Lecture 2: Forex

FX of FOREX risk can be classified into 3 key categories, i.e., managed in different ways, we mostly manage this risk
using the following derivatives: Forwards, Futures, Options
The classification breakdown is as follows:
Transaction exposure  changes in value of outstanding debt caused by unexpected changes in FX rates.
Operating (or economic exposure)  Changes in PV of firm’ CFs caused by unexpected changes in FX spot rates
Translation (or accounting) exposure  accounting-derived changes in owners’ equity due to FX translations in
fin.statements

FX Forwards:
In a spot transaction cash is exchanged for an asset even if settlement occurs a few days later, ownership changes
instantly. While in a forward transaction both parties agree to exchange cash for the asset at some future date (T) at
a price agreed upon now (in t), the ownership changes at settlement (at T).
Forwards are a binding agreement, specifying that in time t: a $ amount is to be paid, an exchange rate and a
transaction date.
At t there are no cash flows and there is no uncertainty about cash flows in T. There is a counterparty risk (CP Risk)
that the other party will be unable at T to fulfill its obligations.
Forward contracts are: not standardized, OTC traded, the buyer is termed as a long position & the seller is termed a
short position

General FX forward pricing formula:

we assume interest is continuously compounded, we need only to use yearly interest rates and keep track of the
time horizon.
The forward price in T years of an asset worth S o today is: F = S0*e(r + v - c - d)*T
*r  domestic annual interest rate,
*v  annualized, continuously compounded storage costs or depreciation
*c  convenience yield (leasing, foreign currency interest rate)
*d  cash payouts

Covered-interest parity: theoretical condition: relationship between interest rates and

the spot and forward currency values of two countries are in equilibrium. The covered interest rate parity situation
means there is no opportunity for arbitrage using forward contracts, which often exists between countries with
different interest rates.

Example: forward contract on January 5th where a French firm agrees to purchase CHF 100K on April 5 th
The CHF is sold at a spot of 0,8275
The Swiss annual interest rate is 0,5% and the Euro area’s is 0,75%
F = 0,8275 * e(0,075 + 0 – 0-0.05)*(4/12) = 0,8275 * exp[ (0,75% - 0,5% ) * 0,25]
F = 0,828 Euros
Forward mkts are OTC bilateral mkts where you need to find a CP and an intermediary.
Thus, in addition to CP risk, we have the risk of illiquidity.

FX Futures:
Future contracts convey the obligation to buy or sell a standard Q of an asset or security at a fixed priced on a fixed
future date.
Futures are standardized and the contract specification ties down the nature, timing, location of the product to be
delivered, etc. This helps generate more liquidity in the futures contract mkt compared to forwards.

Mark-to-mkt:
Total payoffs to long or short sides of a future contract are exactly the same as forwards.
Futures money is exchanged daily throughout the lifetime of the contract rather than in one lump on the delivery
date.
The marking-to-market calls for:
 Margin accounts to hold $ deposited by the buyer in the futures contract
 Initial margin deposited by the buyer in the margin account
  Variation (changes in the margin account balance) as the mkt price of the futures contract changes
and daily gains/losses accrue.
 Maintenance margin which is the least $ available before being required to deposit enough to
restore the initial margin (margin call).

Example: a US investor speculates that the price of gold will rise over the coming 2 to 3 months, rather than buying
gold itself and facing the whole risk and costs alone (storage, security, etc), the investor takes a long position on gold
futures with the specifications:
Size: 100oz
Futures price: $300/oz
Maturity: 90days
Initial margin: $1500
Maintenance Margin: $1000
 the margin balance fluctuates by the variation or relative change between periods. If the Margin Balance falls
below the maintenance margin, a margin call is made to bring back the balance to the initial margin. Between the
initial margin value and the maintenance margin values, no margin calls happen.
 the loses are thus spread over time, in opposition the forward contracts where they are computed as a
lump sum.
 the CP default risk is reduced: as soon as the speculator decides not to respond to a margin call, the
exchange closes the contract limiting the losses at a day at most.

** if the maturity is the same, and interest rates are constant over time and across maturities (or predictable over
time), futures and forwards prices are seen as identical.
IRL interest rates do not fulfill any of the two conditions which makes the prices different.  futures contracts are
slightly more expensive than forwards because of the existence of this correlation:
If S rises, an inflow of daily gains to the long position that can be invested at a relatively high interest rate
If S falls, the daily losses have to be finance with lower interest rates.

