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The Use of Derivatives To Hedge Market Risk in Corpotare Financing
The Use of Derivatives To Hedge Market Risk in Corpotare Financing
ABSTRACT
In this tutorial article, the strategies available to hedge market risks arising
from different financing instruments are explained. Financial derivatives,
whether futures or options have been widely applied in companies to
mitigate or eliminate potential losses due to the uncertainty in interest or
foreign exchange currency rates. However, the mathematical complexity of
derivatives has sometimes been a barrier to non-highly specialised financial
managers in understanding their foundations, advantages and ways to apply
them in exposure reduction strategies. To address this issue, a practical
approach to the use of derivatives is presented in this article. The swap
valuation concepts and foundations of pricing are dealt with in the text, but
their formal valuation techniques are described separately in the appendices.
Explanations will be provided to calculate option premiums with the
extensively used and free downloadable software of John Hull (Derivagem),
but the mathematics involving the models used in option valuation will not
be shown as they are outside the scope of this paper.
JEL: A20,A22,A23,A33,G10,G11,G13,G15,G23,G32,M21
1
jsverdasco@incompany.es
Contents
Abstract .................................................................................................................... 1
Introduction .............................................................................................................. 4
Types of Financial Risks .......................................................................................... 4
Financial Risks in financing structures ..................................................................... 4
What is a derivative? Futures and Options. .............................................................. 5
Hedging interest rate risk in financing ..................................................................... 6
Interest Rate Swap (IRS) .......................................................................................... 7
Definition.............................................................................................................. 7
Fix for Floating IRS (plain vanilla or coupon swap) ........................................... 8
Main features of IRS ............................................................................................ 8
How to use an IRS to hedge a bullet loan that pays a floating interest ................ 9
How to hedge the interest rate of a bond to be issued in the future (rate-lock) .. 10
Forward Swaps ....................................................................................................... 13
Hedging with interest rate options: Caps, Floors and Collars. Swaptions.............. 16
Hedging with CAPs ............................................................................................ 17
Hedging with COLLARs .................................................................................... 20
Swaptions ........................................................................................................... 22
Hedging Exchange Risk ......................................................................................... 25
Currency Forward............................................................................................... 25
Currency Swap ................................................................................................... 26
Hedging a fixed rate facility in a foreign currency ............................................. 26
Hedging a floating rate facility in a foreign currency......................................... 27
Equity Swaps .......................................................................................................... 28
Hedging on stock buys pending settlement ........................................................ 29
Hedging an equity position ................................................................................. 30
Appendix I. Zero-coupon yield calculation ............................................................ 31
Zero-coupon vs par yield rates ........................................................................... 31
How to derive the zero-coupon rates from the Swap Curve ............................... 32
The bootstrap method: .................................................................................... 32
The matrix approach: ...................................................................................... 33
Calculating zero rates (spot) in Excel ................................................................ 35
Appendix II. Forward Rates. Concept and calculation. ......................................... 36
Appendix III. Introduction to Interest Rate Swaps Valuation ............................... 38
Bond methodology .............................................................................................. 38
Forward Rates methodology .............................................................................. 40
Appendix IV. Introduction to Option Valuation.................................................... 41
Intrinsic and Time (or extrinsic) Value of an option .......................................... 41
Interest rate options valuation............................................................................ 43
Caps ................................................................................................................ 43
Swaptions ....................................................................................................... 46
References .............................................................................................................. 47
Figures
Figure 1. Coupon swap: receives floating pay fixed ................................................ 8
Figure 2. Purchase a call interest rate option as a part of a cap (1) ........................ 17
Figure 3. Purchase a call interest rate option as a part of a cap (2) ........................ 18
Figure 4. Sell a put option as a part of a floor ........................................................ 21
Tables
Table 1. Floating interest rate loan. Cash flow structure .......................................... 9
Table 2. Interest Rate Swap yield curve ................................................................. 10
Table 3. Hedged structure: floating rate loan + IRS. Cash flow structure.............. 10
Table 4. Interest Rate Par Swap and Zero-coupon yield curves ............................. 11
Table 5. Interest Rate Par Swap + 1% and Zero-coupon yield curves ................... 12
Table 6. Hedge structure: floating rate loan + forward swap (1)............................ 14
Table 7. Interpolated zero-coupon rates ................................................................. 15
Table 8. Hedge structure: floating rate loan + forward swap (2)............................ 16
Table 9. Several zero cost collar alternatives ......................................................... 22
Table 10. IRS Market rates EUR and USD ............................................................ 26
Table 11. Hedging a fixed rate bond in foreign currency through a ccy swap ....... 27
Table 12. Hedging a floating rate loan (bond) in foreign currency through a ccy
swap ........................................................................................................................ 28
Table 13. Equity swap ........................................................................................... 29
Introduction
The effort that a company makes to correctly manage its operations can be
worthless if the financial risks cause a loss in business results. The key
challenge for the corporate risk manager is to determine the risks the
company is willing to run and the ones it wishes to mitigate through a
hedging strategy, frequently, by using financial derivatives (futures and
options).
