Lecture 3 Interest rate derivatives

IMQF, Spring Semester 2011/2012

Module: Derivatives and Fixed Income Securities
Course: Derivatives, part I
Lecturer: Milo Boovi

Lecture outline
Interest rate forwards and futures
Swaps

Interest rate forwards and futures

Types of interest rates

Treasury rates
Interbank rates
Repo rates

Treasury rates
Rates on instruments issued by a government in its own
currency

Interbank rates
Daily rates of interest at which a panel of banks is
prepared to lend or borrow money in an interbank
market
Lending -> offer rate
Borrowing -> bid rate

Examples:
LIBOR (London Interbank Offered Rate)
EURIBOR (Euro Interbank Offered Rate)
BELIBOR (Belgrade Interbank Offered Rate)

Repo rates
Repurchase agreement (or repo) is an agreement
where a financial institution that owns securities agrees to
sell them today for X and buy them bank in the future for
a slightly higher price, Y
The financial institution obtains a loan.
The rate of interest is calculated from the difference
between X and Y and is known as the repo rate

Zero rates
A zero rate (or spot rate), for maturity T is the rate of
interest earned on an investment that provides a payoff
only at time T

Forward rates
The forward rate is the rate of interest agreed today for
borrowing that will occur in the future.
It is implied by todays term structure of spot interest rates.
No-arbitrage argument

Example
One-year spot rate = 4%
18-month spot rate = 4.5%
Find the forward rate between 12 and 18 months.
Solution:

(1 + R0,18m ) 3 / 2 = (1 + R0,1 )(1 + F12 m ,18m )1/ 2

(1.045) 3 / 2 = (1.04)(1 + F12 m ,18m )1/ 2
F12 m ,18m = 5.51%
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Forward rates: general case

Annual compounding:

[1+ R(0, t1 )] [1+ F(t1, t2 )]

t1

t2 !t1

= [1+ R(0, t2 )]

t2

Continuous compounding:

e R(0,t1 )t1 e F (t1,t2 )(t2 !t1 ) = e R(0,t2 )t2

R(0, t2 )t2 ! R(0, t1 )t1
" F(t1, t2 ) =
t2 ! t1
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Forward rate agreement

A forward rate agreement (FRA) is an OTC agreement
that a certain rate will apply to a certain principal during
a certain future time period

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Forward rate agreement

Simplest OTC interest rate contracts.
Two parties exchange cash flow:
Only once, at a predetermined date.
Based on two different rates
Usually, one is fixed and predetermined.
The other is variable and determined during the life of the
contract.

The difference between two rates is multiplied by the

notional principal.
Risk is symmetric, therefore no premium.
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Example
Consider a long position in a 3-month forward on LIBOR 3x6:
We pay F(3m,6m) = 4.85% in 6 months.
We receive 3m spot LIBOR determined after 3 months, R(3m,6m).
N = $ 2,000,000.
Day count convention is 30/360.

Cash flow depends on R(3m,6m):

If R(3m,6m) = 4.64%, our cash flow is
(4.64% 4.85%) $ 2,000,000 (90/360) = $1,050.
If R(3m,6m) = 4.90%, our cash flow is:
(4.90% 4.85%) $ 2,000,000 (90/360) = + $ 250.
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Day count convention

Defines:
The period of time to which the interest rate applies
The period of time used to calculate accrued interest
(relevant when the instrument is bought of sold)

14

Day count conventions in the U.S.

Treasury Bonds:

Actual/Actual

Corporate Bonds:

30/360

Money Market Instruments:

Actual/360

15

Treasury Bill prices in the U.S.

360
P=
(100 Y )
n
Y is cash price per $100
P is quoted price

16

US Treasury Bond price quotes

17

Treasury Bond futures

Cash price received by party with short position =
Most recent settlement price Conversion factor +
Accrued interest

18

Example
Most recent settlement price = 90.00
Conversion factor of bond delivered = 1.3800
Accrued interest on bond = 3.00
Price received for bond is 1.380090.00+3.00 = 127.20

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Conversion factor
The conversion factor is the present value of cash flows
generated by the bond.
Inputs:
Yield curve is flat at 6%
Semiannual compounding

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CBOT T-Bonds and T-Notes

Factors that affect the futures price:
Delivery can be made any time during the delivery month
Any of a range of eligible bonds can be delivered

