FINANCIAL E,NGINEERNG

lntroduction
Derivatives can mean fear to some and opportunities for others ...
This book. as I explained in the Preface, is meant to open-up and dem.'-stify the'black bor'
imaee created by the'Rocket Scientists'and to simplify and expiain the structuring, pricing.
trading. hedging. evaluation and risk management oi cieriratives (forwards. futures. swaps
and optrons).
There is perhaps no other area ol investment finance where theorv plays as important a
role in the practitioner's world as in the field oi derivatives. Sophisticated mathematics have
been kept to the minimum necessary and in order that the understanding of underlying
concepts is not compromised. The theory is then applied to the practical pricing, trading,
hedging and risk management techniques used in the market. Most importantly, I have
expiained the different approaches that the market uses wherever there is no one single correct
methodology or solution to, say, hedging or pricing of a complex swap/option.
Arbitrage and exploitation of cashifutures/options relationships are explained. Financiai
engineering methodology and asset,rliability management techniques are covered in detail.
Portfolio immunisation and optimisation strategies are based on market practices while
providing theoretical background.
The understanding. practical uses and'manipulation'of derivatives to create nerv. slnthetic,
or structured products is aided by worked-through examples and step-by-step illustrations.
The basic models of cash ffo"vs, yield calculations, durations. simulations, projections and
risk management can be used conceptuaily. The diagrams and methodologies can be used
generically. Having explained the chess pieces and rules of the game. I would leave you (the
Readerl to create erciting trading, hedging and investment strategies as new ideas are not
the monopoly ol any one person.
The phenomenal
-qrowth
of volume in the derivatives market and the rapid pace o[
innovation have left many sell-proclaimed derivatives specialist houses, with more aspirations
than technical resources. gasping for breath. And while the lesser securities houses are trying
to muscle-tn with a me-too marketing hype, the corporate treasurers and fund managers are
beine rrpped-off by the big bad wolves ol the city u'ho cleverly ofl'-load a lot of derivatires.
which are either unnecessarv or unsuitable. at excessive premiums.
Hence. rvhere options are over-priced (ior new products, off-market structures or where
demand is sreater than supply'). thrs book shows how the treasurer can replicate the option
at a much reduced cost *'ith dy'namic hedging by buy'ing and selling the underlying cash and
futures contracts. It explains how to modify the original Black-scholes pricing model to suit
different t1,pes of options and the related hedging techniques.
Pricing options
The most commonly used models lor interest rate options are based on the Black-Scholes
modei which was developed lor short-date equity options. The modified BIack-Scholes models
work well for simple interest rate options such as caps, floors, collars and European options
on zero-coupon bonds. Howeuer,
for
more compler options and swaptions, the modified
Blqck-Scholes models do not price well and, more importantly, they do not hedge well.
Therefore. newer models are needed and the risk management techniques refined. We go
through these in depth *'ith the associated pros and cons as there is no such thing as a perfect
option prrcing and hedging model universally suitable for all situarions.
Chapter i5, the Financial engineering chapter in the book, deals with applications for
derivative techniques. It includes the latest swap innovation, the index differential or.quanto,
swaPs, which allow a borrower or an investor to separate currency and interest rate exposures,
by paying interest rates based on one currency while taking the currency risk oi another. It
sho*'s how to take advantage of different shaped vield curves to create lower cost finance
for the borrower while providing higher returns for the investor, without changing currency
exposure. There is correlation risk for the trader while the risk for the borrower or investor
is that the shape of one or both yieid curves will change more rapidly than expected, turnins
exoected profits into losses.
Other yreld-curve plavs such as the Libor-in-arrears swap (which is a pla1, on rhe impiieci
forward rates by having Libor set say, 6-months in arrears). and the ipread swap (which
enables. lor example, one party to pay the 5-year swap rate and receive the 10-year rite, both
reset semi-annualll', or the counterpartv could even pay the seconci ieg in 5-rnonth Libcr).
We examine how the diversity ol new products can be used to tailor very precise
risk-rew,aro
profiles anci create acided value.
13. Risk management of complex diffs
Let tts now perfornr in-depth anulyric,s ol'inile.r lilJ'ercntiul s*'aps-the pricing, hedging anl
risk ntanagement oJ' inrerest and IX risAs.
\\'e ri'rll pick an exampie rvhere on at least one leq, payments are determined b1'an rnder
in one currency but paid in another. Tirat is, instead ol coupon pa)'ments based on a fired
rate or a Libor rate rn the base currency. the rate used is an index in another currenct'.
6-month Libor or the 5-1'ear swap rate.
Example
CHF-USS indcr
Base currency':
Face value:
Stirr datc:
End date:
Frequeno':
Receive:
Pav:
differential swap
USS
USS200m
5 Aug l99l
5 Aug i996
Semi-annual
USS Lrbor
CHF Lrbor
USS Libor on 3 Aug 199 I was 6ozu
CHF Libor on 3 Aug 1991 was 1.9315"/'0
On first coupon payment date (5 Feb 1992), for 6 months and adjusting [or daycount
Net payment :
USS200,000,000 x (60/o
-
1.93659h)
Pricing the diff
A swap is priced by discounting each component cash ffow at the current zero coupon yield
curve lor that currency. Although luture Libor settings are not known today, they can be
implied irom the current yield curve. Therefore, to price an index differential swap, all cash
flows depending on luture rate sets are calculated using implied forward rates in the
appropriate currency. Once these cash flows are determined, they can be discounted from the
zero coupon curve in the currency the cash flow is denominated in.
Table i-1 shows the component cash ffows for our sample swap. Known cash flows are in
bold, implied cash flows are in regular print. Note that the lorward rates implied show USS
Libor will be exceeding CHF Libor in a lew years, even though it is currently 300 bp less.
The present value of the cash flons shown, all in US$, is
-
2,703,326.
lnterest rate risk
An index differential swap has interesl. rate risk in both the payment and index currencies.
In our example, if USS interest rales change, the payments based on USS Libor will change,
as will the discounting of cash flows on both sides of the swap. Il CHF interest rates change,
the payments based on CHF lonvard rates will change. Note, howeuer, that the CHF/USS
exchange rate has no efect on the price of the swap.
As there is risk to both USS and CHF interest rates, there is an interest rate hedge in both
currencies. The USS hedee is found in the usual way: the sensitivity ol the swap is founci for
a I bp move in each point oi the yield curve, which is hedged by the appropriate amount ol
a current coupon srvap olthe same maturity. Finding the CHF hedge involves an extra step.
The sensitivity is again found for a l bp move in each point of the CHF yield curve, but this
produces a gain or Ioss rn USS, as the swap payments are denominated in USS. Therefore,
this gain or loss needs to be converted at spot to CHF, which is then hedged by the appropriate
amount oi a CHF current coupon srvap ol the same maturity as the maturity in the yield
curve
'blipped'.
Table l6 shows the interest rate hedges (in millions) for our example swap:
Note that the CHF hedge is approximately the lace value oI the swap (200m) converted at
the lorri,ard exchange rate at the maturity (1.498).
