to
change in the underlying (like bond convexity)
Gamma =

in delta /

in underlying asset price

Higher gamma means that delta will not work for large
changes in underlying price
Gamma is large when option is at-the-money and close
to expiration
39

Asset Cash Flows & Option Prices

Similar to forwards and futures, PV of asset cash flows needs
to be adjusted against current asset price, S0 (i.e. cash flows
reduce S0)
Reduce call values
Increase put values

Where applicable, use continuous dividend yield this way:

S0 x e-cT to adjust S0

40

Estimating Future Volatility

Volatility is a critical variable; option prices are immensely
sensitive to volatility
Volatility can be estimated in 2 ways, from:
1. Historical Volatility: use past data to compute standard
deviation of log-normal returns
2. Implied Volatility: equate the Black-Scholes-Merton Model
with option market price and solve for Volatility
41

Put-Call Parity for Options on

Forwards/Futures

Options on forwards/futures give the holder the option to establish a

forward/futures position upon exercise

Similar to the put-call parity seen earlier, except that

Bond has a face value of X F(0,T) instead of X
Underlying asset is the Forward/Futures contract, instead of S0

Put-call-forward parity given as:

0,
0 +
= 0 +
1+
Recall that initial value of forward contract = 0, so parity
0,
0 +
1+

= 0

42

American v/s European Options on

Forwards/Futures
Options

Forwards

Futures

European
Options

Priced Using Black Model(derived from BSM Model)

(Substitute discounted value of FT for S0)

American
Options

Never exercised early

because no cash flow
involved; Similar to
European Options

Exercised early to take advantage

of interest earnings on margin
account; priced higher than
European Options

American Options are exercised only to take advantage of

underlying cash flows
43

The Black Model

The Black Model is a modification of the BSM Model to price
European options
Also used to price interest rate option and swaptions

Substitutes the spot price of underlying asset with discounted

futures price

44

Swap Markets and Contracts

Swaps: Brush-Up
Contract between two parties to swap or exchange sequence
of future cash flows
Often one party makes fixed payments and the other, variable
or floating payments

Also called a plain vanilla swap (term commonly used in

interest rate swaps)
Parties can swap payments originating from interest rates,
equity returns, currency rates, bond coupon payments
For example:
Equity returns similar to floating/variable payments
Coupon payments similar to fixed payments
46

Swap Price and Swap Value

Price of a swap = determine the fixed rate that the fixed-rate
payer must pay
Initial market value of the swap, usually = 0

i.e. PV(fixed) = PV(floating)

Market value during the life of the swap can be positive or
negative to either party
Positive value = asset to that party
Negative value = liability to that party

47

Equivalence of Swaps to FRAs

Swap = series of forward contracts
Swap rate involves fixed set of cash flows Series of FRAs are
priced at different rates

So, we say off-market FRAs to compensate for the implied

similarity

48

Likening Swaps to Options

Interest Rate Swap = Series of Long calls + Short puts or series
of FRAs
When the party is long the call, and short the put, and < X,
s/he would have to make a net payment = X
Rationale: one who is long the put will exercise it

When the party is long the call, and short the put, and > X,
s/he would receive a net payment = X
Rationale: the party will exercise the long call it holds

Option expiration date = swap payment date

49

Fixed Rate on Interest Rate Swaps

Bond transaction = Interest Rate Swap
E.g. Fixed rate payer = Issuing a fixed coupon bond + Investing
the proceeds in a floating rate bond

To compute the fixed rate on interest rate swaps, we set the

initial market value = 0
i.e. PV of Fixed Payments = PV of Floating Payments
PV of Floating Payments = Par value = 1
Therefore, PV of Fixed Payments = 1

