Interest Rate Derivatives

Interest Rate Derivatives

 The following securities can be considered
interest rate derivatives
◦ Forward contracts on fixed income instruments
◦ Futures contracts on fixed income instruments
◦ Options on these contracts
◦ Interest Rate Swaps
◦ Swaptions (options on swaps)
Forward Contracts
 A Forward Contract is:
◦ An OTC Agreement between two parties
◦ Contract between a buyer and a seller
◦ Seller delivers a predetermined amount of a good at a
predetermined date (Settlement or Delivery Date )
◦ Buyer takes delivery on that day, and pays a
predetermined price.
Forward Contracts
 No money changes hands until delivery – Price
predetermined
 Two sided default risk
◦ Seller could default, and not deliver
◦ Buyer could default, refusing delivery (not paying)
 Agreements are tailored to participants – therefore,
not liquid
Example
 When-issued trading of bonds is like a forward
contract.
◦ Investment bank agrees to deliver the security when it is
issued
◦ The investor agrees on a yield
◦ Both parties are exposed to interest rate risk
Example
 You enter into an agreement with Goldman Sachs
to buy a one-year bond with a coupon rate of 10%
in three months.
 The bank guarantees a price.
 In three months, you deliver money, Goldman
Sachs delivers the bond
Pricing Forward Contracts

 Two ways to get goods at settlement:

◦ Forward Contract
 Enter contract now for 1-yr 10% bond
 Take delivery at settlement
 Make payment at settlement
◦ Replicate contract
 Borrow money now
 Purchase 15 month, 10% bond
 Store bond for three months
 Pay back loan on settlement date with cash and coupon
Forward Contracts
 Liquidity increase in counter party risk

◦ Forward contracts can’t be sold easily

◦ Participants may “get out” of a contract by entering a
contract with someone else
 Investor sells contract to Citibank
 Goldman sells contract to Morgan Stanley
 Note – this increases counterparty risk
Futures Contracts
 A Futures Contract is like a forward contract – but
◦ Traded on exchanges
◦ Standard contracts make them more liquid
◦ Counterparty is always the exchange -- so safer
◦ Margin requirements
◦ Participants rarely take delivery
◦ Marked-to-market
 Daily cash settlement
 Keeps contracts standard
Financial Example
 Eurodollar Futures (traded on CME)
◦ The underline security is a $1million 90-day LIBOR.
◦ Prices are quoted as (100 - interest rate, in percent, on a
three-month Eurodollar deposit). Therefore a price of 95
corresponds to a 5% interest rate
◦ Result: get/pay $25 for each b.p. difference when marked-
to-market
Financial Example

 Eurodollar Futures (Continued)