FX rate risk
As stateci above, the current exchange rate has no effect on the vaiue ol an index differentiai
srvap. FX exposure anses. however, because su'aps in the index currency are put on to heclge
interest rate risk. Changes in interest rates rvill cause a gain or ioss denominated in the inciex
currency, rvhich are then converted at spot and netted with the gain or loss on the index
srvap in the base currency. If the spot rate has not changed irom that used to derermine the
inlerest rate heciqe, the gain (loss) on the index swap rvill ecual the loss
(gain)
lrom the hedee
_converted
at spot. If the exchange rate has moveci, horvever, the eain and ioss wiil not cancci
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4. Minimising interest rate sensitivity directly
Let us assume that the yreid curve is a contrnuous iunction denneci for a finite number o[
maturrties and linearly interpolated lor points in bet*'een these. Let us also assume that we
have hedging instruments in each of those maturities. Ideally, *e \r'ant a hedge such that:
AV
:0
ior any possible changes in interest rates. This is, of course, impossible to achieve because
we rvill have a fixed number of hedging instruments. We can, ho*'ever, make the absolute
chanqes quite small by requiring that the hedge satisfies:
EV
;-:
0
cfi
ior i:1,
,n
where r,, i
:
1,..., n are the interest rates (YTM) ior the n maturities that define the yield
curve. The hedge could easily be determined by soiving the above system of equations for
the additional amounts of each hedging instrument. This is possible because a system of n
equations with n unknowns will always have at least one solution.
These solutions, however, might be very sensitive to changes in the coefficients. This means
that the hedge might be unstable and frequently lead to very large hedging positions. This
problem can be eliminated by the introduction of tolerances in place of the equalities in the
system oi equations above. The solution will not be unique anymore (in fact we will have
an infinite number o[ solutions) and we will have a choice in selecting the hedge. We can
Iook for some additional properties like low trade volume in the execution of the hedge. We
can then pose the hedge selection as an LP problem:
minfX,+fY, i:1,...,n
subject to
I
:
1,..., n
V':V-
rvhere: X, is the additionai long position in the i-th hedging instrumenr,
Y, rs the additronal short position in the i-rh hedging instrument:
a, and b' be the limits on the sensitivity o[ the portiolio value to changes in the
rnterest rate in the i-th maturity;
V, V* and V- be the present value of the whole portfolio including all the hedges,
of the assets and oi the liabilities respectively; and
D* and D- the duration of the assets and liabilities respecrively.
The stability oi the soiution to this LP problem will depend essentially on the magnitude
ol the tolerance limits, a' and b,: the larger these limits the more stable the solution. On the
other hand, the protection against interest rate risk will be reduced as the absolute size of
the limits increases. The actual values ol 0YlAr, indicate the magnitude of the change in the
portiolio value for a change in the interest rate in the i-th maturity. Examining the set of
these values the book manager could adapt his positions in order to maximise the benefirs
from anticipated changes in interest rates.
Summary
This chapter on hedging theory has defined the concepts of duration and convexity, and used
them to outline three conditions for portfolio immunisation. These conditions are sufficient
to guarantee that the net worth oI the portfolio will be non-negative w'hen subject to parallel
shrlts in the yield curve. Because there are many possible hedges to provide this level of
immunisation, M: is introduced as a means to tighten the cash match between the portfolio's
assets anci liabiiities and thus provide some protection againsr non-parallel rate movernents.
This is shown to have some weakness in that it only looks at the variance of cash flows about
one point in trme-the duration-and it does not take tracing cost into consideratron.
Suggesticns for improvement include accepting a trade ofr between iower transaction cosrs
and increased M2, and minimising cash mismatch across more than one date. Finailv, a
general framework for minimising the sensitivity to arbitrary changes in the yieid curve \r,as
in r rociuced.
AV
a <_<b
of;
2. Hedging interest rate risk
Hedging objectives and hedging instruments
A single swap or a s\\'ap portfolio is hedged in order to protect its value from changes in
interest rares. Iimark-ro-marker accounting is used, these changes in portlolro vaiue are takcn
into income direcril. Correct hedging minimises the volatilitl'of earnings and book value at
the same time. Even in the absence of mark-to-market accountins, hedging is extremely
important because a change in net market vaiue measurcs the economic gain or loss in present
value terms to be reaiised over time.
In managing a swap portfolio, each currency' book should be hedged against interest rate
risk, to the extenr efficient hedging instruments exist. Hedge efficiency is determined by trvo
lactors:
(l) Correlation-how well the value ol the hedge tracks the value of ihe target hedged
position; and,
(2) Cost-the rransaction and carry'ing cost ol maintaining the hedge position.
Traditional hedge instruments include
qovernment bonds,
Sovernment
interest rate lutures
and Eurodollar futures. All of these instruments are imperfect hedges in that their price
behaviour is not periectly correlated with price changes in the swap markets. Note in
parricular that ir is very difficult-if not impossible-to hedge movements in swap spreads
(knorvn as spread risk) other than by writing offsetting swaps. For this reason, a srvap book
should be managed so as to lay ofl-open swap positions as quickly as possible rvith offsetting
swaps which are structured as hedges.
For some books such as the CS book, where the bid-offer in the CS bond market can be
as high as
j
point. rhe transaction cost can be a major lactor in the hedging decision. The
book runner will have to decide on lhe trade-off between interest risk protection and cost.
Of the three main categories of hedge instruments, government bonds are the simplest
conceptually. If a neu,swap is entered paying US$100m fixed rate lor 5 years versus Libor,
then the hedge will be approximately a USSl00 long position in the 5-year on-the-run US
Treasury. There are several practical considerations, however, that limit the use olgovernment
bonds. In DM, for example, it can be very expensive to short the Bunds because there is no
active repo marker. and the pricing of DM swaps should take into account the cost of the
negative carry. In adcjition, the hedge instruments available in Bunds are only in the longer
end of the market, i.e. the 7-10 year range. Hedging a 3-year DM sivap with IO-vear Bunds
therelore exposes the swap book to greater interest rate risk than il 3-1'ear Bunds were
available.
Interest rate futures are advantageous for several reasons. Futures olten are more Iiquid
than government bonds and have lorver bid-ask spreads. Thereiore, the transaction cost oi
putting on and laying off futures hedges is lorver than that associated with hedging u'ith
treasuries. Additronaiiy, the transaction cost may be less with futures, depending on the
borrowing costs in a given currency. If repo costs ore high, it r+,ill be cheuper to ntaintain the
futures
margin account compared to borrov'ing the
full
price of a treasltry. Futures are also
advanrageous in that they allow short positions to be taken in currencies, such as Dlvl and
sterling, that do not aliow treasuries to be shorted. There are several disadvantases horvever.
Primarily, although changes in futures prices are highly correlated with price changes in the
underlying cash market. the correlation with the swap market is rather poor. Another factor
that diminishes the artraction of lutures as hedges is that there are relatively [eu'maturities
available. This is parricularly true of futures on government bonds. For example, US Treasury
exchange traded lutures are avaiiable only for 3-month, l0-year and l5+ year maturities.
Eurodollar futures are useful as short maturity hedges, with quarterly maturities out to 2
years and to a certain extent out to 3 years in US dollars, although the liquidity in the far
contracts is very thin.