50

Fixed Rate on Interest Swaps

PV of Floating Rate Bond = PV of Fixed Rate Bond

1
1=
+
+
+
+
+
1 + 1 1 + 2 1 + 3 1 + 4
1 + 1 +

1
1
1
1
1
1
1=
+
+
+
..+
+
1 + 1 1 + 2 1 + 3 1 + 4
1 +
1 +
1

11+

1
1
1
1
1
+
+
+
++
1+1 1+2 1+3 1+4
1+

Where = the rate for

n-period

51

Fixed Rate on Interest Swaps

1
1+

= (Discount factor for n-period or price of a $1 zero

coupon bond for n-period)

1
=
1 + 2 + 3 + 4 +
or

where, c = the periodic swap rate

or the periodic fixed coupon

52

Valuing Interest Rate Swaps

Swap value: Difference in PV of fixed and floating payments
To calculate the value, we must find:
PV of remaining fixed rate bond
PV of remaining floating rate bond:
Fixed-rate payer swap value = PVfloat PVfixed

Note: On any coupon rest reset dates, the floating rate bond
will have a value of 1 or par since interest rates would be
adjusted to reflect market rates
53

Valuing Interest Rate Swaps

0

90

120

180

270

360

Fixed rate bond value = PV

(remaining coupons + Principal)
Fixed coupon (x) = Swap rate / qtr

Floating rate bond value = PV

(next coupon + Par value)
Floating coupon = LIBORt-1 / qtr

LIBORt-1/ qtr + 1

Payer swap value120 = Floating rate bond value Fixed rate bond value
54

Currency Swaps
Rationale to compute fixed rates on currency swaps
is the same as that for interest rate swaps
Fixed rate for currency swaps = fixed rate on interest
rate swap in the respective country
4 types of currency swaps:
1.
2.
3.
4.

Pay Currency
Fixed
Fixed
Floating
Floating

Receive Currency
Fixed
Floating
Fixed
Floating
55

Valuing Currency Swaps

Same as Interest Rate Swaps
Calculate PV of cash flows and account for exchange rate
changes!
2 notional principals need to be determined one in domestic
currency ($) and one in foreign currency ()
1$ = 1/0
Fixed-for-fixed example: Value of receive fixed and pay $
fixed side = PV( fixed bond) in USD PV($ fixed bond)
Use yield curve for each currency

56

Equity Swaps
Same formula as computing fixed rates for interest
and currency swaps!
Fixed Rate =

The value is the difference between PV of fixed side

and value of equity portfolio
Index return is the holding period return since last
settlement

57

Fixed Rate and Equity Swaps

Pay Fixed, Receive equity return
Pays fixed rate plus negative equity return
Receives positive equity return
Pay Floating, Receive Return on Equity
PV of Floating Payments = 1
No fixed rate computation required!
Pay Return on Equity, Receive Return on Another Equity
Same as going long one stock, and short another
Again, no fixed rate computation required!

58

Swaptions
Swaption is an option to enter a swap
Most commonly used is the plain vanilla interest rate
swaption

Quoted as FRA, for example, 3 x 5 swaption is an option that

expires in 3 years to enter into a 2 year swap after that
Similar to options, swaptions can be European or American

Payer swaption: option to enter a swap as a fixed-rate payer

Receiver swaption: option to enter a swap as a fixed-rate
receiver
59

Swaptions
Uses of swaptions
1. Flexibility to enter a swap, or leave it and enter into the
market swap instead
2. Speculation on interest rates
3. Terminate an existing swap

Exercising a swaption: generates an annuity over the

term of the underlying swap
E.g. (Current Swap rate Agreed Swap Rate ) x
T/360 x Notional Principal = Payment every T
60

Value of Interest Rate Swaption

At expiration, the value of the swaption is computed as:
Payoff to Payer Swaption =Max (0, Market Swap Rate - Agreed
Swap Rate) x T/360 x Notional Principal
Payoff to Receiver Swaption= Max (0, Agreed Swap Rate
Market Swap Rate) x T/360 x Notional Principal
Value of Swaption = Payoff x (1 + 2 + 3 + 4
+ )
61

