Derivative Instruments

FI6051
Finbarr Murphy
Dept. Accounting & Finance
University of Limerick
Autumn 2009

Week 11 – Interest Rate Derivatives

Black’s Model
 The Black-Scholes Model was an “overnight”
success
 It was quickly adapted for Interest Rate (IR)
derivatives
 But, IR Derivatives are more complex than
equity/currency options because:
 IRs behave differently
 The entire zero-curve must be modeled
 Volatilities across the curve are different
 IRs are used for discounting and payoff

 We start with Fischer Black’s (Black’s) model

 Black’s Model
 Consider a european call option, on an underlying
variable, value V
 T – time to maturity
 F – forward price of V with maturity at T
 F0 – Value of F at time = 0 (now)
 K – The option strike price
 P(t,T) – The price at t, of a zero coupon bond paying $1 at
time T
 VT – Value of V at T
 σ – Volatility of F

 VT has a lognormal distribution, with SD of lnVt =σ T

 E[VT] = F0
 Black’s Model

V=VT
F=F0
E[VT ]=F0

$1
P(t,T)

t=0 t=t t=T

F = F0 V = VT
= forward price of V (maturity T)
 Black’s Model
 At maturity (time = T), the payoff from the option is
max(VT − K ,0 )
given by

 The lognormal assumption implies a payoff

E (VT ) N ( d1 ) − KN ( d 2 )
 where
ln[ E (VT ) K ] + σ 2T 2
d1 =
σ T
ln[ E (VT )K ] −σ T 2 2
d2 = = d1 − σ T
σ T
 Black’s Model
 Discounting at the risk-free rate and
 Assuming E[VT] = F0

c = P( 0, T ) [ F0 N ( d1 ) − KN ( d 2 ) ]

 similarly
p = P( 0, T ) [ KN ( − d 2 ) − F0 N ( − d1 ) ]
 Black’s Model
 Blacks (1976) model is very similar to the Black-
Scholes (1973) model. The two main differences
are:
 Blacks Model uses the forward bond price instead of
the spot price
 There is no drift, we only assume that the forward
bond price is lognormally distributed.
 Bond Options
 Embedded Options
 Callable Bonds
 Puttable Bonds

 European Bond Options

 ( )[ ( ) − KN ( d 2 ) ]
Recall:c = P 0, T F0 N d1
p = P( 0, T ) [ KN ( − d 2 ) − F0 N ( − d1 ) ]
 Where d = ln [ F 0 K ] + σ 2
T 2
1
σ T
 and d 2 = d1 − σ T
 Bond Options
 Recall that the forward contract on an investment
asset providing an income with PV = I

F0 = ( S 0 − I ) e rT
 Substituting from previous slides:
B0 − I
F0 =
P (0, t )

 All prices are assumed to be cash prices (not quoted

prices)
 Bond Options
 Take the example from Hull p649:

Item Description
B0 $960 Current Bond (cash price)
K $1,000 Strike Price
T10m 0.8333 (=10/12 years) Option Time to Maturity
r10m 10% Risk free rate, 10months
r9m 9.5% Risk free rate, 9months
r3m 9.0% Risk free rate, 3months
C 10% Annual coupon (paid semi-annually)
σ 9% Forward Bond Price volatility
 Bond Options
s s
th
s th mth
3m = 9m 10
t= t t=

t=0
t=9.75yrs
9years, 9months – Bond Maturity
10months
Option Maturity

A coupon of 5% is paid ($50)