FOREX Hedging Basics:

straightforward hedging operation: locking price of a future purchase or a future sale of an asset.

Whenever we own an asset and
we might sell it sometime in the
future we are considered to be
on a long position. To lock in a
price for a future sale, we can
simultaneously take a position in
futures or forwards of the same
asset that is negatively correlated
with the asset  short
futures/forwards’ hedge.
When we are short on the asset
and we expect to purchase it
sometime in the future, to lock in
A perfect short forward hedge:
If there is no basis risk (no volatile interest rates)  St = Ft
a price of a future purchase we forward payoffs with future
can simultaneously take a contracts fails sometimes.
position in futures or forwards of  basis risk is the difference
the same asset that is negatively between spot and futures price.
correlated with the asset Basis risk arises whenever there
 we use long futures/forwards’ is uncertainty about interest
hedge. rates and hence about the basis.
Notes:
futures and forward prices
diverge systematically (by a small
amount) due to (1) the volatile
interest rate (2) replicating
If we have Q units of an asset that we have to sell in time t=1 and the forward price in t=0 is F 0.
*each unit is worth S1 (spot) in t=1. The total value at maturity is aS 1
*shorting h forwards at t=0 pays h(F0 – S1) in t=1
 total value is:
qS1 + h(F0 – S1) = hF0 + S1 (q – h)

if q=h, the CF stops being exposed to all mkt risk of the asset!

A perfect long forward hedge:

A long exposure hedged with a short forward position pays:
qS1 + h*(F0 -S1) = hF0 + S1*(q – h)

if we are short on the asset, we go long forward by h units, the total payoff is:
- qS1 + h*(S1 – F0) = -hF0 – S1*(q – h)

With - qS1 being the short exposure // & // h*(S1 – F0) being the long hedge

 again, if q=h, the CF is not exposed at all to the mkt risk of the asset

The hedging ratio:

The hedging ratio is the ratio of the size of the position taken on the hedging instrument to the size of the position
exposed to risk.
 In the previous example the hedging ratio was 1: the q units of the asset were hedged with q forward
contracts.
The hedge is said to be perfect whenever the value after hedging is certain: the volatility of the CF is zero ** a
hedging ratio of 1 does not imply a perfect hedge

Examples on slides 30 and 31

Transaction exposure hedging using forwards
EJS is due to receive 20M Euros in 2-Months (June 15 th) for goods sold
At current spot: 0,815 Ponds per Euros, the contract is worth 16,29M Ponds
forward rate quote is 0,79 Ponds per Euro
 the gains or losses in the forward hedge offset losses and gains in the cash position:
Spot maturity is 0.72 Ponds
Cash = 20M Euros * 0,72 = 14,4 M Pond
Forward profits = (0,79 – 0,72) * 20M Euros = 1,4 M Ponds
Spot maturity is 0,83 Ponds
Cash = 20M * 0,82 = 16,60 M Ponds
Forward losses = (0,79 – 0,83) * 20M = - 0,8M Ponds
 In both cases the ex-hedge total payoff is 15,8 M Ponds

Hedging with futures: matched maturities

A June Euro futures contract traded in NYSE Euronext with a contract amount of 125K Euros and a price of 0,7903
Ponds per Euro
EJS can sell 160 futures (200M/125K=160) and guarantee receipt of 15,806M Ponds.
=> future hedge achieves the same perfect hedge using a hedging ratio of 1 because:
There is no basis risk => futures prices = forwards’;
There exists a futures contracts matching the exposure’s maturity date;
The required amounts are a perfect multiple of the units traded in NYSE Euronext.
Example of mismatched maturities slides 33 and 34
In t=1 an American firm realizes it will get a pmt of 100M Euros in t=3
Assume that interest rates are constant and that futures contracts settle at each period

The current price (t=1) of a Euro futures deliverable in t=3 is $2

*we suppose that the Euro futures price can follow either of two possible paths:
(1) => increase its value to $3 in t=2 and stay there until t=3 (maturity)
or
(2) => depreciate to $1 in t=2 and remain until t=3
Both paths are equiprobable (equally likely)

+ Spot price of Euros in t=0 is $2, how can the firm remove its exposure to the Euro?

 the firm has a long position on the Euro, to hedge its exposure the firm has to simultaneously short Euro futures
contracts deliverable at maturity (t=3).