◦ There are 120 different futures contracts, corresponding
to delivery in each month of the next 10 years
◦ Contract is cash-settled with the exchange based on
British Bankers Association Interest Settlement Rate for
three-month dollar deposits as of contract’s last trading
day
◦ Minimum price tick is 0.01 (one basis point of the three-
month interest rate), or $25/contract. The nearest
contract minimum tick is 0.005
◦ No maximum daily price move
Mechanics
 Trades only executed by members of an exchange
 Brokers own chairs, act as intermediaries
 “Locals” act as market-makers
 Clearinghouse is always the counterparty. This
minimizes risk when someone defaults
 Margins are required. Daily settlement.
Margin
 Initial Margin
◦ Cash Deposit to cover daily mark-to-market changes
◦ Usually greater than most one-day changes
 Daily profits added to margin account
 Daily losses taken from margin account
 Maintenance margin: Investor must restore
margin when balance falls below maintenance
level
Treasury Bond Futures
 Contract quoted in terms of a fictitious 6%, 30 year
bond with a face value of $100K
 Trades on CME
 Quotation: Price of bond – Percent of Par
(e.g., 139-31 – 10/26/2011 price for Dec 11
contract)
 Tick Size
◦ 1/64 ($15.625 per contract)
 Daily price limit – 3%
 Contract Months – March, June, September,
December
 Trading Ends – 7th bus. day before last bus. day of
month
Treasury Bond Futures
 Seller delivers
◦ $100,000 face value, 15-30 years
◦ Price depends on bond delivered (conversion factor used)
◦ Seller determines which bond
◦ Seller determines when in month to deliver
 Buyer pays price plus accrued
Treasury Bond Futures
 Quality Option – seller uses ‘cheapest to deliver’
 Timing option – seller can pick date in month to
deliver
 Wildcard option: Seller can give intent to deliver
several hours after market closes.
The Bond Factor
 Note that at a yield of 6%, a 6% coupon bond has
a value equal to the par amount plus any accrued
interest.
 The factor for a 6% bond is 1. You may deliver
$100K worth of it.
 For a bond with a different coupon, find the price
of the bond at 6%.
 For coupons greater than 6%, the value will be
greater than par, so the factor will be greater than
one.
◦ For coupons less than 6%, the value will be less than
one, so the factor will be less than one.
Cheapest to Deliver
 As yields change, the value of the bonds that could
be delivered change.
 Since they have different durations, they change at
different rates.
 Since they have different factors, the relative cost
of these bonds could change.
 Since the investor with the short position in the
futures contract has the ability to switch between
deliverable securities, he has an option
Cheapest to Deliver
 Many analysts use the current cheapest-to-deliver
when doing their analysis.
◦ Technically, this is not correct – as the cheapest to deliver
can change through time
◦ It ignores the probability that the worst case can change
 In practice, you can use a model of interest rates to
price all the securities at the delivery date, and
determine, empirically, which is best to deliver.
◦ This method is completely deterministic, since the universe
of deliverable bonds is finite.
Options on Futures
 Options can be bought on futures contracts:
◦ Contract size: One futures contract
◦ Tick size: 1/64 of a point
◦ Contract months: Next three months plus four quarterly
expiration contracts (Mar, June, Sep, Dec)
Treasury Note Futures
 T-Note Futures – CBOT
◦ Modeled after T-Bond Futures
◦ Deliverable: 6.5-10 year maturity
◦ Less volume than T-Bond
 5 yr-Note Futures – CBOT
◦ Modeled after T-Bond Futures
◦ Deliverable: 4.25-5.25 year maturity
Treasury Bill Futures (CME)
 Seller delivers $1MM face value 90-day T-Bills
 P = 100 - Rate
 Price Paid = $1MM (1-Rate(days/360))
 Minimum Tick – 0.5 b.p.
 Daily limit – None
 Contract Months – March, June, September,
December – plus two months in next quarter
 Delivery – Issue date of T-bill
 One b.p. change: $25
Interest Rate Swaps
 Swaps: An OTC Derivative Contract between two
parties
 Contract specifies:
◦ Notional Principal
◦ Rate (or price)
◦ Payment Frequency
◦ One party pays floating rate
◦ The other party pays fixed rate
◦ Only net change gets paid – principal is never paid
◦ Fixed rate chosen so price is zero at start
 Interest Rate Swaps
 Example:
◦ $10M Notional Principal
◦ Semiannual interest payments for five years
◦ One party pays LIBOR
◦ Other party pays fixed rate (close to 5-year Treasury rate)
 Q: How does this differ from 10 forward contracts
with expirations of 0.5, 1, 1.5, 2, . . ., 5 Years?
 A: It doesn’t
Interest Rate Swaps
 What is the point?
 Consider:
◦ Issue 5-year floating rate debt
◦ Issue 5 year fixed rate debt and enter into 5-year swap
where you get fixed and pay floating.
◦ What is the difference?
 Original swaps were between US companies
who had access to fixed rate market and
European companies who had access to floating
rate market.
Interest Rate Swaps
 How can banks hedge with Swaps?
 Consider a bank with:
◦ Short term (floating rate) liabilities
◦ Long-term (fixed rate) assets.
 The bank can hedge its interest rate risk with a
swap where they pay fixed and receive floating
Interest Rate Swaps
 “Normal Swap Agreement”
◦ Pay Floating based on LIBOR at previous payment (e.g.,
first payment based on current LIBOR)
 Counterparty risk
◦ What is lost if one party defaults?
◦ No principal is lost
◦ Just difference between fixed and floating on future
payment is lost
An Example

 An agreement by Microsoft to receive 6-

month LIBOR & pay a fixed rate of 5% per
annum every 6 months for 3 years on a
notional principal of $100 million.
 Next slide illustrates cash flows that could
occur.

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 Cash Flows to Microsoft

---------Millions of Dollars---------
LIBOR FLOATING FIXED Net
Date Rate Cash Flow Cash Flow Cash Flow
Mar. 5, 2007 4.2%
Sept. 5, 2007 4.8% +2.10 –2.50 –0.40
Mar. 5, 2008 5.3% +2.40 –2.50 –0.10
Sept. 5, 2008 5.5% +2.65 –2.50 +0.15
Mar. 5, 2009 5.6% +2.75 –2.50 +0.25
Sept. 5, 2009 5.9% +2.80 –2.50 +0.30
Mar. 5, 2010 6.4% +2.95 –2.50 +0.45

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 Valuation of an Interest Rate Swap
that is not New

 Interest rate swaps can be valued as the

difference between the value of a fixed-rate
bond and the value of a floating-rate bond.
 Alternatively, they can be valued as a
portfolio of forward rate agreements (FRAs).