Valuing a payer swaption on a 1-year

(quarterly) swap
Option
period

Option
expiration

Swap Period

Payoff in
90 days

Payoff in
180 days

Payoff in
270 days

Payoff in
360 days

PV Payoff 1
+ PV Payoff 2
+ PV Payoff 3
+ PV Payoff 4
= VALUE OF PAYER SWAPTION

Payoff for a payer swaption = Max (0, Market Swap Rate - Agreed Swap Rate) x
T/360 x Notional Principal
62

Credit Risk in Swaps

Initial Market Value = 0, therefore, swap is neither asset nor liability
Credit risk is more in the middle life of an interest rate swap, when
market value changes, and swap is either an asset or a liability to
the party
Credit risk is held by the party to which the swap is an asset
Currency swaps have greater credit risk since payments are not
netted and also involve notional principal
Current credit risk = immediate credit risk for the due payments
Potential credit risk is always present since it is the possibility of
credit risk in the future
Credit Risk can be controlled through:
Netting which reduces the size of the payment
Marking-to-Market that works similar to futures contract
63

Swap Spread
Swap spread is the rate over the respective risk-free rate
US T-Note + Swap Spread = Swap Rate

Swap spread denotes general level of credit risk in the global

economy
Higher spread means credit risk is perceived to be higher

64

Interest Rate Derivative Instruments

Interest Rates Cap

Interest Rate Cap is an agreement where one party agrees to
pay the other when reference rate > predetermined level
Cap Rate is the predetermined Strike Rate for Caps
Profit to the
Cap buyer

Premium

Reference rate
Cap strike rate
66

Interest Rates Floor

Interest Rate Floor is an agreement where one party agrees to
pay the other when reference rate < predetermined level
Floor Rate is the predetermined Strike Rate for Floors
Profit to the
Floor buyer

Reference rate
Premium
Floor strike rate
67

Interest Rates Cap & Floors

Example: Cap Rate = 8%, Floor Rate = 4%, Reference Rate = LIBOR

For the buyer of the

interest rate cap, if LIBOR
> 8%, the buyer will
receive a compensation
For the buyer of the
interest rate floor, if
LIBOR < 4%, the party
will receive a
compensation

LIBOR
CAP = 8%

LIBOR

FLOOR = 4%

68

Cap-Floor Pay-Offs: Example

Continuing with our previous example, assume the
Cap Rate = 8% for a notional principal of $1 million.
The Reference Rate is LIBOR and payments are semiannual. Suppose LIBOR at t=0 is 7.5% and LIBOR in
180 days is 8.5%. Compute the periodic pay-offs.
At t = 180, pay-off = 0 because LIBOR < Cap Rate
At t = 360, pay-off is:
(0.085 0.08)/2 x $1 million= $2,500

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Interest Rates Cap & Floors

Interest Rate Caps and Floors, can be viewed as:
1. Set of Interest Rate Options (e.g. on LIBOR)
2. Options on fixed-income instruments (e.g. on
bond price - value changes inversely with interest
rates)
Buying a cap = buying interest rate calls = buying puts
on a bond
Buying a floor = buying interest rate puts = buying
calls on a bond
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Interest Rate Collar

Interest Rate Collar = e.g. buy cap + sell floor
Zero-cost collar: cost of cap completely offsets by selling the
floor
LIBOR
(Receive
Compensation)

LIBOR
(Pay
Compensation)

BUY CAP

SELL FLOOR

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Credit Default Swaps

What is CDS?
In simple words, CDS is a kind of insurance contract
It is purchased by someone who requires a credit protection
by paying a premium called credit spread to the protection
seller
The CDS buyer is short credit risk and the seller is long credit
risk
CDS doe not provide protection against any other type of
risk(interest rake, etc.) but the credit risk
For a buyer, buying CDS is like buying a put option, if the
investment defaults, he can exercise and cover his losses
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Single Name CDS

