Interest Rate Risk

What are Derivatives?

 A derivative is a financial instrument whose value is derived from the value of
another asset, which is known as the underlying.

 When the price of the underlying changes, the value of the derivative also
changes.

 A Derivative is not a product. It is a contract that derives its value from

changes in the price of the underlying.

Example :
The value of a gold futures contract is derived from the value of the
underlying asset i.e. Gold.
What is a Forward?

A forward is a contract in which one party commits to buy and

the other party commits to sell a specified quantity of an
agreed upon asset for a pre-determined price at a specific date
in the future.

It is a customised contract, in the sense that the terms of the

contract are agreed upon by the individual parties.

Hence, it is traded OTC.

Forward Contract Example

I agree to sell Bread

Farmer 500 kg wheat at
Tk 40/kg after 3
months. Make
r
3 months Later

500kgs wheat Bread

Farmer
Tk.20,000 Make
r
Risks in Forward Contracts

Credit Risk – Does the other party have the means to pay?

Operational Risk – Will the other party make delivery? Will

the other party accept delivery?

Liquidity Risk – Incase either party wants to opt out of the

contract, how to find another counter party?
OTC and Exchange Traded Derivatives.

OTC
Over-the-counter (OTC) or off-exchange trading is to trade financial instruments
such as stocks, bonds, commodities or derivatives directly between two parties
without going through an exchange or other intermediary.

• The contract between the two parties are privately negotiated.

• The contract can be tailor-made to the two parties’ liking.
• Over-the-counter markets are uncontrolled, unregulated and have very
few laws.
OTC and Exchange Traded Derivatives
Exchange-traded Derivatives
Exchange traded derivatives contract (ETD) are those derivatives
instruments that are traded via specialized Derivatives exchange or
other exchanges. A derivatives exchange is a market where
individuals trade standardized contracts that have been defined by
the exchange.

The world's largest derivatives exchanges (by number of

transactions) are the Korea Exchange.
There is a very visible and transparent market price for the
derivatives
What are Futures?

 A future is a standardised forward contract.

 It is traded on an organised exchange (similar to a stock exchange)

 Standardisation-
- quantity of underlying
- quality of underlying(not required in financial futures)
- delivery dates and procedure
- price quotes
Terminology

Long position - Buyer

Short position - Seller
Spot price – Price of the asset in the spot market.(market price)
Delivery/forward price – Price of the asset at the delivery date.
Types of Futures

 Physical Delivery

 Cash Settlement

 Physical delivery is similar to Commodity Forwards

 In cash settlement, no physical delivery takes place; only cash settlement

Example of Cash Settled Futures
A flour manufacturer buys 1 ton of wheat in futures market at Tk 1,000; settlement
after three months
At the time of settlement, the future price of wheat is (1) Tk 1,300 or (2) Tk 800
Under 1, seller will pay to buyer Tk 300 to settle the transaction (since he is bound
to deliver at Tk 1,000 which the buyer can then sell at Tk 1,300 making Tk 300
profit)
Under 2, seller will receive from buyer Tk 200 to settle the transaction (since he is
bound to deliver at Tk 1,000 which the buyer can then sell at Tk 800 making Tk 200
loss)

Buyer Position 1 2
Buyer will buy 1 ton of wheat in spot market (Tk 1,300) (Tk 800)
Gain/ (Loss) from futures Tk 300 (Tk 200)
Net Cost (Tk 1,000) (Tk 1,000)
i.e. the price he bought the futures
Loss/ Gain in underlying transaction: (Tk 300) Tk 200
Gain/ (Loss) in future market Tk 300 (Tk200)
Example of Cash Settled Futures .. 2
A flour manufacturer buys 1 ton of wheat in futures market at Tk 1,000; settlement
after three months
At the time of settlement, the market price of wheat is (1) Tk 1,300 or (2) Tk 800
Under 1, seller will pay to buyer Tk 300 to settle the transaction (since he is bound
to deliver at Tk 1,000 which the buyer can then sell at Tk 1,300 making Tk 300
profit)
Under 2, seller will receive from buyer Tk 200 to settle the transaction (since he is
bound to deliver at Tk 1,000 which the buyer can then sell at Tk 800 making Tk 200
loss)

Seller Position 1 2
Seller will sell 1 ton of wheat in spot market Tk 1,300 Tk 800
Gain/ (Loss) from futures Tk (300) Tk 200
Net Selling Price Tk 1,000 Tk 1,000
i.e. the price he bought the futures
Loss/ Gain in underlying transaction: Tk 300 (Tk 200)
Gain/ (Loss) in future market (Tk300) Tk 200
Types of Futures Contracts

 Stock Futures Trading (dealing with shares)

 Commodity Futures Trading (dealing with gold futures, crude oil futures)
 Index Futures Trading (dealing with stock market indices)
 Interest rate futures
Traders in Derivatives Market

There are mainly two types of traders in the Derivatives Market :

HEDGER
A hedger is someone who faces risk associated with price movement of an asset
and who uses derivatives as means of reducing risk.
They provide economic balance to the market.