CASE1:
The hedging ratio is 1  the firm shorts 1M contracts (100M Euros) // margin gains are deposited to make interest
and losses are covered with risk-free rate borrowing which is 10%
The average payoff at t=3 is:
E(c) = 0,5 * (3+ (2-3)*1,1)*100M + 0,5(1+(2-1)*1,1)*100M = 200M
With volatility:
Vol(c) = [0,5*(190-200)2 + 0,5*(210-200)2]0,5 = 10M

A tailed hedge:
A hedging ratio of 1 makes abstraction of interest gained or paid before maturity
 gains and losses are magnified
 to reduce their impact, we can reduce the hedging ratio
NOTE:
The idea is to give up a little bit of return each year to purchase protection against a market meltdown. The focus
is on identifying the key aggregate balance sheet risk factors and determining the cheapest way to protect
against these risks.

CASE2:
Tailing the hedge – slide 35
A perfect hedging ratio makes the CF constant
We need to choose h to equalize payoffs ex-hedging in both states of
1) [3 + h(2-3)*1,1]*100M
2) [1 + h(2-1)*1,1]*100M

If r=0,1 => the loss of 1 per contract accrues with interest to a value of -1,1 ( = - (1+r) )

For a face value of -1 we take a position of 1/(1+r) = 0,909 short futures per Euro, i.e, we make the hedging ratio h =
0,909

Tailed hedging in 3 periods

In general, the hedge has to be adjusted from the starting date to maturity, because each period there is settlement.
** Suppose the firm must hedge a short exposure of size q, maturing in 3 periods, but the futures contracts mature
every period.
<!> we will need to find: how much to hedge in each period, i.e., the hedging quantities h 1, h2, h3.
 the total hedge payoff in time 3 is:
- qS3 + h1*(F1 - F0) * (1+r)2 + h2*(F2 - F1)*(1+r) + h3*(F3-F2)

To make the previous CF fully predictable, we make:

h1 = q x (1+r)-2
h2 = q x (1+r)-1
h3 = q x 1
With these hedging amounts the total CF is – qF0, i.e., today’s known 3-period future value of the short exposure
instead of the spot value in 3 periods.

Generalized tailed hedging:

An exposure that is longer than the settlement frequency requires a hedging program, i.e., a list of how much to
hedge at each settlement date.
* The amount to hedge increases over time as: h 1 < h2 < h3 = q
 by induction, with T settlement times before maturity, we need this program of hedging ratios:

Example slide39
Dynamic hedging by a gold mine;
 A gold mine has sales contracts maturing on December 31st for £100,000.
 It is January 1st and the price of gold in the spot market is £10 per ounce.
 Futures contracts for gold mature on March 31st, June 30th, September 30th and December 31st of every
year and each contract must be for 100 ounces of gold.
 Suppose that there is no basis risk.
 Suppose the annual interest rate for continuous compounding is 5%.

Design of the hedging program:

**the price of a 3-Months futures contract on gold is:
F = S0erT = 10 Ponds x exp [5% * 3/12] = 10 x exp(0,05/4) = 10,126 Ponds

Since we are long on gold (we are a gold mine), and we ill hedge the exposure with the same underlying then we will
short gold futures with the following program:
 We open the futures account on Jan 1 st,
 Our roll-over dates will be: March 31st, June 30th and September 31st
 On December 31st (sales contracts maturity) we do not roll-over to match the maturity of our sales contracts
with the futures

The hedging ratio should be determined using the previous formulas,

we get:
h jan = exp (9/12 * r) = exp (3/4 * 5%) = 0,96319
h march = exp (6/12 * r) = exp (0,5 * 5%)= 0,97531
h june = exp (3/12 * r) = exp (1/4 * 5%) = 0,98758
h september = 1

The number of contracts we will use is equal to:

Hedging ratio x [Total Pond exposed (spot)]/[Spot price (ponds/oz)] x 1 / [oz. per future contract]

Which yields:
January : 0,96319 x [100K Ponds / 10 Ponds] x 1/100 = 96
March : 0,97531 x … x …. = 98
June : 0,98758 x … x …. = 99
September :1 x … x …. = 100

Hedging with basis risk

Whenever there is basis risk, the futures price at T will not coincide with the forward and spot prices, i.e., it is no
longer the case that  ; FT = ST
 the perfect hedge is no longer feasible because:
For any q and h: qST + h(F0 – FT) =/= qST + h(F0 – ST) (=qF0)

The perfect hedge may not be feasible ⇒ we need to find an optimal hedging ratio with futures contracts.

