Professional Documents
Culture Documents
ISDA Section 03 Interest Rate and Currency Derivatives
ISDA Section 03 Interest Rate and Currency Derivatives
David Mengle
Vice President
J.P. Morgan Securities Inc.
Today's schedule
Basic concepts
Interest rate and currency derivatives
Pricing, valuation, and unwinds
Structure of a derivatives business
Future value
hit = -5.50
So one could invest $5 now at 10% and
receive $5.50 in one year.
Compounding: Computing future value
Solving for FV when given PV, r, t
10 L l
20 R
hit = -100
-
Streams of payments: Annuities
What is PV, of $10 for 5 years at lo%?
,
General formula
10
10 I
So, $37.90 will buy $1 0 per year for five 5
years at 1 0%.
= -37.9
Streams of payments: Annuities
What annual payment for 5 years is worth $37.90 today at lo%?
37.9
This formula is useful for caps or floors, when
calculating the annualized up-front premium. 10
7
Three forms of derivatives activity
Exchange-traded
- Futures
- Exchange-traded options
Over-the-counter (OTC)
- Swaps
- Forwards
- OTC options
Assets Liabilities
Loan Deposit
(2-year, fixed rate) (1 -year Libor)
US$100 MM US$100 MM
Interest rate risk
Situation
I -year 2-year
Libor Fixed Rate
Deposit Client Loan
Forward rate agreement (FRA)
A forward contract on interest rates
*-FI-
One year from now
Deposit Loan
1
m
Reference : Contract
Rate Rate
/ I
\ Forward rate,
Libor, determined I
rates,
- But will not benefit if rates fall A$h bfk
/ @&w"
Client assumes credit exposure to Dealer (and vice
versa)
Uses of FRAs
/L - R) x DxA
Settlement sum =
(B x 100) + (L x D)
L = Reference Rate
R = Contract Rate
D = Days in Contract Period
A = Notional Principal
FRA payout
/L-R) x D x A
Settlement sum =
(B x l o o ) + ( L x D )
Where do forward rates come from?
Yield curves
yields
Where do forward rates come from?
No-arbitrage conditions
- Two-year: 7%
Choices:
- Invest $100 for two years at two-year rate
+ R,,~36 )2 * (1 + .06) = (1 + .
+ R12x36) -
- 1.25566
+ R,,x36 = 1.120563
R12x36 = '
120563
Assume:
- 6-month Libor is 5.83%
Find:
- 12x24 forward rate
- 6x 12 forward rate
Find the 12x24 forward,rate
Libor greater than one year
Using your HP,
Assume:
- 12-month Libor is 6.12%
1.0653
- 2-year zero coupon rate is 6.53%
2
(1.0612) * (1 + RI2,,, ) = (1 .0653)2
1.0612
(1 + R12x24)
= (1 .0653)21 1.06 12
+ R~2x24= 1.0694 El
0694 .0694
R1 2x24 =
1
So 6x12 forward rate is 6.23% 2
.0623
Futures contracts
An alternative to forward contracts
- Organized exchanges
- Margin requirements - W 9@ $
- Loss-sharing arrangements
Interest rate exposure
Situation
Client has purchased a US$100 MM 5-year U.S.
Government Agency note yielding 6.5%
Purchase funded with one-year US$ deposits
Client is concerned that US$ interest rates will rise
Assets Liabilities
Fixed Rate
(6.5%)
-0
Libor
Libor . Swap
Rate
..
... (6.1%)
Dealer
Trade Date - The date on which the parties commit to the swap and
agree to its terms
Effective Date - The date on which payments begin to accrue
- Normally two days after trade date
- Forward starting swap: Effective date can be any future date
Swap cash flows
0 100 -- -- 100
1 (LIBOR) LIBOR (6.1) (6-1
2 (LIBOR) LIBOR (6.1) (6.1)
3 (LIBOR) LIBOR (6.1) (6.1)
4 (LIBOR) LIBOR (6.1) (6.1)
rn
If Dealer receives fixed, swap rate is 6.12%
But, swap rates increasingly used by market
Dealer
participants as benchmark rate instead of
treasury rates
Applications of interest rate swaps
10
0
q/,
Gain +
..........................
90
I I
100
Premiuni = 10
Strike = 100
I
Gain +
8; ...dl
I
Premium = 8
Strike = 100
Sell
..........................
I I
-1 0
BUY / y.
0
1.