Though financial risks arise not only from financing decisions but also from
export-import activities that involve exchange and commodity risks, this
article will deal just with the former by identifying interest and exchange
risks appearing in different financing instruments and showing how can they
be hedged using futures (or forwards) and options.
An option, however, gives the buyer the right to buy (call) or sell (put) the
underlying asset at the strike or exercise price. The option will be only
exercised if it is convenient for the option holder (the option buyer).
When the deal is contracted through an option, in the case the spot price at
expiration is 22 €, the buyer will exercise the option and obtains a payoff of
2 €. However, the option will not be exercised if the stock price is 17 € since
there is no gain in exercising at 20 € when the stock can be bought at 17 € in
the market. Differently from futures, the buyer will exercise only when the
payoff is positive, so the seller will require being compensated with an
option premium. This option premium paid by the buyer represents his
privilege with respect to the seller of having rights but no obligations.
• Bank loans.
• Bond issues.
2 OTC: Over the Counter refers to bilateral dealing and no clearing house intervenes to
regulate the market. The OTC markets are more flexible but less secure in terms of credit
risk than the exchange markets.
month LIBOR) whose levels are unknown in advance. On the other hand,
the short-term financial debt has to be rolled over to meet the operating
working capital needs, again at unknown interest rates. In the case of an
increase in interest rates in a financing structure, financial expenses rise, and
earnings decrease.
• Bullet, the same nominal throughout the life of the loan or bond and a
unique principal payment at maturity
• Oscillating:
− Accreting, when the nominal increases through the life of the loan.
This type of loans is related to construction projects (highways,
hospitals, power facilities) where increasing financial resources are
needed up to the end of the construction. Once the project is
finished, the loan generally follows a bullet or amortising pattern
of payments.
Definition
Coupon swaps involve an exchange of fixed rate for floating rate payments
on a notional amount during a period. For instance, a company may receive
annually during 5 years the 1 year LIBOR rate (whatever the rate is every
year) multiplied by a notional amount of 1 million USD and pay yearly to a
bank a fixed rate (the 5-year swap rate at inception of the deal) on the same
notional. Conversely, the company can receive the fixed rate and pay the
floating one (see figure 1).
Fixed rate
Company Bank
Floating rate
LIBOR
3M, 6M or 1Y
This type of IRS is the one used for hedging floating rate financial facilities.
Other IRS such as basis swaps, where an institution receives and pays
floating rates of different terms (e.g. receives EURIBOR 3M and pays
EURIBOR 6M), are related to positions on the slope of the interest yield
curve. These swaps are outside the scope of our objective.
• There is a credit risk, since one counterparty may not commit to its
obligation to the other party throughout the life of the swap.
How to use an IRS to hedge a bullet loan that pays a floating interest
Assume a floating rate loan with the following features (table 1):
Loan
Years Pay
1 Euribor 1.12% + 1%
2 Euribor??? +1%
3 Euribor??? +1%
Swap
Years
rates
1
1.12
2 1.50
3 1.87
5 2.46
7 2.91
10 3.34
Table 3. Hedged structure: floating rate loan + IRS. Cash flow structure
so that, whatever happens, the financial cost remains fixed at 2.87% for the
next 3 years (the 3-year swap rate + the spread over Euribor)
How to hedge the interest rate of a bond to be issued in the future (rate-
lock)
When a company plans to issue a fixed rate bond to meet a financing need
in the future, it is running an interest rate risk from the date the issue is
considered up to the moment it is settled. To hedge this risk, the company
can contract an IRS receiving floating and paying a fixed interest rate. This
IRS will be cancelled at the date the bond is issued. The result will be that
the cancellation value of the swap will compensate the interest rate variation
in the market, as shown below 3.