Optimal hedging ratio:

 the idea is to construct a hedge that offsets the spot price movements with the hedge’s (futures) movements ;
** For a short hedge:
A perfect hedge makes the total change equal to zero (risk-free CF) by making the hedging ratio equal to [the change
in the spot price of the asset] / [the change in the futures price]
Without basis risk:
Even if we don’t know the changes in S and F, we know that ∆F = ∆S x e r(T–t) which allows us to set the hedge ratio to
e -r(T–t);
With basis risk:
We don’t know what this relationship will be. The best we can do is to maximize our utility from the combined CFs
(spot + hedge)  often simplified by minimizing the CF volatility.
Value of the firm: this strategy maximizes the corporation value when?????

Volatility minimizing hedge:

The variance of the CF stated above is:
V = Var(∆S) + h2*Var(∆F) – 2h*Cov(∆S, ∆F)
 V = σ2S +h2σ2F −2hρS,FσSσF (1)
We try to minimize (1) by choosing an appropriate h:
If h minimizes (1) then:

If ρ < 0  then the hedge should be positive

If ρ > 0  then the hedge should be negative, i.e., we hedge long exposures with a short on futures and we hedge
short exposures with a long on futures.

*the hedge ratio takes account of the correlation between the two assets and then uses the ratio of the standard
deviations to adjust for differences in the scale of the two asset returns.
If ρ = 1 and σS = σF  the optimal hedge ratios is -1,0 since the spot and futures contracts move in lockstep
If ρ = 1 and σS = 0,5 σF  the optimal ratio is – 0,5 since the futures price moves by twice as much as the spot’s

Estimating the hedge ratio:

h can be estimated by the slope of the regression line of ∆S on ∆F using historical data.
* we measure the hedge effectiveness with the R2 of the regression (=h2*σF2/σS2)
this ratio gives the proportion of the variance eliminated by hedging.

<!> a better estimate can be derived from: allowing variances and correlating to time-vary using multivariate GARCH

framework

Lecture 3: Options
The basics of options:
Hedges we have seen before are for linear risks. These hedges will typically:
Eliminate risk by guaranteeing a forward price / Minimize risk effectively if basis risk is low with future contracts
 our downside losses are removed at the expense of upside potential. The alternative to which would be to buy an
insurance.
Notes on insurance contracts:
 Insurance contracts are contingent claims, they only pay if something happens
 payoffs are non-linear
o If the event insurred against happens, buyer receives a pmt, in the opposite case, no cash is paid out
Option contracts have similar payoffs to insurance contracts.

Definitions:
Call option  buy a certain asset by a certain date for a strike price K
Put options  sell a certain asset by a certain date for a strike K.
o The seller of either type is called an option writer
o The date of exercise is maturity
o An option itself is bought at a price called option premium
o Option premia, c and p, are quoted per units of the underlying asset, e.g., share of MSFT stock or per
oz. of gold, but contracts are for
bundles of 100 units only.
Options moneyness:
Price of the underlying maturity ST, and a strike K.
the payoffs to all types of positions are:

Hedging with options:

Consider the following alternative situations:
• You hold an asset and want to hedge against price falls (long on the asset)
• You are due to deliver an asset and want to hedge against price rises (short on the asset)
• You have a liability to pay and want to hedge against rising costs (short on bonds)

Protective puts:
We are long an asset; we risk that its price might fall
 a fixed exposure (linear), we lose 0,01 Ponds for each 0,01 Ponds drop in value

A Long-Put profits at maturity by 0,01 for each 0,01 fall in the underlying (but only once the underlying drops below
the strike price) is an option position that pays off as the underlying falls in value.
Example: we buy stock at $125,94 and a put option in this stock with K=$125 and a premium of $11,50. This matures
in one year.
The total payoff is: (ST – SO) + max(K – ST,0) – p
<!> The breakeven point is when the total payoffs = 0; i.e., when ST = 137,44

Protective puts with different strikes:

Compare now two puts at strikes of 120 and 130
⇒ The 130 put must be the most expensive to buy. As the 120 put pays out for a smaller range of values for the
underlying price, i.e., it provides less insurance.
Hedging trade-off: the cost of a protective put increases with
the ammount of protection.

