INTDERIV Ch07 Lecture PDF

An Introduction to Derivative Securities, Financial Markets, and Risk Management
© Jarrow and Chatterjea 2013

 This chapter studies financial engineering.
◦ First, we introduce some simple examples of financial
engineering.
◦ Then we introduce swaps, which were among the first
applications of financial engineering. We briefly discuss
applications and uses of swaps and illustrate the basic
workings of four major varieties of swaps.
◦ Finally, we describe the much maligned but highly useful
credit default swaps.
Chapter 7, Slide 2
© Jarrow-Chatterjea 2013
 In 1993, the French chemical and pharmaceutical
giant Rhône-Poulenc offered its employees an
opportunity to buy discounted shares as part of its
forthcoming privatization plan.
◦ With the goal of wide employee participation, the
scheme involved a dizzying array of features.
◦ The plan flopped badly.
◦ Bankers Trust streamlined the terms of the plan and also
added a critical safety feature—the investment would
earn a guaranteed minimum return.
◦ The modified plan was a success.
Chapter 7, Slide 3
 How could the plan guarantee a minimum return?
◦ It protected the downside by buying a put option.
◦ Buying the put option was financed by selling a call
option.
◦ This is an example of financial engineering.
 Financial engineering involves how firms design

derivatives to solve practical problems and exploit
economic opportunities.
◦ It applies engineering methods to finance.
◦ Financial engineering and risk management apply the
“build and break” approach to finance.
Chapter 7, Slide 4
 The build and break approach
◦ Sometimes we combine derivatives and financial
securities to create new derivatives tailored to meet
investment needs.
◦ At other times, we break down a complex derivative into
its simpler components.
Chapter 7, Slide 5
The build and break approach is important for two
reasons:
It provides a method for pricing derivatives. We can
break a derivative into simpler parts, price the simpler
parts, and sum to get the original derivative’s price.
Examples
◦ convertible bonds
◦ extendable bonds
Itenables the use of derivatives to modify a portfolio’s

return.
Example
◦ callable bonds
Chapter 7, Slide 6
 The signs of the cash flows (CF) and asset values
can be the same or different. To avoid confusion,
“Follow the cash flow.”
When constructing a portfolio: the signs of the CF
and asset values are opposite.
 A positive value means that you are purchasing an
asset; hence there is a negative CF.
◦ Example
 If the value is negative, you are creating a liability,
and there is a positive CF.
◦ Example
Chapter 7, Slide 7
At liquidation: the signs of the cash flows and asset
values are the same.
When liquidating a positive value position, you are

selling an asset; hence, there is a positive CF.
◦ Example
If
the value is negative before liquidation, then the CF is
negative, because you are closing a liability.
◦ Example
CFsand cash values at liquidation are referred to as the

payoffs.
Chapter 7, Slide 8
 Goldmines, Inc. is a gold-mining company.
◦ It sells pure gold in the world market.
◦ It needs money for exploring, for setting up a mine, for
running a mine, and for refining operations.
◦ The company’s fortunes move with the price of gold.
 Goldmines decides to raise cash by selling bonds.

◦ Interest payments are tax deductible.
◦ But they are vulnerable in conditions of financial distress.
Chapter 7, Slide 9
 An investment banking firm designs a bond with
the following payoff on the maturity date T:
◦ a payment of $1,000
◦ an additional amount tied to gold’s price per ounce, S(T)
0 if S(T) < $950

10[S(T) – 950] if $950 S(T)
 Build and break approach:

◦ first payment synthesized by investing in zeros
◦ second payment looks similar to a long call: buy ten calls
with a strike price of $950
Chapter 7, Slide 10
 Consequently, CFs from the traded bond may be
obtained synthetically by forming a portfolio
consisting of
◦ a zero-coupon bond worth 1,000B
◦ ten long European calls, each with a price of c and a strike
price of $950 (see Table 7.2)
Chapter 7, Slide 11
Chapter 7, Slide 12
Chapter 7, Slide 13
Chapter 7, Slide 14
 The no-arbitrage principle ensures that the traded
bond will have the same value as the replicating
portfolio, (1,000B + 10c).
 This commodity-indexed note raises more cash up