The zero-coupon interest rates derived from the par swap shown in table 2
are:
Zero
Par Swap
Years Coupon
rates
Rates
1 1.120 1.120
2 1.500 1.503
3 1.870 1.879
One of the methodologies used in IRS valuation is to consider that the swap
is composed in fact of two bonds: the first leg is a floating rate bond
(receiving in our example) and the second one is a fixed coupon rate bond
(paying). 4
While a fixed rate bond worths also 100 at inception -when receiving the
market fixed interest rate and discounted with the market zero coupon rates-
the price of the bond will change when a movement in interest rates takes
place: the discount rates will change but not the coupon received, that is
fixed.
3
See appendix I to understand the calculation of the zero-coupon yield from the par swap
yield curve and appendix II for an introduction on swap valuation)
4
See appendices II and III for further detail
Zero
Par Swap
Years Coupon
rates
Rates
1 2.120 2.120
2 2.500 2.505
3 2.870 2.884
Therefore, the cancellation value of this IRS would be + 2.85. The intuition
behind the calculations is that the swap holder is quite comfortable paying a
fixed rate of 1.87 when under the new circumstances the fixed market rate to
be paid per year would be 1% higher. If the counterparty wants to convince
the swap holder to cancel the deal, a compensation for the present value of
the difference has to be offered:
2.85 = 1 + 1 + 1
(1 + 0.0212 ) (1 + 0.02505) (1 + 0.02884 )
1 2 3
If the bond is now issued, the coupon to be paid will be 1% higher, but
through the IRS cancellation, 2.85% will be obtained. This amount is
precisely the present value of the extra-cost of the bond. The same applies
when, for instance, the issue of the bond is to be performed in 6 months.
Then, a forward swap will be contracted: a 3- year IRS starting in 6 months
time.
Forward Swaps
When plain vanilla IRS are used in hedging floating interest rate loans, the
IRS cash flow exchange takes place from inception, though, in fact, the first
loan payment does not incorporate any risk, since it is known from the
beginning. In our example (table 1), the first year Euribor has been already
established (at 1.12%) and only the second and subsequent cash flows of the
loan are unknown. Despite that, the plain vanilla IRS (exchange of cash
flows since the beginning) is, due to its operating simplicity, the most often
used instrument for hedging floating rate loans. In such a way, the firm will
fix its financial expenses at 2.87% for years 1, 2 and 3 (the 1.87% three-year
swap rate plus the 1% bank margin) 5.
5
Note that the net cash flow of the IRS at the first year-end is already known 1,000,000
(1.12% − 1.87%).
The forward swap rate to be applied to those 2 remaining years is the one
making both alternatives financially equivalent:
Thus, the cash flow structure of the loan + forward swap combined position
will be:
Loan + FW
Loan Forward Swap
Swap
Rate of interest Euribor 1 Y + 1%
Fixed rate +
Euribor 1 Y (current) 1.12% Receive Floating Pay fixed
spread
Loan notional 1,000,000
6
The what if /goal seek Excel tool can also be used by forcing the left side of the equation
to be 5.4327 by changing “x”
The forward swap concept above has been developed from the equivalence
with a plain vanilla IRS: the results of performing the hedge in one way or
the other are indistinct.
Zero
Par Swap
Years Coupon
rates
Rates
Note 8
Then, the rate of the forward swap to be applied to a floating rate financial
facility starting in 6 months with a residual life of 2 years will be:
7
See table 7
8
For the sake of simplicity zero rates have been obtained through linear interpolation. More
sophisticated techniques are applied in financial institutions’ Treasury Desks (such as the
Spline Cubic Methodology). The results differ around 0.01%. Therefore, the linear
interpolation can be used as an acceptable reference in corporate hedging strategies.