Futures vs. Options: linear exposures

Suppose we are long on an asset with maturity in T  the
unhedged exposed CF at maturity is: ST .
With a futures price F0 = 125, adding a short hedge using futures with a hedging ratio of 1, will produce a total unit
CF of: ST + h*(125 – ST) = 125
Alternatively, a short hedge using h=1 put options at a strike of 125 will produce an overall CF of:
ST + h max(125 – ST,0) – 11,50
= max(125, ST) – 11,50

 preference of options over futures:

 The futures hedge stabilizes the cashflow, removing downside risk but also upside potential.
 The options also removes downside risk while enjoying upside potential, but at the cost of a premium.
 thus, options are the best when:
1. The firm wants to place a bet on appreciation (leveraged buy)
2. When having excess cash is important in the upside, for arriving investment opportunities per example.
There are actually case where options-based hedges dominate futures-based hedges. Let’s consider a risk factor,
worth ST at maturity and a cash flow with a long but concave exposure G(S T).
Note: an exposure will not be fixed whenever the correlation between the exposure and the CF falls at extremes.

A short hedge using futures has a unit CF: G(ST) + h*(F0 – ST)
A short hedge using put options has the unit CF: G(ST) + h*max(K – ST,0) – p
Key elements from this part:
1. When the correlation between ST and the cash flow, G(ST ) weakens, there is less need to hedge
 a futures hegde makes the overall position becomes more exposed to the downside risk.
2. This downside is avoided with the options contract because the put eventually becomes out-of-the-money.
3. For linear, i.e., fixed exposures to a risk factor, the choice between using forwards or options depends on how
the firm values
a. having surplus cash available in the upside vs.
b. the costs of the options premia.
4. For non-linear exposures, i.e., with changing sensitivities to different values of the risk factor, options hedges
tend to be superior because they have non-linear payoffs themselves.

Exercise slide 21
We have a real option: the firm can sell the widgets at market that maximizes profits, ether in France for 1 Euro now
or in the UK for 1 Pond in 3-Months.

Let the exchange rate at T be S T;

 the payoff in Ponds from selling in France is ST x 1M (1Million is the number of widgets).
 The payoff from selling locally is 1M Ponds
 the unhedged payoff is:
1M x max (ST, 1)

Shorting Euros forward at 1 Pond/Euro has the payoff:

1M x [max(ST,1) + (1-ST)]
= 1M x [1+ max(1- ST,0)]

Writing a call (shorting look at definitions) has a payoff in T of:

- max(ST – 1,0)
Thus, the option hedged CF is:
1M x [max(ST,1) – max(ST – 1,0)]
= 1M

⇒ In fact, the firm will realize a higher cash flow because it has written (shorted) a call option.
⇒ We must add the future value of the premium ce rT.

Summary:
There exist several strategies to approach FX transaction exposure. You can
• choose between forward, futures and options;
• choose within instument classes, e.g., different strikes; or
 don’t bother.
 Pros and Cons of hedging alternatives:
Forwards
• can be tailored to perfectly remove FX risk
• BUT, item may be illiquid and involve CP risk
Futures
• Are liquid
• BUT, trying to match maturities (tailed hedging) may fail due to basis risk
• AND, hedge poorly against non-linear exposures
Options
• Allows for upside potential while protecting the downside,
• Hedge non-linear exposures as well,
• BUT, have an up-front cost.

 one can evaluate the relative benefits and costs of futures vs. options by simulating future exchange rates
 e.g., expecting appreciation, options may be a good idea but futures and options prices incorporate these
views  no arbitrage
 hedge based on future expectations are actually bets.

The final decision must rely on:

1. Whether forwards for perfect hedges are available at low search costs (time)
2. The value of extra cash in booms or contractions
3. Exposures are linear or non-linear

Lecture 5: interest rate risk

Hedging interest rate risk:
The treasurer is worried interest rates will rise, increasing interest rate costs. This can be hedged by:
Refinancing, to change the rate mix, Forward rate agreements, Swaps, Interest rate futures or options

The optimal floating/fixed-rate debt mix:

• A firm need not always preferr to lock in an interest rate to serve all its debt.
• Uncertain debt payments, i.e., floating rates payments, may themselves provide a hedge against cash flow
volatility.
• The share of fixed rate debt that minimizes the volatility is higher ...
o … the lower the correlation between the firms’ CF and interest rate, and
o … the higher the interest rate volatility
• Intuitively, the debt service pmt naturally hedges the firms’ CF if interest rates and CF are positively
correlated.