1.
ilu: i 0
Loss -
Break even
at 110
I
Loss -
Break even
at 92
Up-front premium
- - (on Trade Date)
Libor
Deposit 4 Client Dealer
C Max (L-Strike,O) -
(on each Payment Date)
Definitions: Caps and floors
Interest Expense
on US$100 MM
Interest rate cap on US$ LIbor
-
-- I [(Libor-6.0%) - 0.40%]
Out of the Money 1
- & w ~ I
I
4.50 5.50 I 1 5 0 7.50 US$ Libor (%)
-- I
I
In the Money -
w e
I
6.00 Up-front Premium = 180 bp = $1,800,000
Annualized Premium = 40 bp = $400,000
Interest rate cap on US$ Libor
Cap Strike = 6.0%
million
Annualized Premium =
Interest Expense
on US$100 MM
I
Exposure
US$ million
Interest Expense
on US$100 MM
I / Collared
Exposure
Net Premium = 0
4.0 5 .O 6.0
US$ Libor (%)
5.0% < Collared Funding Cost < 6.0%
Foreign exchange basics
Quotation conventions
- Foreign currency1USD
Deutschmark (DEM), Swiss franc (CHF), Canadian dollar (CAD)
- USDIForeign currency
British pound sterling (GBP), Australian dollar (AUD)
If the DEMIUSD exchange rate rises from 1.75 to 1.80,
- The USD has appreciated of because $1 can now buy more DEM
- The DEM has depreciated because it now takes more DEM to buy
$1
Assets Liabilities
Note Deposit
(1-year, fixed rate) (1-year @ 1-year DM Libor)
US$100 MM @5.90% DM180 MM 633.95%
Currency forward
-I -
US$105.90 M M DM 187.11 MM
Note Client Deposit
Dealer
DM 187.11 MM
FWD = 1.6066
Emerging markets considerations
Situation
Risks of NDFs
- Basis risk between onshore and offshore rate movements
- Local government opposition to NDF
Assets Liabilities
Loans Note
(5-year, fixed rate) (5-year, fixed-rate)
US$100MM (236.8% DM180 MM @4.8%
Currency risk
US$ Loans
US$
Interest
,
German Bank
I US$lOO
million
A
DM DM 180
Interest million
V
DM Note
Currency swap
$ I00 million
A
DM 180
million
DM Note
Currency swap
US$ Loans
6.8%
I
German Bank 4
6.1% (US$)
w. Dealer
4.8% (DM)
Payments during swap
4.8%
DM Note
Currency swap
US$ Loans
US$l 00
m~ll~on
v
Dealer
German Bank
-
f--
A
I
DM Note
DM 180
million Final principal exchange
US$100 million
DM 180 million
Currency swap
$ I00 million
V
6.1% (US$) -_
7
Dealer
German Bank 4
4.8% (DM) -~
A
.- Payments during swap
4.8%
Final principal exchange
V
US$100 million
Assets Liabilities
Loans Deposits
(5-year, fixed rate) (1 -year)
US$lOO MM 636.8% DM 180 MM @DM Libor
m &&
Uses for currency swaps
Assets Liabilities
Loans Note
(5-year, fixed rate) (5-year, fixed rate)
US$100MM @6.8% DM180MM @4.8%
Currency options
ProfitfLoss
US$ Put
(DM million)
\
\
\
\
\
-----
Types of contracts
- Basis swaps
- Options on swaps (swaptions)
Structured notes
Underlying risks
- Credit derivatives
- Commodity derivatives
Interest rate risk
Assets Liabilities
Loans Deposits
(Prime Rate) (3-month Libor)
US$100 MM US$100 MM
Solution: Basis swap
Libor, Prime
Rate
Deposits Client Loans
rn
rn
Libor
f Prime -
' 2.75%
Dealer
Cross-currency basis swap
.
DM Libor : US$ Libor
+ 10
Dealer
Gives the holder the right, not the obligation, to enter into
a swap contract in the future
- Combines an option contract with a swap contract
Fixed
income 1
I
Derivative
Structured
Structured securities
Basic structure
7.38% + (R(10)-R(2))
Investor 4 Issuer
.
I 4
2-year rate I I 10-year rate
a
Protection buyer
X bp per annum
*
I Protection seller
Results:
- Credit swap hedges both default risk and credit concentration risk
- Buyer trades credit risk of reference credit for counterparty credit risk of
seller
Total return swaps
LIBOR + X bp p.a.
TR Receiver TR Payer
TR of reference
obligation
27.0-
Sell put
26.0--
I I
I Price
50 255 260
/ Buy put
/
I I I I
I
Fixed
Shipping
Company 4 Producer
Floating fuel Floating
oil price crude price A
v
Fuel Oil
Supplier Market
Average price ('Asian') options
Description
- Payoff is the strike compared with the average commodity price
over a specified period (e.g., monthly averages with monthly
settlements)
- Most commonly used commodity option structure
Motivation
- Useful in markets in which participants buy or sell on a continuous
basis
- Less expensive than American or European options because
volatility of average price is less than volatility of daily price
d.p +