Note 9
Isolating the unknown, a forward swap rate 1.883% is obtained and, to see
what the rate of the financial structure is, the spread of 1% is added:
Loan + FW
Loan Forward Swap
Swap
Rate of interest Euribor 1 Y + 1% Fixed rate +
Receive Floating Pay fixed
spread
Loan notional 1,000,000
Hedging with interest rate options: Caps, Floors and Collars. Swaptions
Swaps protect the results of the firm from an upward movement in interest
rates, but they do not permit the firm to take advantage of a decrease in the
financial expenses in the event of a fall in interest rates. Options allow the
right to buy (call) or sell (put) an underlying asset if convenient for the
buyer 10. Then, by using options, it is possible:
9
The term (0.9/2)/(1+0.009 x 0.5) does not indicate any actual flow in this case. It is used
to calculate the forward swap rate to be applied from year 0.5 to 2.5 based on the present
value of both financial structures with different cash-flow distribution but an equal result.
10
See a more detailed description of financial options in Appendix III
As the option buyer has only right but no obligation, the seller will ask him
to pay a premium.
Following the 3-year loan example (table 5), for the first year we do not
need to buy an option (the 1-year Euribor is already established), but to
hedge the 2 remaining years with options, the following steps will have to
take place:
• First, buy an option call at exercise price 2.257% (the forward swap
rate of the above example) expiring the first day of the 2nd year. On
that date, the decision of exercising the option or not will be taken.
The eventual option payoff will occur on the last day of the 2nd year.
Option
2.257%
premium = 0.044 %
1 year Euribor rate
• Second, buy another call option, same exercise price, to hedge the 3rd
year, that is to say, one expiring on the first day of the 3rd year, with
an eventual payoff at the end of the 3rd year.
2.257%
Option
premium = 0.498 % 1 year Euribor rate
Note 11
A caplet represents each of the interest rate call options composing a CAP,
which is a chain of caplets one after another. By adding these two caplets a
premium CAP= 0.044% + 0,498% = 0.5424% is obtained.
The CAP exercise price -level of protection- can be decided by the hedger.
Conversely, the IRS or the forward swap rate are defined based on the
market yield curve, therefore cannot be chosen. A strike equal to the
forward swap rate has been applied in this example to facilitate the
comparison between both alternatives.
11 Option premiums have been obtained using the zero-coupon rates shown in table 4 and a
flat volatility of 20%. Calculation has been performed using the software Derivagem
(John Hull) www.rotman.utoronto.ca/~hull/software/DG200.01.xls
2. Indicate:
a) The maximum and minimum cost of each alternative.
b) In which circumstances one would be inclined to choose one
alternative or the other.
Solution
1.
HEDGING WITH FORWARD SWAP HEDGING WITH CAP
Loan + Fw
Loan Forward Swap CAP Loan + CAP
Swap
Pay 0.5424% for 2 options
Rate of interest Euribor 1 Y + 1%
Receive Fixed rate (years 2 and 3)
Euribor 1 Y (current) 1.12% Pay fixed
Floating + spread
Loan notional 1,000,000 Euribor < Euribor > Euribor < Euribor >
2.257% 2.257% 2.257% 2.257%
Years Pay Years Pay Pay Receive Pay Pay
No payments
2.a)
In case of hedging with a CAP, if there is an increase in interest rates above
the strike, an annualised extra payment of 0.5424%/ 2 years = 0.2712% has
to be added. Consequently, the maximum annual cost will be 2.257%+1%
+0.2712%. However, if rates go to zero, the minimum yearly cost of the
financial structure will be just 0%+1%+0.2712%, thus taking advantage of
the decrease in interest rates.
2.b)
Assuming that an interest rate hedging is necessary since its evolution is
uncertain and can negatively affect business results if we believe that:
Rates can fall, then a CAP is preferable since we take advantage of
that decrease (though the option premium needs to be afforded).
“Almost sure” rates will rise. Then we will contract a swap since the
payment of the CAP premium is avoided and the cost of the
resulting financial structure, if interest rates finally rise, is lower than
the one of the CAP.
b) No exercise will occur in case interest rates are above the strike,
and the investment proceeds will be higher the greater the
interest rates.
premium cap with this money; then I would not have any costs for the cap
protection.
1,89%
Option premium=
0,17 %
Assume that a cap with a 3% strike costs 0.17%. We ask the options
calculator to tell us the floor level whose premium is 0.17%: the result is
1.89%. Then we buy a cap with a 3% strike and sell a floor with a 1.89%
strike, thereby obtaining a collar which allows paying an interest rate in the
range of (3%, - 1.89%) 12at zero cost. Other zero cost structures could be:
12
To which the margin the bank applies on the floating interbank rates has to be added.