In currencies such as ECU, DM, Sh and Yen where efficient hedge instruments are not
available, interest rate risk is unavoidable. In the Yen swap market, for example, although
rhere are Japanese government securities and futures available, the correlation between the
movements in the swap market and the hedge is generally poor. In the past, swap rates have
moved in one direction rvhile the hedge moved in tlre opposite way, due to the spreads. For
ihese currencies, the best hedges are other swaps. ln other currencies, particularly ,{S and
NZS. iutures either do not exist or are too illiquid to be used for hedging purposes and
governmenr bonds crnnot practically be shorted. The solurion is that $rap exposure in these
currencies should be run short (i.e. net
.fixed
ouerborroweil, and hetiged with lona positions in
gouerrunent bonds as requiretl. Short hedges are created by writing short swaps (fixed rate
Pa-YUr /.
B Swap options
1. 'Swap derivatives'
Swap options are contracts where the underlying asset is a srvap. The most common types
ol swaD options are caps and floors and swaptions.
A cap gives the holder the right to pay a predetermined coupon at interest pavment dates.
Caps are generally bought by borrowers in order to put a ceiling on interest payments. A
floor, on the other hand, gives the holder the right to receive a predetermined coupon at
interest payment dates. Floors are often purchased by investors in order to guarantee a
minimum coupon. Caps and ffoors are essentially a sequence of European options on a
ffoating rate wirh expiry set on the coupon payment dates,
A collar is the combined sale oi a cap and purchase ol a floor, or the combined purchase
ol a cap and sale of a ffoor. A corridor is the combined purchase of a low strike cap and sale
of a higher strike cap, or the combined purchase of a high strike floor and sale of a lower
strike ffoor.
A swaption gives the holder the right to enter into a swap at a given date lor a prespecified
time paying and receiving predetermined interest rates. We shall see that since the ffoating
rate leg of a swaption has a value close to par, swaptions can be considered as options in
the value ol a fixed rate bond. Examined in this way, the call swaption gives the holder the
right to receive fixed, while the put swaption allows the holder to pay fixed.
Other types of swap optrons also include: currency swaptions (an option where the
underlyrng asset is a currency swap); currency options (simply a currency swaption where the
underll'ing currency swap is a zero coupon swap).
rnctng
turopean swaptions
Denote:
Then assuming all other notation as in the calculation
a European swaption which gives the hoider the right
to be the strike (expressed
annually ilcoupons are to be exchanged annually;semi-annual
il' coupons are exchanged
on a semi-annual basis. etc.):
to be ln.n, expressed in the same iorm as X.
of the forward swap rate, the cost
to receive fixed is given by:
ol
(3)
where
I ort-
ln-+
"
x2
and dz
=
dr
-
oJT"
A-
U1
-
oJt"
a2 denotes the volatility of rhe lorward swap rate and N(.) is the cumulative normal
distribution.
Equation (3) has a coupon ol extra terms which merit some discussion.
The pay-out in a swaption does not occur at one instant (unless the holder of the swaption
exercises and at the same time enters into a swap to close out the position). Thus the
summation term sums the pay-outs and discounts each by the zero coupon rate relevant lor
that maturity. The division by v ensures that for sw'aptions, where coupon exchanges are not
annual, the expected pay-outs are correctly scaled.
The price oi a put swaption is given by:
C=
[XN(-dr)-N(-d,)],
1
i
v
i=il r
r,(t,)\"'
_/
la
P:
UN(dr)-
XN(dr)l x -
L
v,=n*
c: [2f N(-d.)
-
8 ss4
N(-d,)-l * Discount
Lr00
r00
'l
(4)
,
(,
\'-
notation as above.
Consider pricing a DM European call swaption with a slrike ol 9.3% where the maturity
of the option is 2 years and the underlying swap 5 years. We calculated above that the iorward
3 year swap rate,2 years forward is 8.554%;therefore the price of the swaption is given by:
r,(ti)\'"
rvhere
Discount
:
(1 + 0.09091)3 il + 0.08810)' (r
+ 0.08778)s
Using a volatility oi 10% then:
0.08554
ln_ +
0.093
dr
:
-
0.520s
0 10J2
dz
:
-0.5205 -
0.10J2
:
-0.6620
Finally, from normal tables N(-d')
:
0.698
and N(-dz):0.7+S
also Discount
:
2. 140
so the cost of the swaption is 2.05% up front.
The cost of the put, swaption i.e.. the right to pay fixed. is only 0.46o/o.
The put is less
expensive than rhe cail because the iorward rate is below the strike. II the strike was set equai
to the forward swap rate then the put and call would be exactl,v' the same
price.
r0.10):
'
(2)
)
4. Camma
When the hedging ol currency oprions was studied, it rvas nottceo that in a cielta-hedged
portlolio, ii the trader was long gamma (long on options) and interest rates moved, the value
of the portfolio was always posirive
(assuming time decay can be isnored). The concept can
be exrencied drrectly to swap options. Figure 12.1 shows the profit and loss pronle of the
European swaption posirion (described above in section 3) under parallel shifts in the yield
curve. The movement of the hedge (shown as swap on the plot) is also recorded for movements
in the yield curve. The bold continuous line shows the combination of the swaption and the
hedge. The profit and loss profile is concave as we would expect from our experience of
hedging currency options.
For a single swaption, the gamma we recall is a measure of how often a hedge should be
adjusted in order ro retain delta hedging. A position with a large gamma should be rehedged
for small moves in interest rates.
5. Hedging time decay and volatility risk
Time decay (as noted in section I above) usually only affects long option positions. If the
decay is severe, the option is at-the-money and close to maturity (see Chapter
!
and in
particular Figure
l.l
the trader could sell at-the-money options.
In practice, traders have limits on the time decay of an entire portfolio. Volatility risk, on
the other hand, affects both buyers and sellers of options. If a trader is Iong volatility (in
general long at-the-money options) then a fall in volatility will lead to a loss in value.
We discovered empirically (see Chapter
!)
that the effect of a change volatility ol l.5oh
amounted to only a 20 bp change in the value ol a swap option in the worst case. Thus the
volatility risk is small lor a single swaption.
I08.I2TAB.TXT
Table l. Swap positions required to hedge
lyear European style DM call swaption with
strike at 9.3% (notional principals shown in
millions of DM, negative indicates short
position)
Current coupon
swap maturity
Notional principal
(millions of DM)
6-month
l2-month
2-year
3-year
4-year
5-year
0.00
-
0.02
+ 35.00
-
0.30
-
0.38
-35.14
Table 2. Swap positions required to hedge
Syear European style DM call swaption with
strike at l2% (notional principals shown in
millions of DM, negative indicates short
position)
Current coupon
swap maturity
Notional principal
(millions
of DM)
6-mon th
l2-month
2-year
3-year
4-yea r
5-yea r
0.00
0.17
49.62
-
1.23
-
1.34
-
50.91
4.
Quanto
options
Quantos
are based on the use of a foreign cxchange rate as an index, but with a pavout in US
dollars (or some other third currency).
Example
On 28 lvlay 1992 rve bought a European-style quanto'put', giving us the right to sell lira ior
Deutschmark at 765.4 L/DM on a'notional'ol $100 million but with the payout in US
dollars; the option expires 1i December 1992, but delivers the pay-out (if any) 6 months later
on ll June 1993.