front. And it hedges some of Goldmines’ output
price risk.
◦ If gold prices are high at maturity, Goldmines shares
some of its profits—that’s not too bad.
◦ If gold prices decline, only the principal is repaid.
Chapter 7, Slide 15
 A commodity-indexed note has its return tied to
the performance of a commodity (such as a
precious metal or oil) or a commodity index (such
as the Bridge/CRB Futures Index).
 An equity-linked note (ELN) combines a zero (or a

low-coupon) bond with an equity option whose
return is tied to the performance of a single stock,
a basket of stocks, or a stock index. The equity
option:
◦ makes ELNs attractive to buyers
◦ raises more cash up front
◦ hedges some of the risks in the business
Chapter 7, Slide 16
 Venturecap Co. has purchased 1 million shares in
Starttofly, Inc., a start-up company, at $3 per
share.
◦ Starttofly has done very well and is about to go public.
Venturecap bought these shares through a private
placement. They cannot be sold for two years.
 Venturecap can issue a hybrid debt and effectively

sell the bond.
◦ A hybrid debt (also called a structured note) is a
combination of a bond and a stock.
Chapter 7, Slide 17
 Premium equity participating securities (PEPS)
give Venturecap the benefits of a sale without
Venturecap’s actually selling Starttofly stock. As a
PEPS holder, Venturecap gets:
◦ interest for three years at an annual coupon rate of 4
percent per year on $20
◦ a share of Starttofly after three years
 The no-arbitrage principle ensures that a PEPS

seller’s position is equivalent to buying a bond
and selling the stock.
Chapter 7, Slide 18
 Venturecap’s benefits
◦ Venturecap sells 1 million PEPS and raises $20 million up
front.
◦ It pays capital gains taxes only when it sells the Starttofly
stock, which will be three years from now.
◦ It gets to deduct the interest payments of $800,000 from
its taxes every year.
 Hybrids are popular contracts. They have sold in

the United States, Asia, Europe, and Australia.
Chapter 7, Slide 19
 In 1996, the media giant Times Mirror Co. issued
1,305,000 shares of PEPS, due in five years.
◦ The issue price was $39.25.
◦ The interest rate was 4.25 percent per year, or $1.668 per year.
◦ The underlying stock was AOL Common, received in five years.
 In 1999, the Kansas City–based UtiliCorp United sold

10 million units of PEPS at $25 per unit, with a yield of
9.75 percent.
◦ Holders of the PEPS received UtiliCorp stock on November 16,
2002, at the then current common-stock price.
◦ The PEPS matured two years after that date.
Chapter 7, Slide 20
 Knowledge of financial engineering can help
people in many finance-related jobs:
◦ a corporate financial manager issuing securities
◦ a banker designing, pricing, and trading securities
◦ an investment manager running an actively managed
securities portfolio
◦ a financial regulator overseeing markets, seeking the
reasons for firms’ behavior, and preventing financial
catastrophes
Chapter 7, Slide 21
 A swap is an agreement between two
counterparties to exchange (swap) a series of
(usually) semiannual cash flows over the life
(tenor, or term) of the contract.
 Swaps provide an efficient way of transferring one

cash flow to another with very low transaction
costs.
◦ 1981: Salomon Brothers arranged the first swap, between
International Business Machines Corp. and the World
Bank
◦ twenty-five years later: the swap market had over $250
trillion in outstanding principal
Chapter 7, Slide 22
 A swap contract specifies the underlying
currencies, applicable interest rates, payment
timetable, and default contingencies.
◦ Being OTC instruments, swaps do not enjoy the same
level of protection as exchange-traded derivatives.
◦ Swaps must be carefully documented and must have
collateral provisions to mitigate credit risk.
 The simplest swaps are called plain vanilla; more

complex swaps are called exotics.
Chapter 7, Slide 23
 Plain vanilla interest rate swap: counterparties
exchange fixed interest payments for floating ones
 Plain vanilla currency swap: counterparties exchange

fixed payments in one currency for fixed payments in
another currency
 The bbalibor rate for eurodollars traditionally has been