Note that, when broadening the collar range significantly, the result is
practically a floating rate financial cost and if the range is too narrow it is
equivalent to contracting a forward swap paying a fixed rate. Obviously,
non-zero cost collars can be structured by renouncing a decrease in interest
rates from a lower interest rate level. Then, a lower floor premium will be
received so that only a part of the cap cost will be subsidised.
Swaptions
1. It is probable, but not sure that external financial resources are going
to be needed.
For instance, we are negotiating an acquisition whose success is
subject to the shareholders meeting or the antitrust commission
approval. Buying an option on an IRS, the financing cost can be
fixed to assess the feasibility of the project in case it finally takes
place.
− If at that time, the market rate of the IRS is higher than that of
the exercise price, the swaption will be exercised, and
immediately cancelled, since a profit from the present value of
the difference between market and strike prices will be obtained
13
.
− If the market swap rate is lower than the strike, the swaption
will not be exercised, and an IRS will be contracted at market
price with a more favourable rate.
− The market rate is higher than the strike, the swaption will be
exercised entering into an IRS at the strike fixed rate.
13
If, for instance, the exercise price of an option on a IRS with annual payments is a fixed
rate of 2% and the market rate is 3%, by entering into the IRS and immediately
cancelling it, the amount to be received will be the summation of the present value of
each annual difference (3%-2%) x Nominal, discounted at the respective zero-coupon
rates.
Solution
• The CAP premium will be higher since the CAP protects from
interest rates higher than the strike, receiving the difference between
the market and the strike rates multiplied by the nominal. No
negative cash flows will take place, in any case. Conversely, in the
case of a swaption, once it is exercised, entering into an IRS paying a
fixed rate, it could occur that the floating rate (receive) is lower than
the fixed rate (pay) and, consequently, payments must be transferred
to the counterparty.
The best hedging strategy in this case -and probably the only one
useful- is trying to find natural hedges by compensating revenues
and expenses in the foreign currency where the company operates.
Currency Forward
n
1 + i$
(1 + i$ )n / 360
Fw = Spot
360
Fw = Spot
1 + i €
n
(1 + i€ )n / 360
360
Currency Swap
EUR/USD 1.2
PAR PAR
Years SWAP SWAP
EUR USD
1 1.120% 0.590%
2 1.500% 1.230%
3 1.870% 1.830%
Table 11. Hedging a fixed rate bond in foreign currency through a ccy swap
EUR/USD = 1.20
BOND CCY SWAP
USD USD €
Pay interest Receive interest Pay interest
1.83% 1.83% 1.87%
Lend Borrow
Year
(deposit to) (deposit from)
As shown, the bond and the USD leg of the CCY swap offset each other,
leaving just the EUR leg fixed payments of the CCY swap remaining.
converted into fixed-rate cash flows in the local currency, eliminating both
the interest and exchange risks:
Table 12. Hedging a floating rate loan (bond) in foreign currency through a ccy swap
EUR/USD = 1.20
Equity Swaps
Equity swaps are characterised by an exchange of cash flows in which at
least one of them is an equity flow. They can be classified into two types:
1. Transfering the change in equity results to a third party.
Counterparty A makes payments to B by the positive or negative
returns on a determined stock or index (including dividends), while
Assume that a purchase of shares of a listed company has been agreed upon
but cannot be settled for formal or legal reasons or, just, because no
financing resources have yet been obtained.
To all effects, both the buyer and the seller consider that the positive or
negative proceeds from the stocks belong to the buyer. Both parties enter
into an equity swap with the following structure:
The financial effect for the “B” counterparty of the equity swap is as if he
actually has the economic rights on the shares and he pays the cost of
financing the amount needed to purchase them. While, for “A”, it is as if he
sells the shares and places the proceeds in a deposit receiving an interest rate
on the corresponding principal amount.
The equity swap is also used when the holder of an equity position wishes to
maintain the legal rights (i.e. voting capacity in stockholder or board of
directors’ meetings) but wants to transfer the economic results (change in
stock price plus dividends) to a counterparty, generally a financial
institution. Obviously, that decision will be taken when a downward
movement in stock returns is expected or unaffordable.
