1. 7 May 2001 International Swaps and Derivatives Association Mexico City Derivatives and Risk Management in Mexico Interest Rate and Currency Derivatives David Mengle Vice President, J.P. Morgan Securities Inc. Associate Professor, Fordham University Graduate School of Business

2. 2 Three forms of derivatives activity  Exchange-traded –Futures –Exchange-traded options  Over-the-counter (OTC) –Swaps –Forwards –OTC options  Structured securities

3. 3 Interest rate risk  A U.S. bank (“Client”) expects to receive a loan repayment of US$100 million in two years from a domestic corporation  Loan funded with one-year US$ deposit  Client is concerned that US$ interest rates will rise Situation AssetsLiabilities Loan (2-year, fixed rate) US$100 MM Deposit (1-year Libor) US$100 MM

4. 4 Interest rate riskClient 2-year Fixed Rate Loan Situation Deposit 1-year Libor

5. 5 Forward rate agreement (FRA) A forward contract on interest rates Dealer Client Reference Rate Contract Rate Fixed Rate Loan Libor Deposit One year from now Forward rate, determined when contract is agreed (dealing date) Libor, determined at settlement date

6. 6 Result of hedging with FRA  Client has given up interest rate risk by locking in forward rate (replaced risk with certainty) –Client will be protected from rising deposit rates, –But will not benefit if rates fall  Client assumes credit exposure to Dealer (and vice versa)

7. 7 Futures contracts  Institutional features that promote liquidity –Standardized contracts –Organized exchanges  Institutional features that reduce credit risk –Clearinghouse is counterparty –Daily settlement (mark to market) –Margin requirements –Loss-sharing arrangements An alternative to forward contracts

8. 8 Interest rate exposure Situation  Client has purchased a US$100 MM 5-year U.S. Government Agency note yielding 6.5%  Purchase funded with one-year US$ deposits  Client is concerned that US$ interest rates will rise AssetsLiabilities U.S. Agency Note (5-year fixed @6.5%) US$100 MM Deposit (1-year Libor) US$100 MM

9. 9 Net Funding Cost: 5-Year Swap Rate = 6.1% Interest rate swap Dealer Client Libor Swap Rate (6.1%) Fixed Rate (6.5%) Libor DepositAgency Note

10. 10 Swap cash flows At inception, PV(Floating Rate Leg) = PV(Fixed Rate Leg) Time DepositSwap Net 0 100 ---- 100 1 (LIBOR)LIBOR(6.1) (6.1) 2 (LIBOR)LIBOR(6.1) (6.1) 3 (LIBOR)LIBOR(6.1) (6.1) 4 (LIBOR) LIBOR(6.1) (6.1) 5 (100 + LIBOR)LIBOR(6.1) (106.1)

11. 11 Interest rate swaps  Interest rate swap – A contractual agreement between two counterparties to exchange cash flows on a notional principal amount at regular intervals during a stated period (maturity) –Notional amount is never exchanged  Trade Date – The date on which the parties commit to the swap and agree to its terms  Effective Date – The date on which payments begin to accrue –Normally two days after trade date –Forward starting swap: Effective date can be any future date Definitions

12. 12 Result of hedging with swap  Client has given up interest rate risk by locking in swap rate (replaced risk with certainty) –Client will be protected from rising deposit rates over term of swap, –But will not benefit if rates fall  Client assumes credit exposure to Dealer (and vice versa) over term of swap

13. 13 Currency risk Situation  Client has purchased a one-year US$ note, which it funded with a one-year DM deposit  Both the note and deposit rates are fixed  Client wishes to eliminate the DM/US$ currency risk AssetsLiabilities Note (1-year, fixed rate) US$100 MM @5.90% Deposit (1-year @ 1-year DM Libor) DM180 MM @3.95%

14. 14 Currency forward Dealer Client DM 187.11 MMUS$105.90 MM DepositNote One year from now: US$105.90 MMDM 187.11 MM Spot rate = 1.800 Forward rate = 1.767 Note: Currency forwards are normally physically-settled, that is, each party makes a currency payment to the other

15. 15 Result of hedging with forward contract  Client has locked in forward exchange rate of 1.767  Client is protected against appreciating DM, but will not benefit if DM depreciates  Client assumes credit exposure to dealer

16. 16 Interest rate parity Money rates (1-year) US$ Libor = 5.90% DM Libor = 3.95% Exchange rates Spot: 1.800 1-year forward: 1.767 5.90%3.95% 1.800 1.767 US$105.90 MM US$100 MM DM187.11 MM DM180 MM Two ways to get to the same result...

17. 17 Currency risk Situation  German bank wants to lend in U.S.  Not well-known in US$ capital market  Will fund by borrowing in DM  Exposed to rising DM (falling US$) AssetsLiabilities Loans (5-year, fixed rate) US$100MM @6.8% Note (5-year, fixed-rate) DM180 MM @4.8%

18. 18 US$ Loans German Bank DM Interest Currency risk German bank exposed to rising deutschmark DM Note US$ Interest DM180 million US$100 million

19. 19 DM180 million Dealer Currency swap US$ Loans German Bank US$100 million DM Note DM180 million $100 million Initial principal exchange

20. 20 6.1% (US$) 4.8% (DM) Dealer Currency swap Payments during swap US$ Loans German Bank 4.8% DM Note 6.8%

21. 21 Currency swap Dealer US$ Loans German Bank DM Note DM180 million US$100 million DM180 million Final principal exchange

22. 22 Dealer US$100 million DM180 million Currency swap Final principal exchange German Bank 6.1% (US$) 4.8% (DM) Payments during swap DM180 million $100 million Initial principal exchange US$ Loans 4.8% DM Note 6.8%

