all rights reserved dr david p echevarria 1 interest rate derivative markets chapter 15

Dr David P Echevarria 1All Rights Reserved

INTEREST RATE DERIVATIVE MARKETS

CHAPTER 15

Dr David P Echevarria 2

First Objectives

A. Primary Function of Interest Rate Derivatives

1. Protect the value of a fixed or variable rate portfolio of debt securities

B. Secondary Function1. Speculate on future interest rate moves

2. If rates Rise – go short

3. If rates decline – go long

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FUNDAMENTALS

A. Interest Rate Swap: exchange one set of interest payments for another

1. Notional Principal: valuation basis for stream of payments to be received

2. Note this need not be an identity with the original securities.

3. Bond Indexes are normal basis for setting interest rate.

B. Purpose of Swaps1. Hedge future [adverse] movements of interest rates →

payments2. Immunize portfolios of interest-sensitive assets


FUNDAMENTALS

C. Types of Swaps1. Plain Vanilla Swaps (fixed for floating rate)

2. Callable Swaps (Swap options = fixed rate party has option to terminate early)

3. Putable Swaps (floating rate party has option to terminate early)

4. Forward Swaps (future stream of interest payments)


BASIC HEDGING STRATEGIES

A. Short-Term Interest Rate Hedges1. If interest rates go up in the future, bond prices go down.

2. If a bond is purchased at time t(1) and sold at t(2) and interest rates have gone down, (price of bond increases), then profits on selling bond and vice-versa.

3. If you are going to invest, you want interest rates to rise - prices to fall.

4. If you expect interest rates to fall, you want to avail yourself of the opportunity to profit from the increase in prices.


PRICING INTEREST RATE SWAPS

A. Prevailing Market Interest Rates1. Supply and Demand

2. Level of interest rates: high, low, expectations

B. Availability of Counterparties

C. Credit and Sovereign Risk1. Probability of default

2. Political risks: prevents one party from delivering payments when due


INTEREST RATE CAPS, FLOORS, AND COLLARS

A. Interest Rate Caps1. Help offset [lower] interest payments when rates rise

2. Seller is betting rates will RTS or decline.

B. Interest Rate Floors1. Hedge against declining rates

2. Seller is betting rates will RTS or increase.

C. Interest Rate Collars1. Combination of Cap and Floor

2. Hedging against interest rate volatility


HOMEWORK QUESTIONS

A. What is the purpose of a Swap?

B. What does the term notional principal mean?

C. What is a plain vanilla swap? What are the expectations of the counterparties?

D. How does a callable swap differ from a putable swap?

E. What is sovereign risk?

F. How do Rate caps work? Floor caps?


Arbitrage Hedging Example Alternative Time Value Play: Borrowing to finance the buy

1. Suppose we buy a Zero-coupon (Zc) bond with 41 quarters remaining to maturity selling to yield 6%. Price = $ 543,115.59

2. Suppose further that we can borrow money at 5 % per annum for 3 months with the loan collateralized by the Zc-bond.

3. We borrow $ 543,115.59 and repay $ 543,115.59 * 1.0125 = $ 549,904.53 or a cost of $ 6,788.94

4. We sell (= open a short position) a futures contract to deliver the Zc-bond, 3 months hence, priced to yield 6.00%: Price = $ 551,262.32 for a expected profit of $ 8,146.73.

5. We have created an arbitrage portfolio in which we have no money invested and have earned a profit of $8,146.73 - $6,788.94 = $1,357.79 with no risk.

6. In this example, the 6 % is the implied repo rate or the IRR on Zc-bond.

all rights reserved dr david p echevarria 1 interest rate derivative markets chapter 15

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