A zero rate (or spot rate), for maturity T, is the interest rate earned on an
investment that provides a payoff only at time T (no intermediate coupons
are paid). It is the rate used to discount cash flows to calculate the present
value of any investment. This curve cannot be directly observed in the
market since most of the bonds pay coupons periodically, instead of a
unique coupon at maturity.
The par yield rate for maturity T is the fixed periodical coupon rate that
causes the bond price to equal its face value (100%). In this case, the coupon
paid is always equal to the internal rate of return (IRR) of the bond, For
instance, for a 3-year bond, coupon 5 and IRR= 5%:
5 5 105
100 = + +
(1 + 0.05) (1 + 0.05) (1 + 0.05)
1 2 3
If the market return asked for an investment (IRR) is 5%, then the issuer of
the bond pays a coupon of 5 so as the price to be paid for the bond will be
100 (par value).
When the market rate (IRR) changes to a different rate different from the
fixed coupon, the price of the bond will not be 100 any more:
5 5 105
102.78 = + +
(1 + 0.04 ) (1 + 0.04 ) (1 + 0.04 )
1 2 3
The Swap Curve is a par yield curve at which top rated Banks (at least AA)
operate with Interest Rate Swaps (IRS) in the interbank market.
Years to Annual
BOND Price
maturity coupon
A 1 3% 100%
B 2 4% 100%
C 3 5% 100%
103
100 = (I)
(1 + r1 )
1
4 104
=
100 + (II)
(1 + r1 ) (1 + r2 )
1 2
5 5 105
100 = + + (III)
(1 + r1 ) (1 + r2 ) (1 + r3 )
1 2 3
Where r1, r2, r3 are, respectively, the 1, 2 and 3 years zero rates.
4 104
100 = + ; r2 =
4.02%
(1 + 0.03) (1 + r2 )
1 2
5 5 105
100 = + + ; r3 =5.07%
(1 + 0.031 ) (1 + 0.0402 ) (1 + r3 )
1 2 3
When calculating the zero rates yield curve, this method is not practical (due
to the number of steps involved). To simplify the calculations, the matrix
approach can be utilised to obtain the discount factors simultaneously and
their correspondent zero rates.
1 1 1
=d1 = ; d2 = ; d3
(1 + r1 ) (1 + r2 ) (1 + r3 )
1 2 3
100 = 103 d1
=
100 4 d1 + 104 d 2
100 = 5 d1 + 5 d 2 + 105 d3
103 0 0 d1 100
4 104 0 d 2 = 100
5 5 105 d3 100
−1 −1
103 0 0 103 0 0 d1 103 0 0 100
4 104 0 4 104 0 d
2 = 4 104 0 100
5 5 d 5 100
5 105 5 105 3 5 105
−1
d1 103 0 0 100
d
2 = 4 104 0 100
d 5 100
3 5 105
d1 0.970873786
d 2 = 0.924197162
d 0.862139479
3
Once the discount factors are known, the equivalent present value of any
stream of cash flows can be obtained. Therefore, the zero rates are not
necessary to carry out any valuation. Notwithstanding, those zero rates can
be derived as follows:
1/1
1
1/1
1 1
d1= ; r1= − 1; r1= − 1; r1= 3%
(1 + r1 ) 0.970873786
1
d1
1/2
1
1/2
1 1
d= ; r= − 1; r= 0.924197162 − 1; r= 4.02%
(1 + r2 )
2 2 2 2 2
d2
1/3
1
1/3
1 1
d= ; r= − 1; r= 0.862139479 − 1; r= 5.07%
(1 + r3 )
3 3 3 3 3
d3
Thus, obtaining the same zero rates than those calculated using the
“bootstrapping” method.
103 0 0 =MINVERSE()
4 104 0
5 5 105
0.00970874 0 0
-0.0003734 0.009615 0
-0.0004445 -0.000458 0.00952
Discount
Year Zero rates
rates
Let’s continue with the spot zero coupon yield curve obtained above:
4.02%
3% ??