 Optimal mix implementation: forward rate agrrements

The borrowing firm wants to lock-in the future borrowing costs:
• The total payback (face value) equals the principal (fixed by definition), and the interest pmt (either
fixed or variable);
• The firm only needs to exchange the interest pmts and not the value of the loan.
A forward rate agreement, denoted FRA, is:
• OTC traded
• The buyer commits to pay fixed rate on a notional amount over a period of time
• Seller pays an agreed reference floating rate (generally LIBOR soon SOFR) at maturity.
There is no exchange of principal, just of interest computed on a notional amount.

In this OTC traded contract, we specify the notional amount N, the dates t to T, and a price, i.e., the forward rate F 0
such that:
 the buyer accept (Lt – F0)*N in time T,
 the seller accepts (F0 – Lt)*N in time T,
*** Lt is the reference rate, generally LIBOR (that’s why we denote it L)
Coupon-paying, floating rate bonds will typically set the coupon due in T using the reference market rate determined
some time in advance, i.e., t < T . Therefore, the terms of an FRA exchange are settled also in t < T .
The FRA hedge:
The notional is set as to implement the optimal mix of floating and fixed rate, say: (1 – α)% to α%

If the floating rate debt principal is worth D, then the total CF is:
- D Lt + N*(Lt- F0)
As – D Lt is the exposure to hedge

The targeted hedge is achieved by making N = αD so that:

- D Lt + αD*(Lt- F0) = -αDF0 – (1- α)*D Lt

Example slide 9
The first quarterly service of a total debt of 100M Ponds is due in 7-Months
The 3-Months coupon (debt service) is determined using the spot value of LIBOR 3 months before its due, i.e., in 4
months from today.
Let the annualized FRA for 4-Month maturity be 5%
We suppose that a 7-Month FRA with 4-Month reset is agreed today for the quarterly payment of a 100M notional.
And suppose that in 4 months from the agreement, LIBOR was 6% (denoted L 4 = 6%)
The exchanges of cash are:
The exposed CF in 7 months is: - L4 x 90/360 x 100M
Where L4 is random so it constitutes the risk factor.
 the coupon due in 7Months is therefore:
0,25 x 0,06 x 100M = 1,5M
When the FRA is settled in the 4th month:
 the buyer gets: [0,25 x (0,06 – 0,05) x 100M] / [1 + 0,25 + 0,06] = 246,305
 if this CF is invested at LIBOR for 3 Months then it becomes:
0,25 x (0,06 – 0,05) x 100M = 250,000
The next coupon is: 250K – 1,5M = - 1,25M
<!> this amount is equivalent to the coupon on a 5% fixed rate exposure: (-0,05/4)*100M
This 5% fixed leg of the FRA comes from the no-arbitrage relationship.

* What is the 1-Month forward for a 90-day deposit? Example slide12

Portfolio 1:
Invest 1 Pond today at the spot 30-day rate, then rollover in one month time at today’s 90-day forward rate.
Portfolio 2:
Invest 1 Pond today at the spot 120-day rate.
 both strategies are risk-free, costing the same today and deferring all patoffs until the same maturity  they
must have the same payoff.
Strategy payoffs:
Strategy 1:
(1 + L030 x 30/360) x (1 + F030,90 x 90/360)
Strategy 2:
(1 + L0120 x 120/360)

 solving for F030,90, we obtain:

===> the forward rates are completely determined by the LIBOR term
structure.

SWAPS:
A swap is an agreement to exchange payments of different kinds in the future

 Interest rate swap: the exchange is for a sequence of coupon payments over a fixed notional and a specified
period:
 • exchange a fixed rate stream for a variable rate stream, i.e., a repeated FRA;
• exchange floating rate streams based on different basis, i.e., a basis swap, e.g., between LIBOR and Treasury
bills.