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Eurodollar futures
A Eurodollar is a dollar deposited in a bank outside the
United States
Eurodollar futures are futures on the 3-month Eurodollar
deposit rate (same as 3-month LIBOR rate)
One contract is on the rate earned on $1 million
A change of one basis point or 0.01 percentage points in
a Eurodollar futures quote corresponds to a contract
price change of $25

22

Eurodollar futures
A Eurodollar futures contract is settled in cash
When it expires (on the third Wednesday of the delivery
month) the final settlement price is 100 minus the actual
three month Eurodollar deposit rate

23

Eurodollar futures
Date

Quote

Nov 1

97.12

Nov 2

97.23

Nov 3

96.98

Dec 21

97.42
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Example
Suppose you take a long position in a contract on
November 1
The contract expires on December 21
The prices are as shown

25

Example
If on Nov. 1 you know that you will have $1 million to
invest on for three months on Dec 21, the contract locks
in a rate of
100 97.12 = 2.88%
At expiry, the rate is
100 97.42 = 2.58%
Total gain on the futures contract is 30$25 =$750

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TED spread

27

Swaps

28

Nature of swaps
A swap is an agreement to exchange cash flows at
specified future times according to certain specified rules

29

Example: A plain vanilla interest

rate swap
An agreement by Microsoft to receive 6-month LIBOR &
pay a fixed rate of 5% per annum every 6 months for 3
years on a notional principal of $100 million
Next slide illustrates cash flows that could occur (day
count conventions are not considered)

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One possible outcome for cash flows

to Microsoft
Date

LIBOR

Floating Cash
Flow

Fixed Cash
Flow

Net Cash
Flow

Mar 5, 2012

4.20%

Sep 5, 2012

4.80%

+2.10

2.50

0.40

Mar 5, 2013

5.30%

+2.40

2.50

0.10

Sep 5, 2013

5.50%

+2.65

2.50

+ 0.15

Mar 5, 2014

5.60%

+2.75

2.50

+0.25

Sep 5, 2014

5.90%

+2.80

2.50

+0.30

+2.95

2.50

+0.45

Mar 5, 2015

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Typical uses of an interest rate swap

Converting a liability from
fixed rate to floating rate
floating rate to fixed rate

Converting an investment from

fixed rate to floating rate
floating rate to fixed rate

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Intel and Microsoft transform a liability

5%
5.2%
Intel

MS
LIBOR+0.1%
LIBOR

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Financial institution is involved

4.985%

5.015%

5.2%
Intel

F.I.

MS
LIBOR+0.1%

LIBOR

LIBOR

Financial Institution has two offsetting

swaps

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Intel and Microsoft transform an asset

5%
4.7%
Intel

MS

LIBOR-0.2%
LIBOR

35

Financial institution is involved

5.015%

4.985%

4.7%
Intel

F.I.

MS

LIBOR-0.2%
LIBOR

LIBOR

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Quotes by a swap market maker

Maturity

Bid (%)

Offer (%)

Swap Rate (%)

2 years

6.03

6.06

6.045

3 years

6.21

6.24

6.225

4 years

6.35

6.39

6.370

5 years

6.47

6.51

6.490

7 years

6.65

6.68

6.665

10 years

6.83

6.87

6.850
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Day count convention

A day count convention is specified for for fixed and
floating payment
For example, LIBOR is likely to be actual/360 in the US
because LIBOR is a money market rate

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The Comparative Advantage

Argument
AAACorp wants to borrow floating
BBBCorp wants to borrow fixed

Fixed

Floating

AAACorp

4.0%

6 month LIBOR 0.1%

BBBCorp

5.2%

6 month LIBOR + 0.6%

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The Comparative Advantage

Argument

4.33%

4.37%

4%
AAACorp

F.I.