For a single name CDS, swap is referenced to a senior unsecured
obligation, reference obligation
The security issuer is called the reference entity
For the buyer, the CDS pays off
when the issuer defaults on the reference obligation, or
when the issuer defaults on other issues which are ranked
higher or at par with the reference obligation

The CDS seller pays off based on the market value of the cheapest
to deliver bond that has the same seniority as that of the reference
obligation

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Index CDS
The way a stock index allows an investor to take equity exposure to
many companies at once, similarly an Index CDS allow investors to
take exposure to credit risk of several entities simultaneously
In an index CDS, each issuer gets an equal weightage and the total
notional principal is summation of the protection of individual
issuers
The pricing of index CDS also depends between correlation
between default of issuers in the index

Higher correlation among index constituents higher CDS

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Credit Events
A default is when a credit event occurs
Bankruptcy: Filing for bankruptcy protection
Failure to pay: Missing coupon/principal payment date without filing for
bankruptcy
Restructuring: Adjusting terms of repayment with the lenders

15 member group of International Swaps and Derivatives

Association (ISDA), the Determinations Committee declares
when a credit event has occurred
A super majority vote of 12 members of a committee is
required to declare an event as credit event
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Settlement Process
Before Credit event
Protection Seller

Periodic Premium

Protection Buyer

After Credit Event (physical settlement)

Par Amount
Protection Seller

Protection Buyer
Deliverable Obligation

After Credit Event (cash settlement)

Par Amount Market Value
Protection Seller
Payout Amount = payout ratio x notional principal

Protection Buyer

Payout ratio = 1 recovery rate

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Pricing of CDS- Probability of Default

Probability of Default is the likelihood of default by the issuer
in a given year
Since a CDS has a multi year horizon, the probability of default
increases over time
Probability of default in any year is based on the premise that
no default has occurred in any of the preceding years
Hazard Rate is conditional probability of default given the
default has not occurred in any of the previous years

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Loss Given Default

Loss given default is the expected amount of loss when default occurs
Expected Loss = (Hazard Rate) x (loss given default)
Loss given default is inversely related to recovery rate

Premium Leg: Payments by buyer to CDS seller

Protection Leg: Payments by seller to CDS buyer when default occurs
Upfront Payment (By CDS buyer) = PV (Protection Leg) PV (Premium Leg)
Upfront Premium (%) (CDS spread CDS coupon) x Duration of the CDS
Price of CDS (per $100 notional principal) = 100 upfront premium (%)

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Post CDS Inception

Post the CDS inception, the CDS spread may change resulting
in profit for CDS buyer if the spread widens (or vice versa)
Profit for protection buyer change in spread x duration x notional
principal
Profit for protection buyer (%) change in spread (%) x duration

Like any other derivatives CDS buyer or seller can reverse there
position by entering into an offsetting contract to monetize its
gain/loss

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Credit Curve
Credit curve depicts the relationship between a bonds credit spread and its
maturity for a specific issuer
It is similar to the term structure of interest rates
If hazard rate is increasing (longer maturity more credit spread) then
credit curve will be upward sloping
If hazard rate is constant across maturities flat credit curve
In a Naked CDS an investor purchases and sells credit protection without
having underlying exposure
Speculates that the spread will adjust/change for his advantage
Curve trade is when an investor buys and sells CDS of different maturities for
the same issuer
Speculates that the shape of the curve will change for his advantage

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Use of CDS
Basis Trade: Trade to capture credit spread difference between bond and
CDS market
If bond by an issuer is trading at LIBOR + 5% spread & CDS at LIBOR + 3%
Trader will buy the bond and take the protection buyer position in CDS

Anticipating that spreads will converge Profits

Arbitrage involving buying and selling bonds by same issuer based on views
form the CDS market that which bonds are under/overvalued
In case of index CDS, if individual constituents are priced differently in the
CDS market compared to the index CDS arbitrage possible
If a Synthetic CDO which is is created using CDS can be created at lower cost
than Cash CDO Buy Synthetic CDO & Sell Cash CDO Arbitrage profit
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