23. 23 Result of hedging with cross-currency swap  Client has given up currency risk by locking in spot rate on notional principal (replaced risk with certainty) –Client will be protected from rising DEM over term of swap, –But will not benefit if DEM falls  Client assumes credit exposure to Dealer (and vice versa) over term of swap –Potential credit exposure substantially higher than interest rate swap of similar maturity because of final exchange of principal at maturity –Implication: Cross-currency swaps make intensive use of dealer credit capacity

24. 24 Options: Definitions  A legal contract that gives the buyer, in exchange for the payment of a premium, the right but not the obligation to buy or sell a specified amount (contract amount) of the underlying asset at a predetermined price (strike price) at a stated time (maturity date or expiry).  Call option - option to buy –Interest rate cap  Put option - option to sell –Interest rate floor  Option buyer or holder (long)  Option seller or writer (short)

25. 25 Options: Definitions  Exercise (strike) price is the price specified in the option contract  Maturity date is the time after which the option is no longer valid –Also called expiration date or expiry –Maturity sometimes called tenor  European option can only be exercised at expiry  American option can be exercised any time up to expiry

26. 26 Options Dealer Client Max (L-Strike,0) (on each Payment Date) Libor  Purchase interest rate cap struck at maximum rate client can tolerate  Client pays up-front premium for the option  Contrast: Swap locks in a rate, option insures against high rates Interest rate cap Deposit Up-front premium (on Trade Date)

27. 27 Definitions: Caps and floors Interest rate cap  Contract in which the seller compensates the buyer when the observed rate is greater than the predetermined strike rate. Interest rate floor  Contract in which the seller compensates the buyer when the observed rate is less than the predetermined strike rate. Interest rate collar

28. 28 Currency risk  German bank wants to lend in U.S. –Will fund by issuing fixed rate DM note –Exposed to rising DM (falling US$)  Wants to retain benefit if DM falls (US$ rises)  Solution: U.S. dollar put option –In exchange for up-front premium, client buys the right but not the obligation to exchange US$ 100MM for DEM 180MM AssetsLiabilities Loans (5-year, fixed rate) US$100MM @6.8% Note (5-year, fixed rate) DM180MM @4.8%

29. 29 Variations on swap and options contracts  Types of contracts –Basis swaps –Options on swaps (swaptions)  Credit derivatives –Credit default swap –Total return swap

30. 30 Interest rate risk  A U.S. bank makes floating rate US$ loans to corporations priced at the Prime Rate  The bank funds the loans with floating rate deposits priced at Libor  Bank is exposed to changes in the difference between the two floating rates AssetsLiabilities Loans (Prime Rate) US$100 MM Deposits (3-month Libor) US$100 MM

31. 31 Solution: Basis swap  Definition: An interest rate swap in which both payments involve floating rates  Purpose: To lock-in spread between assets & liabilities Dealer Client Prime – 2.75% Prime Rate Libor Loans Deposits Libor

32. 32 Cross-currency basis swap Dealer German Bank US$ Libor US$ Libor + 50 DM Libor US$ Loans DM Deposits DM Libor + 10 Swap includes initial and final principal exchanges

33. 33 Interest rate risk  A company expects to take out a floating-rate bank loan at US$ Libor plus 50 basis points one year from now  Client expects to need the funds for 5 years  Client is concerned that rates will rise  But client is not willing to lock in fixed rate yet –Forward-starting swap would lock in rate now –Five-year series of interest rate caps would be relatively costly because of high amount of protection provided

34. 34 Solution: Swap option  A swap option (swaption) is an option on a forward-starting swap –Gives the holder the right, not the obligation, to enter into a swap contract in the future –Can also be an option to cancel an existing swap in the future –Single option on a long-term fixed rate Contrast: caps are a series of options on short-term rates  Strike price is fixed rate of underlying swap  Up-front premiums normally quoted as percentage of underlying swap notional  Expiry is date on (or until) which swaption can be exercised  Can be exercised into underlying swap or cash-settled

35. 35 Types of swap options  Swap options can be European or American  Receiver swap option –Contract in which the buyer has the right, but not the obligation, to enter into a swap receiving a predetermined fixed rate on a predetermined date in the future. –Also known as a call swaption.  Payer swap option –Contract in which the buyer has the right, but not the obligation, to enter into a swap paying a predetermined fixed rate on a predetermined date in the future. –Also known as a put swaption.  Quotation –‘ 1 into 5’ 7% receiver swation would be an option to enter into a five- year swap as receiver starting in one year

36. 36 Credit (default) swaps  Buyer pays premium for protection against default by reference credit  Receives payout if reference credit(s) default (or other credit event occurs) –Can equal post-event fall in price of reference obligation below par; or –Fixed sum or percentage of notional (binary settlement); or –Par value in return for physical delivery of reference obligation  Results: –Credit swap hedges both default risk and credit concentration risk –Buyer trades credit risk of reference credit for counterparty credit risk of seller X bp per annum Contingent payment Protection buyer Protection seller The ‘plain vanilla’ of credit derivatives

37. 37 Total return swaps  Allows the transfer of the total economic performance of a reference obligation (loan, security, lease receivable, commodity)  Periodic payments are based on changes in market value of reference obligation, whether or not credit event has occurred  Total return: Interest + Fees + (Final Value  Original Value) –TR Payer pays TR Receiver if total return is positive –TR Receiver pays TR Payer if total return is negative LIBOR + X bp p.a. TR of reference obligation TR Receiver TR Payer