Three distinct currencies are involved, so the loreign exchange risks associated rvith a
position in these options can be complex. Hence we need to outline a precise method for
calculating these risks in order to evaluate and hedge them.
How to value a quanto option
The first step involves a clear statement oi the terms of the option. Rather than using the
language of puts and calls, as per the other types of complex options above, it is better to
phase the terms of a complex ('non-vanilla') option directly and explicitly in the form of a
'contingent claim', i.e. in the form of a'contract'where it is stated that the holder of the
security is delivered X on day Y providing condition Z holds, and so on and so forth. In this
way we avoid any risk of ambiguity.
In the case oi a quanto option the ioreign cross rate (L/DM in the exampie above) serves
as an index, and the idea rs that the dollar pay-out depends on the value of this index at the
maturity ol the quanto.
The terms ol Example A can be stated more explicitly as follows. Let K
:
765.4 L/Drv'l
(strike), and let S* be the L/DM rate on Il December 1992 (the expiration date). If S* > K
the holder of the quanto option receives Sl00m
U
-
(K/S-)1, payable on 11 June 1993; if
S* < K the holder receives nothing.
As awkwardness arises from the lact that the exchange rate at expiration S* appears in the
denominator in the expression for the contingent pay-out; this results from the convenient
but inessential market convention that has the exchange rate quoted in L/DM rather than
DivI/L. In Example A, however, the structure of the deal is much clearer if the exchange rate
is reversed and expressed in DM/L. Then the'strike'rate is K 1.3065 x 10-3 DMiL, where
K: (K)-r. Suppose we write S* for the DNI/L rate at expiration (11 December 1992), then
the terms of Example A can be rephrased again as follows: If S* < K then the holder receives
C(K
-
S*), where C
=
USSl00m/K, payable 6 months later; if S* > K the holder receives
nothing.
Note that rvhen the contract is specified in this way the contingent payout is /inear in S*.
lvloreover K
-
S* is the contingent pay-out lunction ol a single'vanilla' ioreign exchange
option to sell one lira at the rate K, and receive Deutschmark in payment. C is simply a
constant.
The quanto option can therefore be valued according to the lollowing methodology:
(i) First we value an ordinary vanilla foreign exchange option to sellone lira on 11 December
1992 at the rate K (:1.3065 x l0-3 DM/L), receiving Deutschmark in payment.
(ii) Then we multiply the result by (l + Ro-)' where t is the time leit to expiration; this
eliminates the Deutschmark discount lactor used in calculating the present Deutschmark
value of the expected Deutschmark pay-out of the vanilla option, and we are lelt with
simply the expected Deurschmark pay-out of the vanilla option.
(iii) This is then multiplied times the'conversion factor'C which derermines the expecred
dollar pay-out.
(iv) This finally has to be multiplied times (l + Rp.)
-('+o s)
in order to discount the expected
dollar payment to the present. Note the extra 0.5 years added to t. which accounts for
the delayed pay-out-this is the only place the delay enters inro the calculation. It is also
worth noting that the dollar interest rate only appears in this term, and not elsewhere.
Complete formula for quanto valuation
Summing up, the Dresent dollar vaiue oi the quanto
oprion in Exampie A is given b-v the
followrng iormula:
e
: (l
* R"rs)
-,'+o.s)C(l
+ RD"{),p
Equations: hedge positions and delta equivalents
So lar rve have not merje anv snecinc assumptions about the
specialise to the case oi Exampie A, rvhere
Q
depends oniy'
exchange rates, i.e.
Q(:, d) =
H(zl0), w'here H(x) is a function
case by the use oi the chain rule rve obtain:
form oi
Qtr,0)
But nori us
on the ratio of the two ioi:ergn
of the single variable x ,t lhal
d,Q(r,
0): []-'6q
^-
,!-, F
where dq: dHidx is the delta of the quanto option, taken with respect to the underlying
index rate (i.e. the DMiL cross-rate). Insertion oi these expressions into the relations deriveci
earlier than leads to:
Nr_
:
0-'6qNa,
Nov
:
aP-26oNo
These are the required lormulae that state precisely the amount oi Iira and Deutschmarks
needed to hedge Nq quanto optrons at time t. Alternatively, reversing the signs, we can think
of these figures as representing the delta equiualent currencv spot position corresponding to a
long position in No quanto options at time t.
In Example A, we have No: l, and do is given explicitly by
Aa
: (1 * Rurr)
-,'ro 5)C(
1 + RDM)'ip
where, 6, is the ordinary delta of a vaniila European option entitling the holder to sell one
lira in exchange for Deutschmark at the rate K on ll December 1992.
Note that il the DMiL rate increases, the value of the quanto option decreases, so dq is
negative. This implies that the hedge consists of a long position in lira, and short position in
Deutschmarks. It should also be observed that when the book is hedged properly the present
dollar value of the lira position aN. should always be precisely opposite the present dollar
value of the DM position
fNo^r.This
can be understood directly since if the DM/L rate does
not change, the book will be immunised against US$iDM fluctuations only if the sensitivitv
to USSiL fluctuations is exactly opposite.
Forward currency positions
For simplicity ol illustration we have assumed that the hedge is achieved by spot positions
in the foreign currencies.ll
fortard
currency positions are used then the method described
above remains appiicable with just
a few minor modifications.
Let us denote by a, the lorward USS/L exchange rate for time r. That is, z, is the present
cost in US dollar o[ one lira delivered at time r. We shall continue to write a lor ao, rhe
present exchange rate (r :
0). For the number olsuch lorward contracts we shall write N.(r).
Note that r need not be the same as t, the option expiration time. The present US dollar
value ol the book in this case is given by:
v5 :
a,Nt(r) +
p,,No"(r')
+
Q(e,
p)No
where r' is the DNI lorward delivery date.
To calculate the hedge positions we proceed as be[ore, this time making use olthe relations
d,(r,)
:
t,fa and ,ls(0,)
:
0,10.
The result is:
N-.(r)
:
-a(t,0)-'dqNo
No*,(r')
:
a(0,'h-
tdoNo
rvhich gives us the number ol lorward positions required in each case
ol the forw'ard currencv reiations:
. Alternatively, by use
Rot)- ''0
r.: (1 + Rusr)'( i * R1)
-'r
anci
0,
:0
+ R,r\sj'il +
15
As the competition among investment banks intensrfies, new products are created by tailor-
ing7structuring cash (shares and bonds) and derivative (forwards, lutures, swaps and options)
instruments to meet specrfic investment or iunding requirements. The purpose of designing
these strategies is to meet investors'specific hedging or investment objectives wirhout which
'new issues'cannot be successfully placed and consequently satisfy borrowers'target funding
requirements. The secret lies in satis[ying the end objective oi providing borrowers with the
lowest cost of funds, while offering investors the highest possible returns.
However, as the gap between the desired cash flows of borrowers and lenders is becoming
increasingly divergent, especially when the borrower has sub-Libor funding target while the
investor is aiming ior Libor+ yields (not to mention the intermediary arranger,/underwriter's
lees), financial engineering becomes the main source of competitive advantage.
