1. INTEREST RATE DERIVATIVE MARKETS
CHAPTER 15
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Dr David P Echevarria

2. 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)
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Dr David P Echevarria

3. 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
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Dr David P Echevarria

4. 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
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Dr David P Echevarria

5. 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)
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Dr David P Echevarria

6. 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. 
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Dr David P Echevarria

7. 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.
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Dr David P Echevarria

8. 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
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Dr David P Echevarria

9. 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
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Dr David P Echevarria

10. 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?
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Dr David P Echevarria

11. 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, and repay $ 543, * = $ 549, or a cost of $ 6,788.94
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Dr David P Echevarria

12. 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, for a expected profit of $ 8,
We have created an arbitrage portfolio in which we have no money invested and have earned a profit of $8, $6, = $1, with no risk.
In this example, the 6 % is the implied repo rate or the IRR on Zc-bond.
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Dr David P Echevarria