 B0 = $960
 I = 50e-r x0.25 +50e-r
3m 9m x0.75
= $95.45
 P(0,T10m ) = e-r x(10/12) 10m
= e-0.1x(10/12) = 0.9200
 F0 = (B0 – I)/P(0, T10m )
= (960-95.45)/0.92
= $939.68
 Floating Rate Notes
 AKA, “floaters”
 A note with a variable interest rate
 The adjustments to the interest rate are usually
made every six months and are tied to a certain
money-market index such as
 3-month Treasury bill or
 3-month LIBOR
 Issued by corporations or agencies such as
 The Federal Home Loan Bank
 Fannie Mae
 Freddie Mac
 Can have a spread above the benchmark
 Floating Rate Notes
 Example terms
 Corporation XYZ issues a seven-year floating-rate
note with the following features:
 Maturity date: September 1, 2010
 Benchmark rate: Three-month U.S. Treasury bill
 Spread: 75 basis points
 Interest frequency: Quarterly
 Initial interest rate: 1.69% (based on an initial Treasury bill
rate of 0.94% on September 9, 2003)
 If three-month Treasury bill rates increase 0.5% to
1.44%, the coupon would reset to 2.19%.
 If three-month Treasury bill rates decline 0.5% to
0.44%, the coupon would reset to 1.19%.
 Floating Rate Notes

2.16000

2.15000

2.14000

2.13000

2.12000

2.11000

2.10000

2.09000 EUR LIBOR

1-Month FRN
2.08000

2.07000

2.06000
05

05

05

05

05

05

05

05

05
1/

3/
2/

4/

5/

6/

7/

8/

9/
/0

/0

/0

/0

/0

/0

/0

/0

/0
03

03

03

03

03

03

03

03

03

Data Source: BBA

 Interest Rate Caps
 OTC Instruments
 Provide insurance against the rate of interest on a
FRN exceeding a certain level
2.8
FRN Rate
2.7 CAP
2.6

2.5

2.4

2.3

2.2 (FRNRate-Cap)*Nominal
----------------------
2.1
No. of Payments per Year
2
Ju - 0 5

S - 05

Ju - 06

S - 06
eb 5

M -0 5

F -0 6

M -0 6
D -05

A -06

D -06
A - 05

N -05

N -06
Ju 05

Ju 06

6
O 05

Ja 05

O 06
M -06

A 06
M -05

A 05
0

-0
n-

-
-

-
-

-
ay

ay
g

g
r

r
n

v
ct
ct

l
n
l

ec

ec
n

ar
ep

ep
ar

eb
p

p
u

o
Ja
F
 Interest Rate Caps
 From the previous slide, assume:
 A 2-year FRN
 Cap Rate = 2.5%
 Principle = €100,000,000
 Tenor (τ) = 1/12 (time between resets)
 On June 1st , the FRN rate set to 2.55%

 So the payment to the cap holder on July 1st (end of

the period)
( 2.55 − 2.50) * €100MM
Payoff = = €4,166.66
12
 Interest Rate Caps
 Look more closely at the IR Cap from before…
 Each reset date is an option

2.8 = Rk
= RK
2.7

2.6

2.5

2.4

2.3

2.2

2.1 time=tk time=tk+1

2
5 5 5 5 5 5 5 05 5 5 5
-0 05 -0 r-0 -0 -0 l- 0 -0 -0 -0 -0
an b- ar ay n ug p- ct v ec
J F e M Ap
M Ju Ju A Se O No D

 It is in-the-money if Rk>RK
 Interest Rate Caps
2.8 = Rk
= RK
2.7

2.6

2.5

2.4

2.3

2.2

2.1

2
5 5 5 5 05 5 5 5 5 5 5
-0 05 -0 -0 -0 l- 0 0 -0 -0 -0 -0
an b- ar pr ay n- g- p ct v c
J Fe M A M Ju Ju Au Se O No De

 Each “option” is known as a caplet

caplet = Lτ max(Rk − RK ,0)
 Where
 L = the principal amount
 Interest Rate Caps
 Recall that for a european bond option:

c = P( 0, T ) [ F0 N ( d1 ) − KN ( d 2 ) ]
 Setting K = RK and F0 = Fk

caplet = Lτ .P( 0, t k +1 ) [ Fk N ( d1 ) − RK N ( d 2 ) ]

ln[ Fk RK ] + σ k2t k 2
 where
d1 =
σ k tk
ln[ Fk RK ] − σ k t k 2
2
d2 = = d1 − σ k t k
σ k tk
 Interest Rate Caps
 The value of the IR Cap is the sum of the caplets
 A CAP trader is interested in the σk series, I.e. the
volatility of the forward rate for each caplet.

