interest rate exposure

7/30/2019 Interest Rate Exposure

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Interest Rate Exposure


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Management of Interest rate Exposure

Interest Rate Swap

Currency Swap

FRA

Interest Rate Options

Interest Rate caps , floors and collars


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Interest Rate Swap

A standard fixed to floating interest rate swap, known inthe market as aplain vanilla coupon swap is anagreement between two parties, in which each contractsto make the payment to the other on particular date infuture till a specified termination date

It consists of:

Fixed Rate Payer

Floating Rate Payer

Definition

The fixed and floating payments are calculated asif they were interest payment on a specifiedamount borrowed or lent.

The parties do not exchange this amount at anytime.

Only used to compute sequence of payments.

NotionalPrincipal


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Rate applied to the notional principal tocalculate the size of fixed payment.

A dealer may quote these rates: 2yrs Treasury(4.50%)+45/52

4 yrs treasury(4.75%)+52/60

FixedRate

Ina standard swap at market rates, thefloating rate is one of the marketindexes such as LIBOR, prime rate etc.

The maturity of underlying index equalsthe interval between payment dates.

Floating

rate


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Trade Date

Date On which swap deal is concluded

EffectiveDate

Date from which first floating and fixed payments start to accrue

PaymentDates

D(S), the setting date is the date on which the floating rate applicable

for the next payment is set. D(1) is the date from which the next floating payment starts to accrue.

D(2) is the date on which the payment is due.


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Fixed and Floating Payments

Fixedpayment=

P*Rfx*Ffx

FloatingPayment=

P*Rfl*Ffl

P = notional principal

Rfx = fixed rate

Rfl = floating rate

Ffx = Fixed rate day count fraction

Ffl= floating rate day count fraction


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Currency Swap

Two payment streams beingexchanged are denominatedin two different currencies

Definition

Fixed-to-fixed Currency Swap

Fixed-to-floating CurrencySwap

Types


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Motivation Underlying swaps

Quality Spread Differential

XYZ ABC

Requirement Fixed Rate $ Floating Rate $

Cost Fixed $ 11% 9.5%

Cost Floating $ Prime+0.75% Prime

Bank ABC has an absolute advantage over the corporation XYZ

But the corporation has a comparative advantage in the floating rate market


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Swap Bank

XYZ Corp ABC Bank

9.75% s.a FIxed

9.50% s.a FIxed

Prime -25bp Prime -25bp

Prime +75bp

To floating Rate Lenders9.50% s.a.

To Fixed Rate Lenders

XYZ corp: 9.75%

+[Prime+0.75-(prime-

0.25)]%= 10.75% fixed rate,

25 bp below its own rate of

fixed rate funds

ABC Bank: 9.5%-

9.5%+prime-0.25%=prime-0.25%,25 bp

below its own cost of

floating funds.

Swap bank earns a margin of

25 bp


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Motivation Underlying swaps

Market Saturation

Differing Financial Norms

Hedging Price risks


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Swap Market

Growth & Size of the interest rate swap market


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FORWARD RATE AGREEMENTS

A Forward rate agreement is notionally a agreement between two partiesin which one of them contracts to lend to the other, a specified amount offunds, in a specific currency, for a specified period starting at a specifiedfuture date, at an interest rate fixed at the time of agreement.

The buyer of the Forward rate agreement in turn agrees to borrow, fundsfor a specific duration, starting at a specified future date, at a rate fixed atthe time the Forward rate agreement is brought.


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Seller ofthe FRA

Buyerof theFRA

ForwardRateAgreement


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A typical FRA quote from a bank may look like :

USD 6/9 months: 7.20-7.30% p.a

The bank is willing to

accept a 3-month US dollardeposit, i.e. borrow funds,starting six months fromnow, maturing nine monthsfrom now, at an interest

rate of 7.20% p.a. (the bidrate)

The bank is willing to lenddollars for a period of threemonths, starting six monthsfrom now at an interestrate of 7.30% p.a. (the ask

rate).


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t= 0 t= S t= L

DS DF

DL

SCHEMATIC

DIAGRAM

FRA contracted at t= 0

Applicable for the period between t= S and t= L.

DS and DL are actual number of days from t= 0 to t= S and

t=0 to t= L respectively.

The period from t= S to t= L is the contract period.

t= S is the settlement date

DF is the number of days in the contract period.


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One of the two following formulas is used forcalculating settlement payment from the seller to thebuyer :

Here the notation is

L: The settlement Rate (%)

R: The Contract Rate (%)

DF: The number of days in the contract period

A: The notional principal

B: Day count basis (360 or 365)

P = (L-R) * DF * A / [(B*100) + (DF*L)]

P = (R-L) * DF * A / [(B*100) + (DF*L)]


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A call option on interest rategives the holder the right toborrow funds for a specifiedduration at a specified interest

rate, without an obligation to doso.

CALL

OPTION A put option on interest rate

gives the holder the right toinvest funds for a specifiedduration at a specified return,without an obligation to do so.

PUTOPTION

INTERSET RATE OPTIONS(A less conservative hedging device for interest rate exposure)


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A CALL OPTION ON INTEREST RATEConsider first a European call option on 6-month LIBOR. The contract specifications

are as follows:

Time to expiry: 3 months (say 92 days)Underlying interest rate: 6-month LIBOR

Strike rate: 9%

Face value: $5 million

The current three and six months LIBORS are 8.60% and 8.75% respectively.

Assume that the option has been purchased by a firm which needs to borrow $5million for six months in three months time.

3 months later 6-month LIBOR = 9%

The option is notexercised.

The firm borrowsin the market.

3 months later the6-month LIBOR > 9%

The option isexercised.


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A PUT OPTION ON INTEREST RATE

Consider an investor who expects to have surplus cash 3 months from now to be

invested in a 3-month Euro deposit. The amount involved in $10 million.The current 3 month rate is 10.50% which the investors considers to be satisfactory.

A put option on LIBOR is available with the following features:

Maturity: 3 months

Strike rate: 10.50%Face Value: $10 million

Underlying: 3-month LIBOR

To hedge the risk, the investor goes long in the put. Threemonths later, if the 3-month LIBOR is less than 10.50% he willexercise the option or else let it lapse.


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Thank You..

interest rate exposure

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