 A currency swap: the exchange is for coupon and principal in one currency for coupons and principal in another
• e.g., CHF150 M at 5% for ¬£100 M at LIBOR
Steps in currency swap:
1. Borrow according to comparative advantage
• CalTech issues CHF150M 5-year debt at 5% fixed rate
• Nestl ́e issues USD100m (USD1=CHF1.50) 5-year floating debt at LIBOR
2. Exchange principal
• CalTech and Nestl ́e exchange their proceeds from borrowing
3. Periodic coupon exchanges
• Each CalTech coupon date,Nestl ́e pays CalTech 5% in CHF
• Caltech pays Nestl ́e LIBOR whenever Nestl ́e’s interest payments are due
4. Re-exchange principal
• At the end of the deal, Nestl ́e and CalTech exchange the principal sums so that each can repay their issued
debts

Results of this operation:

CalTech:
• pays a 5% rate on a CHF debt (Eurobond Nestlé:
market) • pays LIBOR on a USD debt
• pays USD LIBOR (swap with Nestl é ) • pays 5% in CHF (swap with CalTech)
• receives 5% in CHF (swap) • receives LIBOR on USD debt (swap)
 borrows USD at LIBOR, saving 25 basis  borrows CHF at 5%, saving 75 basis points
points

SWAP Mkts:
Swaps are private deals  flexibility
Standardized versions, like FRAs or Eurofutures are therefore: More liquid, Easier to price, less CP risk

Caps and Floors:

In general, an interest rate option gives the buyer the right, but not the obligation, to make a known interest rate
payment based on the exercise rate, rK , and receive an unknown spot market interest spot payment.
A cap pays the difference between a floating rate pmt and the fixed, cap rate, based on a contracted notional at the
option of the buyer, i.e., whenever this difference is positive.
The cap be contracted to last as long as the life of a debt, reset at the debt maturity dates and pmt be made at debt
service dates.

Cap payoffs:
=> a cap provides a hedge to a debtor, who wants to lock-in a maximum rate of r
Example slide 22
Constructing a cap hedge.
Suppose that a floating rate loan for $100 M is contracted on January 1st 2021 and:
• must be serviced quarterly, i.e., on 31 st March, 30th June, 30th September and 31st December
• reset dates are two months before each quarterly pmt; i.e., 31 st Jan, 30th Apr, 31st July and 30th October.
To hedge this exposure, the firm can simultaneously buy a cap
• with a notional of $100M
• for the same maturity as the loan
• and with quarterly pmts and reset dates
matching those of the loan.

Note: the cap is actually a group of

individual options (‘caplets’), maturing on each
reset date
Floors:
A floor pays the difference between a contracted, fixed floor rate and the notional pmt at a floating rate whenever
this difference is positive
For the same parameters, the payoff is:
N x max (0, r - rt) x τ
A floor provides a hedge to a creditor who wants to lock-in a minimum rate of r.

Pricing Caps and Floors:

Caps and floors are standard call and put options, respectively, but the underlying is the interest rate (which means
we can use Black-Scholes).

The pmt of one caplet at the reset date, t, is given by:

Example slides 25 to 28
• We borrow e25M for one year on Jan 2nd 2022
• Payments will be quarterly (Apr, Jul, Oct, Jan)
• On each payment date, the rate for the next three months will be the spot 90-day SOFR rate
• SOFR on Jan 2nd is 10%
• To hedge against risk of rising SOFR we also buy a cap with exercise at 10% for a premium of 70K Euros
upfront

At each pmt date the caplet is worth:
25M x max (0, SOFR – 0,10) x 90/360
The loan’s April pmt will be:
25M x 0,10 x 90/360 = 625K Euros
Suppose on April 2nd, LIBOR is 9,75%:
 the loan July pmt would be: 25M x 0,0975 x 91/360 = 616,146 Euros
With no extra pmt from the out-of the money April caplet.
Suppose on July 2nd, SOFR is 12,375%
 25M x 0,12375 x 92/360 = 790,625 Euros
But the caplet is in the money, so it pays in July:
 25M x (0,12375 – 0,10) x 92/360 x 1 / [ 1 + 0,12375 x 92/360 ]
Which in October is worth the following:
 25M x (0,12375 – 0,10) x 92/360 = 151,736 Euros
 net, we pay the maximum of 638,889 Euros
Suppose on Oct 2nd, SOFR is 11,5%
 the Jan 2nd 2014 caplet will be in the money and we will pay the max of 638,889 Euros plus principal
Summary of this part:
With the 10% cap, the effective quarterly interest rate paid is
Without
the cap,
the
implied
yield
would
have
been
11,5%