used as a reference rate.
 Nowadays, many swaps are denominated in euros,

Japanese yen, and British pounds sterling.
Chapter 7, Slide 24
 Swaps have many financial engineering
applications:
◦ transforming loans
◦ hedging currency risk
Chapter 7, Slide 25
 Altering the asset/liability mix: The 1970s showed
that a sharp rise in interest rates can bankrupt a
savings and loan bank (S&L) specializing in home
mortgage lending.
Chapter 7, Slide 26
 creating payoffs that are hard to attain
 avoiding market restrictions
Chapter 7, Slide 27
 Like other financial markets, the swap market has
its own financial intermediaries.
◦ swap facilitators (also called swap banks or banks)
 For simplicity, we omit these dealers from most of

our examples.
Chapter 7, Slide 28
 A plain vanilla interest rate swap exchanges fixed
interest rate payments for floating ones at future
dates.
 Interest rate swaps are extremely popular and

widely used.
◦ Interest rate swaps alone constituted more than 50
percent of the global market for OTC derivatives
contracts in 2011.
Chapter 7, Slide 29
 Fixed Towers, Inc. borrowed $100 million for
three years at a floating rate of one-year bbalibor.
◦ It wants to switch to a fixed interest rate loan.
 Floating Cruisers Co. raised the same sum and for

the same period at a fixed rate of 6 percent.
◦ It wants to switch to a floating rate, the one-year
bbalibor.
Chapter 7, Slide 30
 Fixed Towers and Floating Cruisers enter into a swap:
◦ Fixed agrees to pay Floating 6 percent and receive bbalibor on
the $100 million notional.
◦ This exchange will go on for the swap’s tenor of three years.
Assume that Fixed and Floating exchange cash flows at

year’s end.
 After the swap:
◦ Fixed’s CFs
◦ Floating’s CFs
◦ The $100 million is the notional. It exists as a notion, never
changes hands, and is used for computing payments.
Chapter 7, Slide 31
 Compute the net payments, assuming that
bbalibor takes the values 5, 6, and 7.50 percent,
respectively, over years 1, 2, and 3.
◦ (first-year bbalibor = 5 percent)
◦ (second-year bbalibor = 6 percent)
◦ (third-year bbalibor = 7.50 percent)
Chapter 7, Slide 32
Chapter 7, Slide 33
Chapter 7, Slide 34
 Counterparties in swaps and other OTC
derivatives contracts sign detailed bilateral
agreements.
 Since 1985, the ISDA (International Swap Dealers

Association, later renamed the International
Swaps and Derivatives Association) has been
instrumental in developing convenient documents
for these contracts.
Chapter 7, Slide 35
 In the foreign exchange (forex) market, most
transactions involve the exchange of foreign
currencies for dollars, and vice versa.
 The exchange rate is the price of one currency in

terms of another. Currencies are quoted in:
◦ direct, or American, terms
◦ indirect, or European, terms
 The cross rate is the exchange rate between two

currencies other than US dollars.
Chapter 7, Slide 36
 Think of foreign currencies as tradable goods with
dollar prices.
◦ dollar has depreciated
◦ dollar has appreciated
 Forex swaps are widely used for managing

currency risks. A forex swap (FX swap) is a single
transaction with two legs:
◦ an initial spot exchange of one currency for another
◦ a final reverse exchange of the two currencies
Chapter 7, Slide 37
 Americana Bank has $200 million in excess funds.
Britannia Bank needs the same. They enter into a
forex swap:
◦ The spot exchange rate in American terms is:
SA = $2 per pound sterling
◦ The spot exchange rate in European terms is its inverse:
SE = 1/2 = £0.50 per dollar
 Cash flows (today):

◦ Americana gives $200 million to Britannia.
◦ Americana receives
Chapter 7, Slide 38
◦ Annual simple interest rates are i = 6 percent in the
United States and iE = 4 percent in the United Kingdom.
 Cash flows after one month:

◦ Britannia repays Americana: Dollar amount  Dollar
return
◦ Americana repays Britannia: Foreign currency amount 
Value of £1 invested for one month
Chapter 7, Slide 39
 A forex swap may begin now or at a future date.
Most forex swaps have lives that are measured in
weeks rather than months.
 Forex swaps have many uses:

◦ managing CFs in connection with imports and exports
◦ managing borrowings and lendings in foreign currencies
◦ handling foreign exchange balances
◦ temporarily exchanging excess currency amounts
Chapter 7, Slide 40
 A plain vanilla currency swap (or a cross-currency swap) is
an arrangement between two counterparties involving
◦ start date: an exchange of equivalent amounts in two different
currencies
◦ intermediate dates: an exchange of interest payments on these
two currency loans on intermediate dates
◦ ending date: an exchange of a final interest payment and
repayment of the principal amounts
 Interests are paid in different currencies and are rarely

netted.
 Some currency swaps use notional principals.
 Mid-2011: currency swaps and currency forwards had

$53.3 trillion notional outstanding and $2 trillion gross
market value in the global OTC derivatives markets
Chapter 7, Slide 41
 Americana Auto Co. and Britannia Bus Corp. plan
to build vehicle plants in the UK and the US,
respectively.
 Each company plans to raise cash in its home

country and then convert it into local currencies
via a currency swap.
 This fixed-for-fixed currency swap involves the

regular exchange of fixed payments over the
swap’s life.
Chapter 7, Slide 42
 The vehicle makers enter into a swap with a
three-year term on a principal of $200 million. The
spot exchange rate SA is $2 per pound sterling.
Assuming annual payments, the CFs are:
 The companies basically are exchanging their

borrowings.
Chapter 7, Slide 43
Chapter 7, Slide 44
Chapter 7, Slide 45
Contract Setup
◦ The swap uses the US dollar as the domestic currency and
pounds sterling as the foreign currency.
◦ The swap’s tenor T is three years.
◦ Annual interest payments are made at year’s end.
 Spot exchange rates are
 Principal amounts and interest rates are
Chapter 7, Slide 46
 Americana pays US investors:
C = Principal (in domestic currency)  Interest rate
(on dollar principal)
 Britannia pays UK investors an annual amount:

CE = Principal (in European currency)  Interest
rate (on foreign currency principal)
Chapter 7, Slide 47
Time 0: today (swap begins)
 Principals are exchanged.
Time 1 (after 1 year) and Time 2 (end of second

year)
 Interests are paid at year’s end.
Time 3 (after three years, swap ends)

 Companies return their principals and pay final
interests.
Chapter 7, Slide 48
 Today’s CFs cancel out.
 A swap can be valued by computing the sum of the present

value (PV) of all receipts and payments (in dollar terms).
 To compute PVs, we need zero-coupon bond (or “zero”)

prices. They come from government-issued bonds in US
(Treasuries) dollars and UK (gilt securities) pounds sterling.
 Denote US zero prices by B(t) and UK zero prices by B(t)E,

where t = 1, 2, and 3 years, the times to maturity (see Table
7.3).
Chapter 7, Slide 49
Chapter 7, Slide 50
 Discount CFs by multiplying them by their
respective zero prices.
 Multiplying dollar receipts by US zero prices

gives:
Present value of Americana’s dollar receipts
= PV of dollar interest payments + PV of dollar
principal
= [B(1)C + B(2)C + B(3)C] + [B(3)L]
Chapter 7, Slide 51
 Multiplying pound sterling payments by UK zero
prices gives the PV of Britannia’s sterling receipts
(which equals Americana’s payments).
Present value of Americana’s sterling payments
= PV of interest payments in pounds sterling +
PV of sterling principal
= [B(1)ECE + B(2)ECE + B(3)ECE] + [B(3)ELE]
Chapter 7, Slide 52
 Convert the PV of Americana’s sterling payments
into US dollars by multiplying it by the spot
exchange rate.
 PV of Americana’s sterling payments in terms of

today’s dollars
= PVE × SA
Chapter 7, Slide 53
 The dollar value of the foreign-currency swap to
Americana Auto Company is the
 Value of the currency swap to the domestic

investor
= (PV of Americana’s dollar receipts) – [PV of
Americana’s sterling payments (in dollar
terms)]
= PV – PVE × SA
Chapter 7, Slide 54
 Due to credit risk, it is prudent to avoid any
upfront payment. Make this a par swap with a
value of 0.
◦ You can do this by tweaking the interest rates until the
swap has a zero value.
◦ Example
Chapter 7, Slide 55
A currency swap begins at time 0, when
1. A domestic counterparty (“American”) pays the
principal L dollars to a foreign counterparty
(“European” or “Foreigner”) and receives an
equivalent sum LE in foreign currency.
2. American agrees to pay a fixed interest on LE to
Foreigner in exchange for a fixed dollar interest on
L at the end of each period (times t = 1, 2, . . . , T)
3. The counterparties repay the principals on the
maturity date T.
Chapter 7, Slide 56
Then:
The value of the swap to American, VSWAP
= Present value of dollar receipts – Present value
of foreign currency payments (converted into US
dollars at the spot rate)
= PV – PVE  SA (5)
where PV is the PV of future dollar CFs received by