Consequently, sv/aps, options, forwards and futures (the basic building blocks of structuring
and new products) have become the most important instruments in bridging this gap.
However, as the globalisation and complexity oi these derivatives progress, the arbitrages
available through cross-market differences (e.g. swap windows) are declining, while product-
oriented arbitrages are becoming increasingly important. Today, the best arbitrages are
achieved by providing tailor-made cash flows targeting specific niches in investor demand,
usinq the most efficient static hedges followed with dynamic risk management techniques
utilising sophisticated analytical tools and exhaustive'what-if'simulations.
1. Structuring: techniques and methodology
Financial engineering involves transforming the risk and exposure profiles as shown in the
'CME
Futures and Options Strategy Charts'o (see Appendix). The four basic merhods
involve:
(l) Eliminating price risk completely by locking into a future price using lorward or swap,
while giving up the opportunity of gaining if prices move favourably. For example, usine
currency swaps which lock into forward currency exchange rates.
(2) Protecting against downside risk while still maintaining the full upside potential by using
options. However, lrke any
'insurance'
contracts, this costs money and involves the
payment ol an option premium; for example, buying interest rate caps.
(3) Financing the optlon premium in whole or part by selling some or all of the upside
potential. For example, selling out-oi-the-money currency call options.
(4) Taking on risk by writing options, thereby receiving up-front premiums which are used
to reduce borrowing costs. For example giving put options to bond investors.
It is very important to understand that while derivatives can create risk exposes, they are
also used as a tool ior hedging, managing risks and creating interesting strategies.
Basic building blocks of structured products
Underlying instrument, plus:
a
a
Swaps (exchange oi fixed lor floating payments).
Index or'quanto'swaps/swaptions (fixed payments in one currency exchanged for floating
payments in the same currency but based on lnterest rate
[index]
in some other currency).
Caps (pay if interest rate rises above 'strike' Ievel).
Floors (pay ii interest rate falls below 'strike' level).
Forwards/lu t u res.
Options.
a
a
a
a
Why invest in structured products?
There are tu'o main reasons that structured investments are olten attractive: these are
fexibiiity
and enitancenient ol re!urns.
Flexibility
An asset can be created to meet almost any structural reeuirements of an investor: For
example:
Financial engineering
6. Yen variable redemption/reverse
dual currency bonds
The yen variable reciemption,reverse dual currenc\'lssues are e iurther adVancement oI the
'Helven
and Hell'boncls, but rvhich involve two simultaneous lsstles. One constltutes a
'Heaven
and Hell'issue denominared in yen terms, where the bond pays the investor a high
yen coupon, bul where the redemption is related to the yen/doilar exchange rate at ntaturitr'.
The complimenrary reverse dual currency issue has both initial and final principal fixed in
yen, bur the bond pays a coupon denominated in doiiars. These bonds are usually issued
togerher because the redemption lormula in the yen variable bond creates an implicit lutures
contract which can be effectively used in the redemption of the reverse dual currency issue
to create a lower cost ol fundine ior both issuers.
Example issue
Yen uqriable issue Recerse dual currency lssrre
Amount Y20,000,000,000 Y20,000,000,000
Coupon 870 in yen 7.5% in USS
Issue price 101.5% l0l.75o/o
Commissions 270 2o/o
Expenses 5100,000 5100,000
Maturity 10 years 10 years
Redemption
formulas: P*F* l-
(F-S)l
Par iiF > 84.5
r1+-\{'
'l
Fo F
I
Par*(Fi8.1.5) ifF<81.5
rvhere F
:
Exchange rate at maturitv
P
:
Initiai principal
Fo
:
SPot exchange rate
M
=
Leverage multiplier
S
=
Strike exchange rate
At the time oiissue: Spot exchange rate
=
181.39 Y/S
US Treasury yield :
8.4100% (10-year)
The structure is illustrated in Figure 15.9 and the cash flows outlined in Table 8.
Case 2
Euro-ven uariable rerienrptiorr Euro-1'en rel)erse dual currency
Issue amount Y20b Issue amount Y20b
Coupon 8% in yen Coupon 7.5"h tn dollars
Issue price 101.5% Issue price 101.1 50,6
Commission 2o/o Commission 2"/"
Expenses 5100,000 Expenses $100,000
Redemption iormuia Redemption formula
1,000,000/181.39*(1 + 1.146627(F-158.19.1.1)i F If F
: greater than 84.5 Par
Where F
:
Spot rate aI meturity If F
:
less than 84.5 F*20,000,000,000/81.5
Issuerredemption amount S108,585,760.45 Issuer redemption amount Si28,100,630.08
Spot FX 181.39 Spot FX 181.39
Treasury (s.a.) 8.4100
annualised 8.5868 %
Target spread 0.0500% Target spread T + 0.05% (5 bp)
All-in after expenses 8.6368% All-in after expenses 8.6368%
Explanation of the transaction
We begin the explanation of this transaction by making the assumption that the two issuers
involved are multinational corporations who ultimately wish to borrow in fixed rate dollars.
Corporatron A issues the yen variable redemption bond, while Corporation B issues a reverse
ciual currency bond, each with terms as described above.
The variable redernption bonci may require some further expianation. Prior to maturity,
the yen variable bono pays a coupon which is set significantly higher than a normai straight
yen bond. This higher coupon is the compensation paid to the investor in return ior accepting
a variable redemption payment at maturity. Depending on the exchange rate at maturitv,
F
^z < u.l
7>
d, v,
<r!
ur>
>z
rul
d.
o
tr)
2,
trJ
F
z
ila-
3*
>u)
r-=
pc-
3$
>
t/)
s=
$
I
o
I
-o
J
+
J
f
-
+*a
JO
+F
,l
_:n
??
U9
>-
f
:
+>Q
J6
if
oo
z
tJ
N
t-
ha
!v
z
'lli
+
+
a9
xh
I-.1 oa
=<
c-v
<z
i<
>ts
N
+
x
z
-<
>F
x
I
z
tr
o
E
o
E
d.
ll
N
ts
o
E
o
d
ll
x
x
>f
a
x
t4
Ir I
's)
o
O
\J
q
>F
x t-
X i'r
E!l
ac/,
es
o- IZ
!z
,<
qQ
o
l!
z
o-<
2
U
>f
o
X
(J
a
u1
-
z
xh
aJ.
B<
ll.>
o.v
{z
,<
qa
+
Finall-v. one hlts to weieh up the benefit ol possible pro6t compared ro potentiai loss. For
exampie, rn the currency piay oishort seil Iibuy DN{ the upside on the srerling breaki.'- out
oi ER\{ rvas far greater than the potential loss on suffering interest rate differential
iborr.,ving
CBP,4ending DM) between the two currency rates on money-market interest rates, for a short
period ol time, until the British Chanceiior let sterling devalue and find the marke: rate on
l7 September 1992. Traders then squared their sterling posirion by selling the DI\l and
receiving more f than that needed to pay off the f borrowing, sterling having depreciated
against the DM, hence making a huge currency gain. This was a low risk/high gain situation
against which one has to compare little upside (say possible profit ol 2,h with a 75%
probability) against potentially bigge r loss (say possible loss of l0% with a 25o/o probability).