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Valuation in Terms of Bonds
 The fixed rate bond is valued in the usual
way.
 The floating rate bond is valued by noting
that it is worth par immediately after the
next payment date.
– If notional principal is L, the next exchange of
payment is at time t*, the floating payment that will
be made at t* is k*.
– Then a single cashflow is L+ k* & will be made at t*.
– The PV of floating-rate bond is (L+ k*)e-r*t*, where r*
is the LIBOR/Swap zero rate for a maturity of t*.

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Valuation in Terms of FRAs
 Calculate the corresponding forward rates
for each payment date;
 Calculate the swap cash flows on the
assumption that the LIBOR rates will equal
to the forward rates;
 Discount the swap cash flows.
Example
 Pay six-month LIBOR, receive 8% (s.a.
compounding) on a principal of $100 million
 Remaining life 1.25 years.
 LIBOR rates for 3-months, 9-months and
15-months are 10%, 10.5%, and 11% (cont
comp).
 6-month LIBOR on last payment date was
10.2% (s.a. compounding).

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Valuation Using Bonds

Time Bfix cash Bfl cash Disc PV PV

flow flow factor Bfix Bfl
0.25 4.0 105.100 0.9753 3.901 102.505
0.75 4.0 0.9243 3.697
1.25 104.0 0.8715 90.640
Total 98.238 102.505

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Valuation Using FRAs
Futures on Swaps
 The CBOT offers contracts on:
◦ 30-year Interest Rate Swap
◦ 10-year Interest Rate Swap
◦ 5-year Interest Rate Swap
 They also offer options on these contracts
Futures on Swaps
 Contract Specifications for Futures Contract on 30-year IRS
◦ Notional value is $100,000
◦ Buyer will get contract where he pays 6% fixed (semiannual
payments) and receive floating (based on 3-month LIBOR)
◦ Tick Size: 1/64 of a point (longer term) and 1/128 (short
term)
◦ Contract months: Next three months plus four quarterly
expiration contracts (Mar, June, Sep, Dec)
◦ Final settlement price is determined by:
 6%  6%  r  20 
100 ,000    1 1   
 r  r  2  


◦ Where r is the ISDA Benchmark rate for a 10-year swap on

the last day of trading.
Swaptions
 A Swaption is an option on a swap
 Receiver Swaption
◦ The owner has the right to enter into an IRS where he
receives fixed and pays floating
 Payer Swaption
◦ The owner has the right to enter into an IRS where he
pays fixed and receives floating
 Very liquid market
 Caps and Floors
 A Cap is made up of a series of payments that are
made (or received) if a rate exceeds the Cap.
◦ Payment is the interest paid on a notional amount of the
difference in interest at the actual rate and the cap rate –
when the actual rate exceeds the cap.
◦ Each payment is called a “caplet” – so a Cap can be though
of as a portfolio of caplets.
 Floors work just the opposite.
 Caps and Floors are sold at a positive price – like
options.
 Note that an Interest Rate Swap is equivalent to
being long a cap and short a floor at the same rate.
Interest Rate Derivatives Pricing
 Theoretical Methods:
◦ Make an assumption on the stochastic process of the
underlying asset, and derive the value of derivatives, this
method is similar to BS model;
◦ Based on a term structure model, derive the value of
derivatives.
 Numerical Methods:
◦ Monte Carlo Simulation
◦ Based on a term structure model, construct an interest rate
tree (just like a binomial or trinomial tree), and then derive
the value of derivatives numerically.
Alternative Branching Processes in
a Trinomial Tree

(a) (b) (c)

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Two-Step Tree Example
Payoff after 2 years is MAX[100(r – 0.11), 0]
pu=0.25; pm=0.5; pd=0.25; Time step=1yr
14%
3
12%
1.11* 12%
1

10% 10% 10%

0.35** 0.23 0

8%
8% 0
0.00

6%
0
*: (0.25×3 + 0.50×1 + 0.25×0)e–0.12×1
**: (0.25×1.11 + 0.50×0.23 +0.25×0)e–0.10×1

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