SPECULATOR
A trader who enters the futures market for pursuit of profits, accepting risk in the
endeavor.
They provide liquidity and depth to the market.
What are Options?

 Contracts that give the holder the option to buy/sell specified quantity of the
underlying assets at a particular price on or before a specified time period.

 The word “option” means that the holder has the right but not the obligation
to buy/sell underlying assets.
Types of Options

 Options are of two types – call and put.

 Call option give the buyer the right but not the obligation to buy a given
quantity of the underlying asset, at a given price on or before a particular date
by paying a premium.
 Puts give the buyer the right, but not obligation to sell a given quantity of the
underlying asset at a given price on or before a particular date by paying a
premium.
Types of Options (cont.)

 The other two types are – European style options and American style options.
 European style options can be exercised only on the maturity date of the option,
also known as the expiry date.
 American style options can be exercised at any time before and on the expiry
date.
Call Option Example

CALL OPTION
Premium = Current Price = Tk.250
Tk.25/share Right to buy 100
Co R shares at a
Amt to buy Call price of Tk.300 Strike Price
option = Tk.2500 per share after 1
month. Expiry date

Suppose after a month, Suppose after a month, market

Market price is Tk.400, then price is Tk.200, then the option
the option is exercised i.e. is not exercised.
the shares are bought. Net Loss = Premium amt
Net gain = 40,000-30,000- = Tk.2,500
2500 = Tk.7,500
Put Option Example

PUT OPTION
Premium = Current Price = Tk.250
Tk.25/share Right to sell 100
Co R shares at a
Amt to buy Call price of Tk.300 Strike Price
option = Tk.2,500 per share after 1
month. Expiry date

Suppose after a month, Suppose after a month, market

Market price is Tk.200, then price is Tk.300, then the option
the option is exercised i.e. is not exercised.
the shares are sold. Net Loss = Premium amt
Net gain = 30,000-20,000- = Tks.2,500
2,500 = Tk.7,500
 Features of Options

 A fixed maturity date on which they expire. (Expiry date)

 The price at which the option is exercised is called the exercise price or strike
price.
 The person who writes the option and is the seller is referred as the “option
writer”, and who holds the option and is the buyer is called “option holder”.
 The premium is the price paid for the option by the buyer to the seller.
 A clearing house is interposed between the writer and the buyer which
guarantees performance of the contract.
Variable Interest Rate - LIBOR

LIBOR is the average interest rate at which major global banks borrow from one another.

It is based on:

five currencies including the U.S. dollar, the euro, the British pound, the Japanese yen,
and the Swiss franc,

seven different maturities—overnight/spot next, one week, and one, two, three, six, and
12 months.

Each morning, just before 11 a.m. Greenwich Mean Time, the ICE Benchmark
Administration (IBA) asks a panel of contributor banks (usually 11 to 16 large,
international banks) to answer the following question: “At what rate could you borrow
funds, were you to do so by asking for and then accepting interbank offers in a reasonable
market size just prior to 11 a.m. London time?

Only banks that have a significant presence in the London market are considered for
membership on the ICE LIBOR panel, which is determined annually.

The IBA calculates the LIBOR rate using a trimmed mean, throwing out figures in the
highest and lowest quartile and averaging the remaining numbers.
Interest Rate Risk

2 months 3 months

Loan agreement
signed Loan drawdown Loan maturity

3 MONTH LIBOR

◦ If one borrows at a variable rate, the interest rate risk represents the risk that
at the time of loan drawdown, the rate of interest is higher than the current
rate
◦ If one deposit at a variable rate, the interest rate risk represents the risk that
at the time of loan drawdown, the rate of interest is lower than the current
rate
Interest Rate FRA

This is similar to commodity forward. Interest rate is fixed earlier with a bank to
be applied when the loan drawdown takes place

3v6 FRA

3 months 3 months

Loan agreement
signed Loan drawdown Loan maturity

3 MONTH LIBOR
Interest Rate FRA

A bank has quoted the following rates for dealing in FRAs

Bid Offer
3v6 4.59 4.56

It is 24th March and your company wants to fix an interest rate for borrowing CU 1
million for three months from 24th June.

What is the payment to be made on the FRA if the company entered a 3 v 6 FRA
with a bank, assuming that interest rates rise to 4.65% from their current level of
4.5%?

Also, show the effective rate of interest including the supporting calculations .
 Interest Rate FRA

Solution:

Since the company will be borrowing in three months’ time and wished to hedge the interest rate risk in
the underlying transaction, it can buy (Bid) an FRA. This will mean that in three months’ time, the
company will pay the amount of FRA to the bank and the bank will pay the company the spot rate.

