INTEREST RATE DERIVATIVE MARKETS CHAPTER 15 All Rights Reserved Dr David P Echevarria

First Objectives Primary Function of Interest Rate Derivatives Protect the value of a fixed or variable rate portfolio of debt securities Secondary Function Speculate on future interest rate moves If rates expected to Rise – go short (maturities) If rates expected to decline – go long (maturities) All Rights Reserved Dr David P Echevarria

Futures Hedging Futures Positions to Protect Value of Bond Portfolios Principal concern: Loss of Value Values decline when rates rise Hedge: Open a short position Short position profit when values decline If Holding Short Positions in F.I.S. Hedge: Open a Long Position All Rights Reserved Dr David P Echevarria

FUNDAMENTALS Interest Rate Swap: exchange one set of interest payments for another Notional Principal: valuation basis for stream of payments to be received Note this need not be an identity with the original securities. Bond Indexes are normal basis for setting interest rate. Purpose of Swaps Hedge future [adverse] movements of interest rates → payments Immunize portfolios of interest-sensitive assets All Rights Reserved Dr David P Echevarria

FUNDAMENTALS Types of Swaps Plain Vanilla Swaps (fixed for floating rate) Callable Swaps (Swap options = fixed rate party has option to terminate early) Putable Swaps (floating rate party has option to terminate early) Forward Swaps (future stream of interest payments) All Rights Reserved Dr David P Echevarria

Other Types of Swaps Amortizing Swap - A swap where the notional is reduced over time, generally to match the amortization of the hedged item such as a loan or mortgage. Basis Swap - A swap between two floating indexes, LIBOR vs EURIBOR.  Cross-Currency Swap - a swap where the two legs are in different currencies. Can be a basis swap, fix-float or fixed-fixed.  All Rights Reserved Dr David P Echevarria

BASIC HEDGING STRATEGIES Short-Term Interest Rate Hedges If interest rates go up in the future, bond prices go down. 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. If you are going to invest, you want interest rates to rise - prices to fall. If you expect interest rates to fall, you want to avail yourself of the opportunity to profit from the increase in prices. All Rights Reserved Dr David P Echevarria

PRICING INTEREST RATE SWAPS Prevailing Market Interest Rates Supply and Demand Level of interest rates: high, low, expectations Availability of Counterparties Credit and Sovereign Risk Probability of default Political risks: prevents one party from delivering payments when due All Rights Reserved Dr David P Echevarria

INTEREST RATE CAPS, FLOORS, AND COLLARS Maximum interest rate when rates rise Seller is betting rates will RTS or decline. Interest Rate Floors Hedge against declining rates Seller is betting rates will RTS or increase. Interest Rate Collars Combination of Cap and Floor Hedging against interest rate volatility All Rights Reserved Dr David P Echevarria

HOMEWORK QUESTIONS What is the purpose of a Swap? What does the term notional principal mean? What is a plain vanilla swap? What are the expectations of the counterparties? How does a callable swap differ from a putable swap? What is sovereign risk? How do Rate caps work? Floor caps? All Rights Reserved Dr David P Echevarria

Arbitrage Hedging Example Alternative Time Value Play: Borrowing to finance the buy Suppose we buy a Zero-coupon (Zc) bond with 41 quarters remaining to maturity selling to yield 6%. Price = $ 543,115.59 Suppose further that we can borrow money at 5 % per annum for 3 months with the loan collateralized by the Zc bond. We borrow $ 543,115.59 and repay $ 543,115.59 * 1.0125 = $ 549,904.53 or a cost of $ 6,788.94 All Rights Reserved Dr David P Echevarria

Arbitrage Hedging Example 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. 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. In this example, the 6 % is the implied repo rate or the IRR on Zc-bond. All Rights Reserved Dr David P Echevarria