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Copyright © 1999-2006
Investment Analytics
1
Interest Rate Derivatives
Pricing
Similar vanilla swap
Except that swap coupon set so that swap
is expected to be fairly priced at the start
date
Currently 1-Mar-91
Price a forward interest rate swap
Start 8-Feb-94
Tenor 2 years
Quarterly resets
$100MM notional principal
Excel Workbook: Yield Curve Modeling.xls
Labs: Forward swap
P rin c ip a l: 1 0 0 ,0 0 0 ,0 0 0
S w ap C oupon: 8 .0 0 9 % 8 .0 4 3 %
D a te s Day s L in D .F F ix e d C F PV F ix e d C F C S D is c PV
8 -F eb -9 4 1075 0 .8 3 0 9 0 .0 0 0 .0 0 0 .0 0 0 .8 3 1 0 0 .0 0
8 -M ay-9 4 1164 0 .8 1 5 4 1 ,9 7 9 ,9 3 9 .8 4 1 ,6 1 4 ,3 5 9 .9 5 1 ,9 8 8 ,3 4 2 .3 4 0 .8 1 5 2 1 ,6 2 0 ,9 4 8 .2 7
8 -A u g -9 4 1256 0 .7 9 9 2 2 ,0 4 6 ,6 7 9 .3 9 1 ,6 3 5 ,7 3 4 .5 8 2 ,0 5 5 ,3 6 5 .1 2 0 .7 9 8 9 1 ,6 4 2 ,0 6 1 .8 8
8 -N ov-9 4 1348 0 .7 8 3 1 2 ,0 4 6 ,6 7 9 .3 9 1 ,6 0 2 ,6 9 2 .5 8 2 ,0 5 5 ,3 6 5 .1 2 0 .7 8 2 7 1 ,6 0 8 ,8 1 0 .1 4
8 -F eb -9 5 1440 0 .7 6 6 9 2 ,0 4 6 ,6 7 9 .3 9 1 ,5 6 9 ,6 5 0 .5 8 2 ,0 5 5 ,3 6 5 .1 2 0 .7 6 6 8 1 ,5 7 6 ,1 0 0 .1 9
8 -M ay-9 5 1529 0 .7 5 2 1 1 ,9 7 9 ,9 3 9 .8 4 1 ,4 8 9 ,0 9 6 .4 9 1 ,9 8 8 ,3 4 2 .3 4 0 .7 5 1 8 1 ,4 9 4 ,8 0 5 .6 1
8 -A u g -9 5 1621 0 .7 3 7 0 2 ,0 4 6 ,6 7 9 .3 9 1 ,5 0 8 ,4 1 9 .8 3 2 ,0 5 5 ,3 6 5 .1 2 0 .7 3 6 6 1 ,5 1 3 ,9 3 7 .2 9
8 -N ov-9 5 1713 0 .7 2 1 9 1 0 2 ,0 4 6 ,6 7 9 .3 9 7 3 ,6 7 0 ,0 4 3 .5 9 1 0 2 ,0 5 5 ,3 6 5 .1 2 0 .7 2 1 6 7 3 ,6 4 4 ,2 1 0 .0 1
F ix e d C F N P V : 8 3 ,0 8 9 ,9 9 7 .5 9 8 3 ,1 0 0 ,8 7 3 .3 9
FR N NPV 8 3 ,0 8 9 ,9 9 7 .5 9 8 3 ,1 0 0 ,8 7 3 .3 9
S w ap NPV 0 .0 0 0 .0 0
Caps:
Limits Upside Risk / Gain
Series of interest rate call options
Caps interest rate, or equity index return
Floor:
Limits Downside Risk / Gain
Series of interest rate put options
Collar
Combines Cap & Floor
Fixes interest rate or equity index within a band
Copyright © 1999-2006 Investment Analytics Interest rate Derivatives Slide: 9
Equity Index Floor
Limits the downside exposure
Typical Portfolio Application:
User: stock portfolio manager
Hedge against market retracement after rally
Mechanism: Purchase S&P put option
Swap Application
User: S&P receiver in equity swap
Set minimum return from the swap
Mechanism: Purchase series of European put
options maturing on reset dates
Copyright © 1999-2006 Investment Analytics Interest rate Derivatives Slide: 10
Floor Example: S&P Index Fund
s
Return (%)
rn
tu
Re
d
s
rn
ge
tu
ed
Re
nh
d
U
ge
ed
H
S&P Index
Fund
Contract terms
Cap strike rate, Rx (7%)
Term (3 years)
Reset frequency (quarterly)
Reference rate (LIBOR)
Principal ($1MM)
Payment from seller to buyer:
0.25 x $1MM x Max(LIBOR - Rx, 0)
In arrears, usually starts after 3 months
Each piece is called a “caplet”
Copyright © 1999-2006 Investment Analytics Interest rate Derivatives Slide: 14
Capped FRNs
ln( F / X ) + (σ / 2)t 2
d =
σ √t
1
d = d −σ √t
2 1
Problems:
Unbiasedness: empirically false
Option on R not same as option on F
j j
Discount rate: fixed - but Fj variable
Rates both stochastic and fixed!
If applied to prices the additional problem
Assumes prices can be any positive number
But can’t exceed value of future cash flows
Option on a swap
Right to enter a swap at known fixed rate
Receiver Swaption: right to receive fixed
Payer Swaption: right to pay fixed
Essentially a bond option with strike =
notional
When exercised, will exchange floating for fixed
Fixed payments correspond to a bond
Anticipatory financing
manage future borrowing cost
e.g., bidding for a contract; if get it, will want
to swap, lock in today’s rates
e.g., option to build a plant, so buy swaption
Change terms of existing swap
Cancelable, putable swap
LIBOR Fixed
Receiver
swaption -
Intermediary
exercised if
rates fall
Callable
y* Yield
Copyright © 1999-2006 Investment Analytics Interest rate Derivatives Slide: 34
Features of Callable Bonds
Price compression
Limited price appreciate as yields decline
Negative convexity
As yields fall:
Duration increases (as for non-callable)
Then duration decreases
Swap 3
6.75%
LIBOR
6.75% 6.75%
Swap 1 Investor Swap 2
LIBOR
LIBOR
Cash Flow Summary
Receive on swaps: + 3 x (6.75%)
Pay on swaps: - 3 x LIBOR
LIBOR on FRN
Receive on FRN + LIBOR
Investor