In the former case one might profit by 15% against a possible loss of 2.5ol0. However,
quantiiying
and assigning probability factors to uncertainties on a fast moving trading floor
is perhaps the last thing a trader is thinking of while watching the tempo, trend and volatility
oi the exchange rates and digesting new iniormation/data/statistics as they uniold. However,
for the longer-term portfolio managers, cross-currency swaps easily provided a quick and
liquid method of going short on their sterling portfolios with leverage commensurate with
the firmness of their views and confidence.
Without disciplined analytics and technical research, the thin dividing line between having
market views and speculation disappears. Stop-loss limits are vital, as biding time in the hope
that eveitually the market will turn in your favour, costs money and loses other opportunities.
Quanto
bond structures and reverse/inverse floaters
We shall now look at some of the latest (March 1993) pieces o[ financial engineering and
analyse how they can be used to isolate desired market views. Note that many are highly
Ieveraged and have ernbedded positions in the base currency as well as the indexed portions.
These new products enable pension iunds and insurance companies, which might be restricted
in making foreign investments, to create synthetic structures and exploit specific views that
they have or hedges they require.
Quanto
trades can be used to create positive carry even in
the negative carry trades, while eliminating loreign exchange risks.
Libor differential note
For example: Coupon 5 x
Redemption: Par in USS
Often shown rvith high fixed
Dlvl3m Libor
-
FIM 3m Helibor
-
3a0 bp), paid on US$
coupon and risk in the principal redemption.
Current market. Market prices widening Libor spread, and base currency is positively sloped.
lnvestment view. Investor believes spreads rvill not rviden much and that base currency rates
wiil not rise sharply.
Analytics. The structure is leveraged five times. The 340 bp spread in the DM and FIIvI
drverging curves can be compared to the USS3m Libor ior relative advantage. Furthermore,
the payment is in US$-a positive curve currency-to make currency attractive with as high
fixed rates as possible.
lndexed inverse floaters
For example: Coupon 10.40%-(AuS6m BBR converted to Act/360), paid on Y
Redemption: Par in Y
Often shown with high fixed coupon and risk in the principal redemption.
Market conditions. Index currency and base currency curves are steep.
Rationale. Investor believes that indexed rates (and base rate) will not rise sharply.
Yield curve inverse floater
For example: Coupon 14.65ok-Flr 5-year offer-side swap rate paid on AuS
Redemptron: Par in AUS
Olten shorvn with high fixed coupon and risk in the prrncipai redemptron.
Market conditions. Index currency yield curve is inverted and base currencv curve is positive
Rationale. Investor bullish on index currency's bonds (and does not think base cLlrrenci,/
."tcc rrrill rise)
Table 12. Intermediarr' (l\1')
Yerr Bond's Cesh llcr* F romt(to)rSB Frcm (to)
SB Total
0 99. 100.000 900,000 t00.000,000
I (3.000.000)
3.000,000
(Libor
-
0.10%)
ilibor
-
0.40%)
,
,r.000.000) 3,000.000
(Libor
-
010%) (Libor
-
0 40%)
I il01,000,000) 3,000,000 rLibor
-
010%) ilrbor
-
0.10%)
Table 13. Sr+ap brnk (SB)
I nter-
Fromi(To) (To)lFrom Fromi(To) (To)/From Froml(To) To7(From) mediary
Year SBZ SBZ INTivlED. INTMED. TPB TPB Fee
0 0 (900,000) 0 900,000 0
I 7.161,876 (Libor
-
40%) (Libor
-
.t0%) (3,000,000) (1,243,876) 3,000,000 20,000
2 7.263,876
llibor
-
40%) (Libor
-
40%) (3,000.000) (7,243.876\ 3,000,000 20,000
3 7.263,876 (Libor
-
10%) (Libor
-
a0%) (1,000,000) (7,213,876) 3,000,000 20,000
Table 14. Third partl' bank
(To)/From
From/(To) Option Intermediary Bank's net
Year TPB TPB premium spread cash
0 (900,000) 0 (10,361,030) (10,478,t24)
r (1,000,000) 7,21i,876 0 180,000 4,063,876
2 (3,000.000) 1,243,876 0 180,000 4,063,876
3 (3,000.000) 7.243,8'16 0 180,000
,1,063,876
Table 15. Calculation of the reinvestment rate
Treasury note Swap T + Swap spread Present value Reinvestment
Year yield (s.a.)
spread (p.a.) of original rate
0 ( 10,478,1 24)
I 6.4900,',0 1.000% 1.630% 3,775,775 4,063,876
2 6.860% 1.000% 8.014% 3,483,187 4,063,876
3 6.9209i, 1.000% 8.077% 3,219, t62 4,063,876
10,478, I 24
't
.97290A
Table I. Initial exchange
Amro paid DM Amro rec. USS
Wirh Denmark
-Dlvll83m
rUSSl00m
With Dresdner + DM l83m
-
USS l00m
With ltaly None None
Table 2. Principal exchange-Year 2.5
Amro paid Dlt{ Amro rec. US$
With Denmark + DM l83m
-
USSl0Om
(Final principal exchange)
With Dresdner None None
With Italy None None
Citibank
-DMl83m
+ USSl08.2m
(FX forward sale to Citi at DM/USSl.69l3)
20 Risk management
1. lntroduction
The rechnique oi risk mantgen'rent and portfoiio immunisation is one oi the most important
aspects ol profitiloss and cash florv controls for traders, fund managers and borrowers to
create a risklreward prohle suirable ior their own specific needs. The 6rst step in order to
conrrol and risk mlrnage the derivatives
([orwards, [utures swaps and options). is important
to see how they rrade, methodologies by which these products are priced and analyse their
hedging in theory and practice as we have seen in the previous chapters. Next we determine
and quantily the risks, present and that expected in the future (as per market indicators,
forward prices, forecasrs, etc.), follorved by various simulations ior uncertainties and un-
knowns! Finally, we review the behaviour and correlations between the derivatives and their
hedges/underlying cash nrarkets and monrtor their net impact on a portfolio of cash and
derivative instruments.
Su,aps are essentially instruments that permit institutions to take interest rate and foreign
exchange positions off-balance sheet. They are also the most elhcient instruments available
for assetiliability portfolio restructuring. As banks and other financial institutions warehouse
swaps, i.e. enter into swap agreements without matching counterparties, instead oi hedging
their interest rate risk on a deal-by-deal basis which can prove inefficient and uneconomical,
they develop portfolio management techniques that permit them to take on mismatches in
dates and unusual sets o[ cash flows. These risk controi and immunisation techniques have
become extremely sophisricated with the aim o[ locking in the va]ue oi the trade and enhancing
the net portfolio quantum by at least its cost ol carry.
This chapter demonstrates the management of fixed and floating rate swap exposures and
the risk reporting system lor the ntanagement. It introduces an analytical technique lor
decomposing cash flows of either an individual swap or an entire portfolio into a series of
fixed rate current coupon swaps, known as I + i swaps. These 1 * i swaps provide the means
of marking each book to market, determining the hedges and constructing position reports.
They enable the swap book-runners to manage and hedge complex cash flows on a portfolio
basis and simpliiy the task oi reporting risk positions.
