Forward Rate Agreement

A FRA is agreement to exchange a fixed rate for a floating rate. This contract has value
equal to zero at inception by no arbitrage. Thus, we can write:

FRA ( t ,T , S , N , K )=N ( K L(T , S) ) P(t , S)

By definition of LIBOR rate we have

( P(T1, S) 1) 1

L ( T , S )=

Notice that the amount 1/P(T,S) at time S is equivalent to 1 at time T, infact:

P (T , S )

1
=1
P(T , S)

Therefore 1/P(T,S) at time S, which is equal to 1 at time T, is equal to P(t,T) at time t.

So, we can write

1
1
1 ) P ( t , S )
(
( P (T , S) )

FRA ( t ,T , S , N , K )=N K

FRA ( t ,T , S , N , K )=N ( K P ( t , S )P ( t ,T )+ P ( t , S ))
From this, with nominal = 1, the fixed rate of the FRA is given by

K=

P ( t ,T )P(t , S) 1
P(t , S)

Interest Rate Swap

The discounted payoff of a payer IRS can be expressed as (with nominal equal to 1)

PS ( , , K , 1 )=

i= +1

P(t ,T i) i ( L ( T i1 , T i ) K )

PS ( , , K , 1 )=P ( t , T ) P(t , T )K

i= +1

P( t , T i ) i

Since the value of a payer swap is equal to zero at inception, we have that:

K=S , ( t )=

P ( t , T ) P(t , T )

i= +1

P(t , T i) i

Multiplying and dividing by

P (t , T i ) i

P (t , T i ) i

i= +1

, we have

i= +1

PS=

i= +1

P(t ,T i) i
P(t ,T i) i

P ( t , T )P(t ,T )K

i = +1

P(t , T i) i

i= +1

Which gives:

PS=

i=+ 1

P (t , T i ) i ( , K )

Bond-Swap Relationship
Consider a payer forward swap

PFS ( t , T ,T , , N , K ) =N ( P ( t , T ) P ( t ,T ) ) N

i= +1

i P( t , Ti)

With T = t we have

PFS ( t , T ,T , , N , K ) =N N P ( t , T ) KN

i= +1

i P ( t ,T i )

PS=N CBP(t , T , K , N )
Where PS = Payer Forward Swap NPV.
If we rearrange this relation we get

CBP ( t ,T , K , N )=1PS
Asset Swap
An asset swap is an exchange of flow of payments from a given security (the asset, in
our case, the bond) for a different set of cash flows. For example, if you buy an asset
swap written on a U.S. Government Bond, you will swap the coupons of this bond with
another flow of payments, for example, Libor minus a spread (say 20 basis point). In
this way, you will get a floating coupon (Libor minus spread) instead of the fixed
coupon rate of the bond but you will still have the same risk exposure of the bond. If
you buy an asset swap of this kind, you think that Libor rates will go up, and you will
receive the coupons paid at that level instead of those paid a the level of the safer
U.S. bond.

The asset swap seller pays to the asset swap buyer, or receive from him, the
difference 100-CBPmkt in such a way that the asset swap buyer always receives 100.
So, when CBPmkt trades above par the asset swap seller has to pay more than 100 to
the buyer while the buyer is paying 100 for something worth more. When the price of
CBPmkt is below par, the asset swap seller receives 100 for something below that level
while, who bought the bond, has paid 100 for something cheaper.
Then, a swap is started in which the asset swap seller receives the coupon from the
bond that he has sold and, for that streaming of coupons, he will pay to the asset swap
buyer a floating leg equal to the Libor/Euribor rate plus the spread.
From the perspective of the asset swap buyer (nominal = 1):
mkt

CBP

i=1

i=1

( t , T , K ,1 ) 1+ i P ( 0,T i ) ( L ( T i1 ,T i ) + AS ) K i P ( 0, T i) =0

Since floating notes trade at par, we can write:

n

i P ( 0, T i ) L ( T i1 ,T i ) + P ( 0, T n ) =1
i=1

i P ( 0, T i ) L ( T i1 ,T i )=1P ( 0,T n )
i=1

So:
n

1P ( 0, T n ) + i P ( 0, T i ) ASK i P ( 0, T i )=0
i=1

CBP

i=1

mkt

( t , T , K , 1 )1+

mkt

CBP

i=1

i=1

( t , T , K ,1 ) P ( 0,T n ) + i P ( 0,T i ) ASK i P ( 0,T i )=0

i=1

i=1

P ( 0,T n ) + K i P ( 0,T i )CBPmkt ( t ,T , K , 1 )= i P ( 0, T i) AS

AS=

mkt
CBP ( t , T , K , 1 )CBP ( t , T , K ,1 )
n

i P ( 0,T i )
i=1

When the bond on the market trades at par, we have:

mkt

CBP
1

i=1

i=1

( t , T , K ,1 ) 1+ i P ( 0,T i ) ( L ( T i1 ,T i ) + AS ) K i P ( 0, T i) =0

i=1

i=1

i P ( 0, T i ) ( L ( T i1 , T i ) + AS )K i P ( 0,T i )=0
n

1P ( 0, T n ) + i P ( 0, T i ) ASK i P ( 0, T i )=0
i=1

i=1

CBP ( t , T , K , 1 )1= i P ( 0, T i) AS
i =1

AS=

CBP ( t , T , K , 1 )1
n

i P ( 0,T i )
i=1

Caps and Floors

A cap is a payer IRS in which you receive a stream of coupons given by the maximum
between the Libor forward rate and a fixed rate K:

D ( t , T i) N i max [ L ( T i1 , T i) K , 0]

i= +1

While in a Floor Contract you exchange the reverse:

D ( t , T i) N i max [ K L ( T i1 ,T i ) , 0]

i= +1

Black-76 Model
Black model is a variant of the Black and Scholes option pricing model. The Black-76
approach is to use the same approach of B&S with the use of the forward price F of the
underlying instead of the spot one.
The main assumption is that the forward rates are lognormally distributed.
Black Formula was used to translate volatility into prices. We can see that there is a
one to one relation between prices (of a Cap or a Caplet for example) and volatility.
The Black formula for Cap:

P( 0, T i ) i Bl ( K , F ( 0,T i1 , T i ) , v i , 1)

CapBl ( 0, , N , K , , ) =N

i= +1

Where the general Black formula can be written as:

Bl ( K , F ( 0, T i1 ,T i ) , v i , ) =F ( d 1 ( K , F , v ) ) K ( d 2 ( K , F , v ) )
With

ln
d 1=

( FK )+ v /2
2

ln
,

d 2=

( FK )v /2
2

and

v i= , T i1

where

is the

quoted Cap volatility.

The market quotes caps volatilities for ATM options and several strikes. Cap volatility
are known as flat volatilities while the caplet volatilities are known as spot volatilities.
Caplet volatilities represents a measure of the forward rate volatility.
There is a sort of inconsistency in this market practice: the same caplet belonging to
two different caps is being valued using different volatilities even when it is referred to
the same period. At the same time, different caplets of the same cap have the same
volatility.
Market implied volatilities often display an hump in the beginning of their term
structure. This is due to the meaning assigned to the volatility: uncertainty is bigger in
the intermediate region but lower for longer maturities.
There are two main problems related to the Black-76 model: the first is that negative
rates are not allowed and a zero strike Floor cannot be priced (in fact you will have
ln(F/0) and d1 is not defined). Moreover, d1 is not defined also when rate are negative
because you will have ln(-F/K). The second problem is that the smile is not accounted
for. And this is in contrast of the market practice: if you compute the price following
the Black model for 2 caps with same contract features but with 2 different K, you will
recover 2 different values. To face the smile, the model is used with different input
volatilities for different strikes.
To face the first problem, i.e. the negativity of rates, Black model has been shifted:

dF ( t ,T , S )=

shifted

( F ( t , T , S ) ) d W Qs ( t )

And for a (T,S) caplet with strike K:

Caplet ( t ,T , S , , K , v t , )=P ( t , S ) Bl (K , F ( t , T , S ) , v t )

Where

v T = shifted
, T

Swaptions
An European payer swaption is an option giving the right to enter a payer IRS at a
given future time, called the swaption maturity. If you buy a payer swaption, you will
have the right to enter, at maturity, in a payer swap contract.
Usually the swaption maturity coincides with the first reset date of the underlying IRS.
The length of the underlying IRS is called the tenor of the swaptions. Atm swaptions
are quoted for maturities ranging from 1 month to 30 years with tenors ranging from 1
year to 30 years.
The discounted payoff of a payer swaption with maturity T is given by:

N D ( t ,T )

P ( T ,T i ) i ( F ( T , T i1 , T i ) K ) +

i= +1

Which can be rewritten as:

N D ( t ,T ) (ST ( T )K )
,

P ( T ,T i ) i

i= + 1

For Swaptions the Black formulas become:

S ,
P ( 0,T i ) [ ( T ) N ( d 1 ) KN ( d2 ) ]

PSBl ( 0, T , S , N , K , , ) =N

i= + 1

Where

ln
d 1=

ln
d 2=

( SK )+ v / 2

( SK )v /2
,

v i= , T

And in the market is quoted. Vt / sqrt(T) = can be thought as the average volatility
of the forward rate between 0 and T.