BBBCorp
LIBOR+0.6%

LIBOR

LIBOR

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Valuation of an interest rate swap

Initially interest rate swaps are worth zero
At later times they can be valued as the difference
between the value of a fixed-rate bond and the value of
a floating-rate bond
Alternatively, they can be valued as a portfolio of
forward rate agreements (FRAs)

41

Valuation in terms of bonds

The fixed rate bond is valued in the usual way
The floating rate bond is valued by noting that it is worth
par immediately after the next payment date

42

Valuation of floating-rate bond

Value = PV
of L+k* at t*
Value =
L+k*
0

t*

Valuation
Date

First Pmt
Date
Floating
Pmt =k*

Value = L

Second
Pmt Date

Maturity
Date

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Example
Pay six-month LIBOR, receive 8% (s.a. compounding) on a
principal of $100 million
Remaining life 1.25 years
LIBOR rates for 3-months, 9-months and 15-months are
10%, 10.5%, and 11% (cont comp)
6-month LIBOR on last payment date was 10.2% (s.a.
compounding)

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Valuation using bonds

Time

Bfix cash
flow

Bfl cash
flow

Disc
factor

PV
Bfix

PV
Bfl

0.25

4.0

105.100

0.9753

3.901

102.505

0.75

4.0

0.9243

3.697

1.25

104.0

0.8715

90.640

Total

98.238

102.505

Swap value = 98.238 102.505 = 4.267

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Valuation in terms of FRAs

Each exchange of payments in an interest rate swap is
an FRA
The FRAs can be valued on the assumption that todays
forward rates are realized

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Valuation using FRAs

Time

Fixed
Floating Net Cash
cash flow cash flow
Flow

Disc
factor

PV
Bfl

0.25

4.0

-5.100

-1.100

0.9753

-1.073

0.75

4.0

-5.522

-1.522

0.9243

-1.407

1.25

4.0

-6.051

-2.051

0.8715

-1.787

Total

-4.267

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An example of a currency swap

An agreement to pay 5% on a sterling principal of
10,000,000 & receive 6% on a US$ principal of
$18,000,000 every year for 5 years

48

Exchange of principal
In an interest rate swap the principal is not exchanged
In a currency swap the principal is usually exchanged at
the beginning and the end of the swaps life

49

The cash flows

Date

Dollar Cash
Flows
(millions)

Sterling cash
flow
(millions)

Feb 1, 2011

18.0

+10.0

Feb 1, 2012

+1.08

0.50

Feb 1, 2012

+1.08

0.50

Feb 1, 2014

+1.08

0.50

Feb 1, 2015

+1.08

0.50

Feb 1, 2016

+19.08

10.50

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Typical uses of a currency swap

Convert a liability in one currency to a liability in another
currency
Convert an investment in one currency to an investment
in another currency

51

Valuation of currency swaps

Like interest rate swaps, currency swaps can be valued
either as the difference between two bonds or as a
portfolio of forward contracts

52

Example
All JPY LIBOR rates are 4%
All USD LIBOR rates are 9%
5% is received in yen; 8% is paid in dollars. Payments are
made annually
Principals are $10 million and 1,200 million yen
Swap will last for 3 more years
Current exchange rate is 110 yen per dollar

53

Valuation in terms of bonds

Time

Cash Flows ($)

PV ($)

Cash flows (yen) PV (yen)

0.8

0.7311

60

57.65

0.8

0.6682

60

55.39

0.8

0.6107

60

53.22

10.0

7.6338

1,200

1,064.30

Total

9.6439

1,230.55

Value of Swap = 1230.55/110 9.6439 = 1.5430

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Valuation in terms of forwards

Time

$ cash
flow

Yen cash Forward

Yen cash
flow
Exch rate flow in $

Net
Cash
Flow

Present
value

-0.8

60

0.009557

0.5734

-0.2266

-0.2071

-0.8

60

0.010047

0.6028

-0.1972

-0.1647

-0.8

60

0.010562

0.6337

-0.1663

-0.1269

-10.0

1200

0.010562

12.6746

+2.6746

2.0417

Total

1.5430

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Swaps and forwards

A swap can be regarded as a convenient way of
packaging forward contracts
Although the swap contract is usually worth close to zero
at the outset, each of the underlying forward contracts
are not worth zero

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Credit risk
A swap is worth zero to a company initially
At a future time its value is liable to be either positive or
negative
The company has credit risk exposure only when its value
is positive
Some swaps are more likely to lead to credit risk exposure
than others

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Other types of swaps

Floating-for-floating interest rate swaps

Amortizing swaps
Step up swaps
Forward swaps
Constant maturity swaps
Compounding swaps
LIBOR-in-arrears swaps
Accrual swaps
Diff swaps
Cross currency interest rate swaps
Equity swaps
Extendable swaps
Puttable swaps
Commodity swaps
Volatility swaps

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