In general, the system should analyse pure cash flows which represent actual payments to
or from counterparries. Actuai cash ffows will be sufficient to value and hedge properly
positions u,here no notional principal is involved, i.e. all fixed rate currency swaps, Iong date
foreign erchange and ioreign currency zero coupon swaps. For swaps with notional principai
amounts (fixed interest rate srvaps), the notional principal must be included in the cash florvs
analysed. This is because inreresr rare swaps have the same volatility as current coupon bonds
where principal is returned at maturity, and this relationship must be preserved. Omission
ol rhe notional principal amount will also prohibit the I + i hedging swaps from eliminating
the associated floating exposure.
1+ i swaps rvill be used in examples throughout this chapter and are of fundamental
importance to swap exposure management. By definition, the / + i s*,aps
for
a series of
fred
cash
J7ot,s
contprise tt series of current
('ouporl
bullet svraps x'hose aggregale
fxed
cash
Jlows
exocth.defeose the originul pa)tments. Since the cash flows olthe portfolio are identical to the
cash floivs created by rhe I + i swaps, the present value, duration, and all other risk
characteristics of the original cash tlows are preserved. In particular, if these 1 + i srvaps are
calculated and written ior the fixed rate swap book, there rvili be no interest rate exposure
remaining in the book.
Unlike the origrnal swaps that create our portiolio, the I + iswaps have recognisable cash
florvs and are easy to analyse. These swaps are the basis on which the books rvill be
marked-t.o-market and position reports constructed. In the process, it will also be shown that
in managing the risk ol the cash and fixed rate books with I * i swaps, Libor exposure in
the floating book will be eliminated.
The requirements ol rhe swap management system rvill be outlined in the next section. The
following two sections wrll then examrne the exposures created by cash events in the fixed
rate book and their impact in the cash account. In the process, it will be shown that by
managing the fixed rate book, the Libor exposure in the floating book rvill be eliminated.
Sections 5 and 6 rvill then expiain the implementation of the risk management reporting
sysrem, in theory and practice. The appenciices to this chapter include sampie reports to show'
the layout anci methodology ol being arvare anci managing the risks anci exposures.
21 Risk management reports
1. lntroduction
This chapter deals with the risk management o[ an integrated portiolio, by currency books,
containing: Trading Book-swaps; options; swaptionslcaps/floors; and Hedges--cash and
fu t u res.
Separate risk and evaluation reporting oi each or any singie product type, I believe. defeats
the whole concept oi portfolio management, especially where the derivatives are hedged on
a net exposure basis by the traders/book-runners and where splitting hairs over profit and
loss allocation is quite futile.
Besides the corporate treasuries and iund managers, the banks and security houses dealing
in derivatives manage colossal portfolios of billions of dollars equivalent in a multitude of
currencies and prociucts. Often these books are inadequately reported to the senior directors
who may or may not be capable of understanding the risks involved and the potential losses
to the company in case of unexpected or adverse market movements.
Unscrupulous traders with or without the co-operation of those directly in charge of them,
are capable of 'couering-up'certain trades and exposures and manipulating the profit and loss
results. Furthermore, the back-office (settlement and accounts) clerks are easily overawed by
the complexity of the structures, and at times too timid to approach the traders with'silly'
questions. It is also the case that so many back-offices are far behind the sophistication of
the front-office due to:
r inadequate training; andlor
o outdated accounting/recording/ssltlement systems; and/or
o lack ol integration between diverse front-office pricing tools; and/or
o incompatible software programs handling the front- and back-office operations.
Hence, it is not always possible to enter the transaction into the firm's systems in the lorm
it was struck. Consequently, the deal may need to be replicated as a series of simpler
transactions, which have not, in reality, been made: or suspense accounts are set up to'dump'
the differences between the accounting and the trading P&L, and reconciliations with
unidentified errors and omissions simply hidden among the tons of paperwork. Unfortunately,
automatic processing lacks integration of some systems.
This chapter also shows how risk exposures can be quantified and reported in a practical
and concise way so that sen;or management are aware of what their book-runners are up to,
realise what risk each individual trader is taking, and the total net exposure to the firm:
thereby directors are enabled to participate actiuely in the decision-making process of risk
management.
The reporting formats and information contained should also cater ior traders' needs and
aid traders in managing their positions with technical efficiency and within their limits. The
mark-to-market should be properly carried out with the correct market data and the resultant
P&L analysis followed-up with post-mortem meetings, and whether a profit or a loss was
made-as both are educative.
Portfolios should meet target returns, after charging cost-of-carry for the capital utilised,
and the up-front trading profits/premiums
conservatively accrued over the life of the deal.
Reserves (for potential losses due to market adversities or deficiencies in the pricing
methodologies) and provisions (for bid-offer spreads, future hedging and rollover costs) ihould
be regularly reviewed for adequacy. Stop-loss controls, position limits (overnight and
intra-day) and the quality and type of deals struck by individual traders should be monitored
systematically, without overlooking the credit and liquidity factors.
The rest of this chapter illustrates specimen reports and explains the importance ol various
'greeks'and
exposure analytics. The reports are by no *.un, perfect, but they cover all the
criticalrisks and sensitivities and identify the characreristics of individualbookslby currencies)
and the aggregate exposure to the company as a whole. Mark-to-market (m-t-ml evaiuation
and P&L are also shown.
We start by checking the adequacy olprovisions (future
hedging and other costs lor specific
deals) and reserYes (contingency
for uncertainties). It should U. not.a that this distincrion is
also important for tax reasons, as the former artract tax reliel while the latter cio not. The
accounting treatment also differs and makes a difference to the bottom-line
p&L
as well as
management and traders' perlormance
evaluation.
ilr positions and P&L (mark-to-ntarket rcvalualion) Drtc: l0-June-1992
\otes ri)
Position
at l0-6-92
r1\
Position
at 9-6-92
{3)
({)
Daily CCY Darlv (USS)
P&L Equrv MVT
(5) i,l
\l-T-D CCY \l-T-D
tUS
change
movement
rs)
(9)
Nlonthly Tooal's
P-tareet FX-rate
(s)
Positron
ar 3l-5-92
*aps
is lJook
:: T-bond
Futures
S5
ps Book
rs Book
s-Gilts
Futures
rwapS
ns Book
's-Bunds
Futures
)!I
Swaps
nsB
35-t_-11
-' Futures
I Futuresr
:CU
5.806.700
(19,372)
(314,923)
lt0
i r?1 ?)s
I,223,400
451,860
0
(r s,0s5)
I,660,205
4,639.000
.