American, PVE is the present value of future
foreign currency payments, and SA is today’s spot
exchange rate in American (dollar) terms
Chapter 7, Slide 57
 PV of the CFs is computed as
T 
PV   B(t )C   B(T ) L (6)
 t 1 
T 
  B(t )i  B(T ) L (7)
 t 1 
 where B(t) is today’s price of a US zero-coupon bond that
pays $1 at time t, and C is the coupon or the interest on the
dollar principal that is paid at times t = 1, 2, . . . , T
(computed as dollar principal times the simple interest
rate, or L  i)
 PVE is similarly computed by attaching a subscript E and by

replacing domestic CFs with foreign currency ones and
zero-coupon bond prices in the preceding formula.
Chapter 7, Slide 58
Currency swaps have several interesting features.
 A swap’s value depends on domestic as well as foreign
interest rates of different maturities.
 Most swaps involve semiannual or quarterly payments.
This feature can be added easily in Result 1 of Extension
7.1.
 Swap value is arbitrage free. If an errant dealer quotes a
different price, then alert traders would make arbitrage
profits at his or her expense.
 Because swaps are OTC contracts, they can be tailored by
the counterparties.
Chapter 7, Slide 59
 Aviation fuel is a major cost for airlines. Some
airlines hedge this price risk by entering into a
commodity swap in which they pay a fixed price
and receive the average aviation fuel price
computed over the previous month.
 HyFly Airlines needs 10 million gallons of aviation

fuel per month.
◦ HyFly buys fuel on a regular basis from the spot market.
◦ Seeing a huge rise in fuel costs in recent years, HyFly
decides to hedge by entering into a commodity swap.
Chapter 7, Slide 60
 The swap is structured as follows (see Figure 7.4
for a diagram of this swap):
◦ The notional is 10 million gallons of aviation fuel.
◦ The swap has a two-year term, and the payments are
made at the end of each month.
◦ HyFly pays the dealer a fixed price of $1.50 per gallon.
◦ The dealer pays a floating price that is the average spot
price of fuel during the previous month.
◦ The payments are net.
Chapter 7, Slide 61
 If last month’s average price is $1.60 per gallon:
◦ Dealer’s payment:
◦ Airline receives net payment.
◦ This hedges HyFly’s higher payment in the aviation fuel
spot market.
 If last month’s average fuel price is $1.30 per

gallon:
◦ HyFly saves money in the spot market.
◦ But the airline pays the dealer.
 Commodity swaps are hard to price because they

involve average prices.
Chapter 7, Slide 62
Chapter 7, Slide 63
 The simplest equity swaps involve counterparties
exchanging fixed rate interest payments for a
floating payment that is tied to the return on a
stock or a stock index.
◦ Payments are computed on a notional and exchanged at
regular intervals over the swap’s term.
◦ The index may be a broad-based or a narrowly defined
index.
 Equity swaps allow money managers to change

the nature of their portfolios temporarily.
Chapter 7, Slide 64
 Designed during the 1990s by J. P. Morgan & Co.,
the credit default swap combines the concepts of
insurance and swaps to create a contract that
plays a useful economic role. A CDS
◦ enables the holder of a risky bond to sell the credit risk
embedded in the bond to a counterparty
◦ is a term insurance policy on an existing corporate or
government bond
Chapter 7, Slide 65
 A typical credit default swap
◦ matures in one to five years
◦ has a notional amount equal to the face value of the bond being
insured
 The seller of a CDS (the insurer) receives a periodic premium

payment (usually quarterly).
 If a credit event occurs:

◦ The underlying bond defaults.
◦ The buyer of the CDS (the insured) receives the face value of
the debt from the seller but hands over the bond in return.
◦ A CDS contract ends if a credit event occurs.
Chapter 7, Slide 66
 The premium payment is quoted as a CDS spread
(say, 100 basis points per year).
 The actual dollar payment is the prorated spread

(adjusted for the length of the payment period)
times the notional.
 The CDS spread is quoted so that no cash is

exchanged when the CDS is written.
◦ The CDS has zero value at initiation.
Chapter 7, Slide 67
 Worried Borrowers Fund, a pension fund, buys a
bond issued by Candyfault Enterprises (CE). The
bond:
◦ matures in five years
◦ pays a 5.5 percent annual coupon
◦ has a principal of $5 million
 The fund manager is concerned that Candyfault

might default on its interest payments over the
next year.
◦ She does not want to sell the bond.
Chapter 7, Slide 68
 To hedge the default risk over the next year,
Worried Borrowers buys a one-year CDS on
Candyfault.
◦ The notional is $5 million.
◦ The CDS quoted spread is 400 basis points per year, paid
quarterly.
◦ Worried Borrowers pays a quarterly premium.
Chapter 7, Slide 69
 The CDS seller gets this premium quarterly until
◦ the CDS expires
◦ Candyfault defaults on its bond
◦ whichever comes first
 In the event of default, the CDS seller

◦ pays Worried Borrowers Fund $5 million
◦ collects the Candyfault bond
 The pricing of this simple contract is a difficult

task.
Chapter 7, Slide 70
 Additional comments and discussions
Chapter 7, Slide 71

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An Introduction to Derivative Securities, Financial Markets, and Risk Management

© Jarrow and Chatterjea 2013

 Financial engineering involves how firms design

Itenables the use of derivatives to modify a portfolio’s

When liquidating a positive value position, you are

CFsand cash values at liquidation are referred to as the

 Goldmines decides to raise cash by selling bonds.

0 if S(T) < $950

 Build and break approach:

 This commodity-indexed note raises more cash up

 An equity-linked note (ELN) combines a zero (or a

 Venturecap can issue a hybrid debt and effectively

 The no-arbitrage principle ensures that a PEPS

 Hybrids are popular contracts. They have sold in

 In 1999, the Kansas City–based UtiliCorp United sold

 Swaps provide an efficient way of transferring one

 The simplest swaps are called plain vanilla; more

 Plain vanilla currency swap: counterparties exchange

 The bbalibor rate for eurodollars traditionally has been

 Nowadays, many swaps are denominated in euros,

 avoiding market restrictions

 For simplicity, we omit these dealers from most of

 Interest rate swaps are extremely popular and

 Floating Cruisers Co. raised the same sum and for

Assume that Fixed and Floating exchange cash flows at

 Since 1985, the ISDA (International Swap Dealers

 The exchange rate is the price of one currency in

 The cross rate is the exchange rate between two

 Forex swaps are widely used for managing

 Cash flows (today):

 Cash flows after one month:

 Forex swaps have many uses:

 Interests are paid in different currencies and are rarely

 Some currency swaps use notional principals.

 Mid-2011: currency swaps and currency forwards had

 Each company plans to raise cash in its home

 This fixed-for-fixed currency swap involves the

 The companies basically are exchanging their

 Spot exchange rates are

 Principal amounts and interest rates are

 Britannia pays UK investors an annual amount:

Time 1 (after 1 year) and Time 2 (end of second

Time 3 (after three years, swap ends)

 A swap can be valued by computing the sum of the present

 To compute PVs, we need zero-coupon bond (or “zero”)

 Denote US zero prices by B(t) and UK zero prices by B(t)E,

 Multiplying dollar receipts by US zero prices

 PV of Americana’s sterling payments in terms of

 Value of the currency swap to the domestic

where PV is the PV of future dollar CFs received by

 PVE is similarly computed by attaching a subscript E and by

 HyFly Airlines needs 10 million gallons of aviation

 If last month’s average fuel price is $1.30 per

 Commodity swaps are hard to price because they

 Equity swaps allow money managers to change

 The seller of a CDS (the insurer) receives a periodic premium

 If a credit event occurs:

 The actual dollar payment is the prorated spread