24th March
Company buys FRA at 4.59%

24th June
Company pays bank
Bank pays company
Company receives (net)
Amount
Interest on borrowings
Net Payment
Effective rate of interest
4.59%
4.65% (spot rate)
0.06%
150 (0.06% x 1,000,000 x 3/12)
(11,625) (4.65% x 1,000,000 x 3/12)
(11,475)
11,475 x 12 % = 4.59%
Interest Rate Futures
An interest rate future is a financial derivative that allows exposure to changes in interest rates.
Interest rate futures price moves inversely to interest rates.
Future Price = 100 – i (If interest rate is 5%, future price will be 95)

Simple Example:
I will borrow at LIBOR (Current 3 month LIBOR is 3%) after 2 months
2 month futures are quoted at 97. After 2 months actual interest rate is (1) 4% and future price is 96
(2) 2% and future price is 98

After 2 months
Sell 97 97
Spot 96 98
Gain / (Loss) 1 (1)
Interest payment (4) (2)
Net Cost (3) (3)
Interest Rate Futures
It is 1 January, and a company has identified that it will need to borrow CU 10 million on 31st March for 6 months.
The spot rate on 1 January is 8% and March 3 month interest rate futures with a contract size of CU 500,000 are
trading at 91.
Demonstrate how futures can be used to hedge against interest rate rises. Assume that at 31st March the spot rate of
interest is 11% and the March interest rate futures price has fallen to 89.

Solution
1st January
Sell future at 91
No of contracts 10,000,000 x 6 = 40 contracts
500,000 3
31st March
Sell 91
Spot 89
Gain 2%
Amount 100,000 (2% x 500,000 x 40 x 3/12)
Interest payment (550,000) (11% x 10,000,000 x 6/12)
Net payment (450,000)
Effective Rate 450,000 x 12 % = 9%
10,000,000 6
Interest Rate Options
Panda Ltd wishes to borrow CU 4 million fixed rate in 12June for nine months and wishes to protect
itself against rates rising above 6.75%. It is 11 May and the spot rate is currently 6%. The data is as
follows:

SHORT CU OPTIONS
CU500,000
Strike price Calls Puts
June Sept Dec June Sept Dec
93.25 0.16 0.19 0.21 0.14 0.92 1.62
93.50 0.05 0.06 0.07 0.28 1.15 1.85
93.75 0.01 0.02 0.03 0.49 1.39 2.10

Panda negotiates the loan with the bank on 12 June (when the CU 4m loan rate is fixed for the full
nine months) and closes out the hedge.
What will be the outcome of the hedge and the effective loan rate if prices on 12 June are as follows:

Closing prices
Case1 Case2
Spot price 7.4% 5.1%
Futures price 92.31 94.75
Interest Rate Options
Solution

The strike rate of 93.75% appears to be most optimal considering the differential interest
rate and premium.

On 11 May

Strike price of 93.75

No of contracts (4,000,000 / 500,000) x 9/3 = 24 contracts
Premium: 0.49% x 24 x 500,000 x 3/12 = CU 14,700

On 12 June Case 1 Case 2

Spot rate of interest 7.4% 5.1%
Sell at 93.75 93.75
Future Spot rate 92.31 94.75
Exercise Yes No
Gain 1.44% -
Amount 43,200 (1.44% x 24 x 500,000 x 3/12)
Interest Payment (222,000) (7.4% x 4,000,000 x 9/12)
(153,000) (5.1% x 4,000,000 x 9/12)
Premium (14,700) (14,700)
Net Payment (193,500) (167,700)
Effective Rate of Interest 6.45% (193,500 / 4,000,000 x 12/9%)
5.59% (167,700 / 4,000,000 x 12/9%)
 What are SWAPS?

 In a swap, two counter parties agree to enter into a contractual agreement

wherein they agree to exchange cash flows at periodic intervals.
 Most swaps are traded “Over The Counter”.
 Some are also traded on futures exchange market.

Interest Rate Swap

 A company agrees to pay a pre-determined fixed interest rate on a notional
principal for a fixed number of years.
 In return, it receives interest at a floating rate on the same notional
principal for the same period of time.
 The principal is not exchanged. Hence, it is called a notional
amount.
What are Interest rate SWAPS?

Example 1
Company A has borrowed CU 10 million at a fixed interest rate of 9% per
annum. Company B has also borrowed CU 10 million but pays interest at LIBOR
+ !%. LIBOR is currently 8% per annum.

Both companies decide to swap their obligations.

• Company A thinks that interest rates will come down
• Company B thinks that interest rates will go up

Company A
Company B
Now 9%
LIBOR +1%
Company A pays B LIBOR + 1%
(LIBOR +1%)
Company B pays A (9%)
9%
 What are Interest rate SWAPS?

Example 2
Goodcredit Ltd has been given a high credit rating. It can borrow at a fixed rate
of 11% or at a variable interest rate equal to LIBOR. It would like to borrow at
a variable rate.
Secondtier Ltd is a company with a lower credit rating, which can borrow at a
fixed rate of 12.5% or at a variable rate of LIBOR + 0.5%. It would like to
borrow at a fixed rate.

Solution Goodcredit Secondtier

Total
Preferred rate LIBOR 12.5%
LIBOR + 12.5%
Could borrow 11% LIBOR + 0.5%
LIBOR + 11.5%
Savings
1%