Notice that, with respect to caps, there is one more dimension given by the tenor of
the swaption (the other two are the strike and the option maturity).
Caps can be decomposed in caplets. Then, by summing over all the caplets, you get
the cap price; so you need to model each forward at once. In a swaption this is not
possible: you have to deal with the correlation between the forward rates so you
cannot decompose the sum as you do for caps.
Jamshidian Trick
We know that a swap can be seen as an exchange of coupon bonds; a swaption is
option on an exchange of coupon bonds. So to price of a swaption we need an
expression for a coupon bond option. We can express a coupon bond option as a
portfolio of ZCB thanks to Jamshidian Trick. Given the coupon bond price

t , Ti ,
n

c i P ( t ,T i )= ci ( r (T ))
i=1

CB ( t , C , T )=
i=1

We want to write an expression for this coupon bond option using only ZCB. The Payoff
of the option can be written as (put option):

[K CB(t , C , T )] +
The first step consists in finding r*, solution of the following

t ,T i ,
c i ( r )=K
n

i=1

Which allows to rewrite the payoff as:

T , Ti ,
c i ( r ) (T , T i , r ( T ) )

+
i=1

If the model satisfies the condition:

(t ,T , r ( t ) )
<0, 0<t< s
r
We can write:

(t , T i , r )
+
ci
n

i=1

So we can price a coupon bond option as a portfolio of options on ZCBs. The value of
the strike of these option is calculated as the value of the ZCB given a particular value
for the short rate.
We can use the same trick for swaptions. Swaptions can be thought as options on the
exchange of coupon bonds. A payer swap can be replicated by 1-CB(t,T,C), so the
swaption is

[1CB ( t ,C ,T ) ]+
As before, we set the strike equal to a bond with the short rate that makes equal to
zero the equation:
B ( t ,t i ) r

c i A ( t , ti ) e

= 1

i=1

B (T ,ti ) r

K i= A ( T ,t i ) e

And, as before, we get that a swaption can be priced as a portfolio of zero coupon
bond options.

Bermudan Swaptions
A Bermudan swaption gives the holder the right to enter in an interest rate swap
contract at different dates (usually the swap reset dates) with some days of
notification to the counterparty.
Callable Bond
A callable bond is a bond which allow the issuer to call the bond (usually at par) during
the life of the bond. The replication of a callable bond can be obtained by simply
adding a swaption to the swap used to replicate the bond. If there is more than one
callability date, it is clear that the swaption we need is a Bermudan one. With a
receiver swaption with the same contractual features of the swap, we can offset it,
which represents the economic equivalent of calling the bond at par.
For example, take a 5 year coupon bond that pays a coupon equal to 3.5%. The swap
npv with the same contract features of the bond is equal to 4% (of the nominal). With
a nominal equal to 100, the bond price is 96 so it trades below par; this means that
the market is offering higher rates than the coupon rate, in fact the npv of the swap is
positive, which means that the floating rate (market rate) is higher than the fixed swap
rate. If this bond was callable, to replicate it we need also the npv of a Bermudan
swaption:

NPV callable bond=1( Payer Swap+ Bermudan Swaption)

Moreover, notice that the price of a Bermudan swaption is negatively correlated with
the volatility of interest rates. As the volatility increases, the interest rate oscillates
more and it is more probable that the bond will be called back (because when interest
rates go down, the price of the bond will be more appealing to the issuer):

Callable Bond Bermudan Swaption

=

A non-callable coupon bond usually has an higher price than a callable one.

Reverse Floater
Reverse Floaters are floating rate bonds whose return is inversely related to interest
rates dynamics. Its payoff can be replicated by the sum of an payer IRS and a Cap
with the fixed rate of theIiRS as strike:

KF ( T ) +max ( F ( T ) K , 0)
Nowadays such contracts are not used: rates are too low now, and, if lower than K, this
contract would pay K for a small F. Since nobody gives you money for nothing, a floor
is usually added to that contract. So when rate are very low, you get the difference

KF ( T )

but, at the same time, you have to pay

max ( KF ( T ) ,0) .