 A Floor, is similar to a Cap as a put option is similar

to a call option.
 A floorlet, is a series of put options
 A Floor is the sum of a series of floorlets

 A Collar, is a long Cap plus a short Floor position

 A collar guarantees against a FRN exceeding floor
and ceiling limits
Swap Options (Swap Options)
 A Swaption gives the holder the right (but not the
obligation) to enter into an interest rate swap at
a certain price at a certain date in the future
 These are popular OTC derivative products
 Remember, a swap allows a company to swap
fixed for floating rate
 This can be used for cashflow management
 E.g. “Lock-in” a fixed rate
 Or for speculative reasons
 Bullish on 3-months rate so buys repo
Swap Options (Swap Options)
 A swap can be considered a short position on a
fixed income bond and a long positon in a FRN
 Or visa versa
 Swap Options (Swap Options)
 You can replicate a long swap position by issuing
(selling) a fixed income paying bond and buying a
FRN (I.e. you pay fixed and receive floating)

 Therefore, a swaption can be viewed as the

option to simultaneously sell a fixed income bond
and buy a FRN at a specific rate at a specific time
in the future.
Or
 A swaption gives you the right to pay fixed rate
and receive floating rate
 Swap Options (Swap Options)
 You can replicate a short swap position by buying
a fixed income paying bond and issuing (selling)
a FRN (I.e. you receive fixed and pay floating)

 Therefore, a swaption can (also) be viewed as the

option to simultaneously buy a fixed income bond
and sell a FRN at a specific rate at a specific time
in the future.
Or
 A swaption gives you the right to receive fixed
rate and pay floating rate
 Swap Options (Swap Options)
 A Receiver Swaption is the right but not the
obligation to enter into an Interest Rate Swap
where the buyer RECEIVES fixed rate and pays
FLOATING.
 The buyer will therefore benefit if rates FALL.

 A Payer Swaption is the right but not the

obligation to enter into an Interest Rate Swap
where the buyer PAYS fixed rate and receives
FLOATING.
 The buyer will therefore benefit if rates RISE.
 Swap Options (Swap Options)
 Aren’t swaptions a bit obscure?
 Interest rate swaps are the most widely held
single product type among all over-the-counter
(OTC) derivatives (around 55 per cent of total
notional outstandings worldwide).
 The global interest rate swaps market has
experienced significant growth in recent years.
 Total notional outstandings reached
approximately $347,093,635,353,043 in June
2007†
 Average daily swaps trade volumes rose to
$611bn† †
Source: International Swaps and Derivatives Association (ISDA)
And Bank for International Settlements (BIS)
Swap Options (Swap Options)

†
Source: Swapstream.net
 Swap Options (Swap Options)
 How do we value swaptions?

 We assume that the swap rate at option maturity

is lognormal
 Swap Options (Swap Options)
 Assume we purchase a swaption with the
following terms:
 At option maturity we can pay Sk fixed
 At option maturity we can received LIBOR floating
 The swap agreement lasts for n years
 The option matures in T years

Tyears Nyears
 Swap Options (Swap Options)

Sk ST
 Look at what happens at option maturity…
 The actual swap rate = ST
 But the strike swap rate = Sk
 You would not enter into a swap agreement at a
rate higher than the prevailing market swap rate
 So this swaption expires out-of-the-money
 Swap Options (Swap Options)
 In general, the payoff on a swaption is:
L
max(ST − S k ,0)
m
 Where L is the notional principal and m is the
number of payments per year.
 Further reading
 Hull, J.C, “Options, Futures & Other Derivatives”,
2009, 7thth Ed.
 Chapter 28