0 1y 2y
(1 r ) ; (1 + 0.03) (1 + r ) =+
(1 + r ) (1 + r ) =+ (1 0.0402 )
1 1 2 1
; r1,2 =
1 2
0,1 1,2 0,2 1,2 5.05%
Similarly:
(1 r ) ; (1 + 0.0402 ) (1 + r ) =+
(1 + r ) (1 + r ) =+ (1 0.0507 )
2 1 3 1
; r2,3 =
2 3
0,2 2,3 0,3 2,3 7.20%
Therefore:
It holds an equivalence between the zero rates and the forward rates. For
instance, to borrow or to invest at the 3-year zero rate is equivalent to a deal
at 1-year spot rate, and then at the forward rates of the second and the third
year:
Two main approaches are used for IRS valuation: The Bond and the
Forward Rates methodologies.
Bond methodology
As mentioned on page 11, this method consists of considering the two legs
of the swap as two bonds, floating and fixed coupon.
Let’s go back to the par yield and zero-coupon curves used in table 4 and
assume an IRS that receives floating and pays fixed. Following what we
learnt in Appendix II, we can easily derive the forward rates 14
Zero
Par Swap Forward
Years t Coupon
rates Rates (t-1,t)
Rates
At inception:
14
We include 0.5 year rates. Up to 1 year par and zero rates are the same
Par Zero
Discount Forward
Years t Swap Coupon
factors Rates (t-1,t)
rates Rates
0.5 1.900 1.900 0.991
1 2.120 2.120 0.979 2.120
1.5 2.310 2.312 0.966 2.515
2 2.500 2.505 0.952 2.891
2.5 2.685 2.695 0.936 3.271
3 2.870 2.884 0.918 3.648
The swap valuation using the bond method presents the results stated below:
Beware that the first coupon was defined 6 months ago =1.12, the second
will be the forward rate r(0.5,1.5) and the third coupon, the principal plus r(1.5,2.5).
A short-cut to calculate the value of the floating leg is to assume that, at the
first coupon payment date, we will receive the first coupon and a price of
the bond =100. 16
15
Linear interpolation is used to calculate par and zero rates. Forward rates follow the
Apendix II formula. Consider compounded capitalisation for t > 1 year and a simple cap.
for t < 1 year.
In this method, the floating leg cash flows to be received are the forward
rates 17. Once the fixed payments are subtracted from those floating
proceeds, the sum of the present value of that difference, using the zero
rates, is the swap value. In our example:
Receive Discount
Years t Pay fixed Rec-pay Present value
float factor
As expected, the value of the swap using the Bond or the Forward Rate
methodology is equivalent.
16
Since, from that moment, changes in coupons will be compensated with variations in
discount rates: the price of a floating rate bond is always 100 at inception or interest
revision dates.
17
Except for the first cash Flow which is known, as it has been already defined. In our
example 1.12
An option gives the holder the right, but not the obligation, to buy (call
option) or sell (put option) a given quantity of an asset in the future, at
prices agreed today (strike or exercise price), in exchange of the payment of
a premium.
Intrinsic value is the difference between the exercise price of the option and
the spot price of the underlying asset. Let’s think about a call option giving
the right to buy an asset at 10 (strike) when its current price in the market is
12. In case the option expires now, the holder will make 12-10=2 18 since he
will be happy by exercising the right to buy at 10 and sell the asset one
second later at 12.
Premium
price
Intrinsic
Value
10 12
Strike (or Price of the
exercise price) underlying asset
in the martet
18
And the seller, consequently, will lose 2.
19
Derivagem (John Hull) www.rotman.utoronto.ca/~hull/software/DG200.01.xls. Sheet
Equty_Index_Futures_Options
If the time to maturity increases from 1 second to 1 year, then the seller will
run a higher risk: he not only can lose 2 but more than that. Consequently,
the seller will ask for a higher premium, now: 2.29. Thus, the option
premium can be broken down into 2.29 (total premium) = 2 (intrinsic) +
0.29 (time value).
Underlying Data
Underlying Type:
Calculate
Option Data
Option Type:
Imply Volatility
Price: 2.00027397
Assume know that the volatility (degree of oscillation of the asset price) is
higher than before. Again, the risk of the seller of the option is higher
demanding a higher premium. Let’s say that volatility increases from 20%
to 30%. The price then rises to 2.61; the time value is in this case 0.61. The
risk-free rate is not normally too relevant in the price: it is used to convert
the payoff at maturity in present value:
Underlying Data
Underlying Type:
Calculate
Option Data
Option Type:
Imply Volatility
Price: 2.61195476
For learning about the formulas used in option valuation, see Hull (2016).
Caps
As above mentioned on page 19, a Cap is a chain of interest rate call
options. We pay a premium to “buy” the interest rate at a certain level
(strike) to be entitled to receive the difference between the market rate and
the strike. Since in a floating rate loan, the second, third and subsequent
revisions of interest rate levels generate an interest rate risk, we can hedge
that risk by buying call options for those revisions. If interest rates rise
above the strike, we exercise the option receiving an amount that
compensates the higher rates of the loan.
While in other financial options the market price of the underlying asset can
be directly found in the market (i.e. the price of Microsoft shares, a barrel of
oil, a bond), the correspondent to the different call options composing a cap
are the forward rates. As seen in Appendix II, forward rates can be
calculated from zero rates. Let’s show the calculation of the Cap of page
17. 20
Swap / Cap Data Term Structure
Underlying Type: Time (Yrs) Rate (%)
1 1.120%
Settlement Frequency: 2 1.503%
Principal : 100 3 1.879%
Cap/Floor Start (Years): 1.00
Cap/Floor End (Years): 3.00
Cap/Floor Rate (%): 2.257% Imply Breakeven Rate
Pricing Model:
Floor
Cap
Price: 0.5424256
20
Derivagem DG200.01. Sheet Caps_and_Swap_OPtions
Notice that zero coupon rates need to be input (last column). In fact, what
the calculator is doing is to compute the forward rates internally (they are
not shown on the screen)
To go one step forward in our analysis, we are going to decrease the strike
to 2%, introduce the forward rates (those not shown in the screen) and
disclose the results of the second year and third year caplets.
The current market interest rate is the forward rate r1,2 (1 year in 1 year
time): 1.887 (last column). Comparing 1.887-2.00 we obtain an intrinsic
value of zero: the market interest rate is below 2.00, so no proceeds from
exercising the option will be obtained. However, there is still some time
remaining to maturity, and the market rate could change to an “in the
money” position. That is why the option premium worths 0.1087, which
represents the time or extrinsic value.
Swap / Cap Data Term Structure
Underlying Type: Time (Yrs) Rate (%) Fw Rates
1 1.120%
Settlement Frequency: 2 1.503% 1.887%
Principal : 100 3 1.879% 2.635%
Cap/Floor Start (Years): 1.00
Cap/Floor End (Years): 2.00
Cap/Floor Rate (%): 2.000% Imply Breakeven Rate
Pricing Model:
Floor
Cap
Price: 0.1087852
Repeating the process for the option to hedge the third year, in which the
market rate is r2,3 = 2.635, the intrinsic value is now positive 2.635- 2 =
0.635. As the total option price is 0.679, the difference shows the time or
extrinsic value. 21
21
In the total option price there is also an effect of the present value of the payoff. In fact
the contribution of the 2.635-2=0.635 is 0.635/(1+0.01879)^3= 0.601
Pricing Model:
Floor
Cap
Price: 0.6788437
The Cap price to receive the difference between the market and the 2%
strike rate is then the sum of the two caplets option premiums = 0.1088
+0.6788= 0.7876. This price is obtained directly considering a Cap starting
year 1 and finishing year 3, as shown below:
0 Term Structure
Underlying Type: Time (Yrs) Rate (%)
1 1.120%
Settlement Frequency: 2 1.503%
Principal : 100 3 1.879%
Cap/Floor Start (Years): 1.00
Cap/Floor End (Years): 3.00
Cap/Floor Rate (%): 2.000% Imply Breakeven Rate
Pricing Model:
Floor
Cap
Price: 0.7876289
Swaptions
To calculate the premium of the Swaption of the exercise of page 24, we use
the same data than that of the Cap and change the underlying type from
Cap/Floor to Swap Option:
0 Term Structure
Underlying Type: Time (Yrs) Rate (%)
1 1.120%
Settlement Frequency: 2 1.503%
Principal : 100 3 1.879%
Swap Start (Years): 1.00
Swap End (Years): 3.00
Swap Rate (%): 2.257% Imply Breakeven Rate
Pricing Model:
Rec. Fixed
Pay Fixed
Price: 0.3685026
References