r 2,630
0
( 14,915)
4,636,715
(382,300)
0
0
(57,28 7)
0
(439,s 87)
5,8r2,r00
(18,3i l)
(315, I 96)
4,610
5,461,201
r,235,000
447,013
0
( r 3,1 80)
r,668,833
4,652,200
13,590
0
(20,645)
4,615, I 45
(388,700)
0
0
(59,r87)
0
(41't,987)
5,69 5,600
(?0,5 r 6)
(287,285)
4,430
5,392.229
(s,036,800)
49t,347
6,234,996
( 1,867)
t,687,67 6
4,773,600
r 4,209
0
(99,e26\
4,687,883
(276,000)
n
0
(53,465)
(270)
(329.135)
l I 1,100
l,l+{
(27,638)
(4, l l0)
80,,{96
6,260,200
(39,487)
(6,234,996\
(r3,r88)
(27,471)
( 1 34,600)
( l,s79)
0
85,011
(5 1,1 68)
( 1 06,300)
0
0
(3.822)
132
(109,900)
USS/I
l.8300
DIVT/USS
1.5963
US/ECU
L2813
Yen/U$
127.1250
(5.400) (5,100)
(1,052) (i.051)
ln 1?': ln l?1
(4,300) (1,i00)
o <r, 0
(r,
il 1,600) (21,228)
4,841 8,E70
00
(1,875) (3,131)
(8,628) ( r s,789)
( r 3,200) (8,269)
(960) (60r)
00
5,730 3,590
(8,430) (5,280)
6,400 8,2 r 9
00
00
2,000 2,569
00
8,400 10,788
l, .00
I . 1.+.1
(27,6r8)
(1, l l0)
80,496 USS-r00,000
1 1,156,166
(72,261)
(11,4r0,043)
(24, r 34)
(50,272) Sl25,ooo
(84,320)
(e8e)
0
53,255
(32,054) DM500,000
( 1 36,52 1)
0
U
(4,e0e)
170
(141,260) ECU75,000
595,342
(463,2ss)
(93,es2)
(68,506)
(30,371) Y75 million
waps 2,051,988,100 2,051,975,900 12,200
nsBook (932,618,710) (931,008,926) (1,609,814)
e*-JGBs (12,000,000) (12,000,000) 0
Futures (l1,400,000) (10,150,000) (1,250,0m)
i'en I,095,969,360 I ,093,8 I 6,974 (2,847,614)
olio totals (in baselreporting currency) USS (23,054)
l ,975,948,000
76,040,100
(873,449,5t1) (59,t69,226)
(12,000,000)
(2,650,000) (8,750,000)
1,099,848,486 (3,879,126)
us$ (.11146r)
95
( l 2,603)
0
(9,787)
(22,295)
)&L
summarv/reconciliation
!rlLI
Trader's P&L
Estimate Today's P&L M.T.D P&L M-T-D Target
Reserves &
Provisions Trader's comments
ss 0 9.522
a
'.-
(7,000) (8,628)
\{ no estimate given (8,430)
lu 5,000 8,400
e n (3,000,000) (2,8.{7,6 14)
80,496
(21,47 t)
(5 1, 1 68)
( l 09,990)
8, I 20,874
166,667 0 Hedged portfolio; no new deals today.
41,661 0 Unexpectedlossesdueto......
166,667 0 Losses due to strategic mispositroning
25,000 0 Portfolio haemorrhaging; hedge problem
25 million (45 million) Provision for basis risk cross-ccy swap
:s'& Explanations:
)osition
at l0-6-92
=
The net long/(short) fixed srde m-t-m book value, today.
:)osition
al 9-6-92: The net long/(short) fixed side m-t-m book value, yesterday.
)aily currency change
=
Increase/(decrease) in the net worth olthe portfolio
=
column (l)
-
column (2) gives profit/(loss).
)aily (US$) equivalent movement: This is the USS translation of 'The daily currency change'= column (3) x column (9).
rosition
at 3l-5-92: Net book value as at the end of previous month.
ll-T-D currency change
=
Cumulative P&L for the current month.
\1-T-D
US$ movement: Translation ol-(6) above at today's FX rate.
\lonth's profit target: Monthly apportionment of annual target set by the Board of Directors.
.y target
=
Trader's pro6t targett + Portfolio cost of carry, lor I day
:formance target set by the management
ier's achievement: M-T-D P&L, i.e. Actual performance versus Target set by management.
iX rate used
=
This is today's currency exchange rate used to translate the results into the base currency for head office reporring
es: ECU Book can be hedged by a cash basket, of the government bonds, making up its constituent currencies in the same proportion. However.
:rsnsaction costs are prohibitive and the non-availabiiity and illiquidity ofcertain government bonds render the hedge inoperative. Alternatively.
:rttal cash basket is created with a mtxture ol say, Bunds and Gilts only resulting in a partial hedge rvith the associated correiation risks.
'wrng
to the lack of iong ECU futures, ii Bund and Gilt futures are used ior long hedges rhen these are rranslated into ECU. for booking purposes
he above exampJe, oniy Bunds futures were used and translared dailv irom DM to ECU. which creares FX P&L besides the futures m-t-rn.
he ECU portfolio has a negative NPV which accrues over rrs life. The pro6ts therefore come lrom the trading and hedging operations only.
5 Portfolio immunisation
1. Risks and hedging of risks of a single swap
Havinr: investrgated the mark-to-nrarket rnethodology to value swaps, we shall in this chapter
identrly the rrsks ol entcring into u swap, and then go. on to explore how these risks can be
hedged. One such method, involving constructing a portfoiio of the swap together wirh a
series of current coupon swaps, is described in detarl. Although the suggested metnod is quire
inefficient to hedge a single swap, the extension of hedge portfolio of swaps (and indeed swap
options) is trivial.
The risks of a swap
The holder of a swap laces three types oi risk. Credit risk, the first of the three, is the risk
that one counterparty in a swap defaults on payments and has an exposure to the other
counterparty. This subject is discussed exhaustively in Chapter
l.
The second risk, which is perhaps the most important is that of In(erest rate risk. As interest
rates change the mark-to-market olthe cash flows alters and thus the value of a swap changes.
The third risk faced is Currency risk. Swap dealers manage swaps in single currency books.
By doing so currency swaps are simply treated as two sets ol cash flow and hedged with
other cash ffows ofthe same currency in different books. Foreign exchange hedging ofa swap
book is discussed in grearer detarl in Chapter
t.
Hedging the risks
The perfect hedge lor a single swap, as mentioned before, is to enter into an equal and opposire
swap. As the cash flows are exactly equal and opposite, the only risk which remains is credit
risk.
In a large portfolio, however, this method of hedging is extremeiy inefficient and it would
be vtrtually impossible to execute as a result of bid-ask spreads. Clearly an alternative
approach is required.
Prevlouslv, we saw that swaps can simply be considered as a strip oi cash ffows and that
the value ol an interest rate swap is given by:
n
v
:
f
C(ri)D(ti)
where there are n cash ffows and ti, ...., tn represents the time at which these cash florvs are
made. The cash flows at time t, is C(t,) and the relevant discounting factor at time t, is D(t,).
It is possible to hedge the interest rate risk oi a swap by creating a portfolio consisting of
the swap plus a set of new current coupon swaps. Let the value ol the portlolio ...ut.J b.
denoted by v. Then:
v:
f
X,v,
j=o
(1)
(2)
where vo is the original swap, Xo is l, v1,..., v.
swaps with notional principal I and X,,..., X-
required to neutralise interest rate risk. Notice that
COUpOn Swaps vr :
V2 :
...V-
:
0 SO the present
equal to that ol the original swap vo.
To be certain that the value oi (2) is preserved
lact ensure that:
are the value of the added current coupon
are the number of current coupon swaps
since v,,..., v- are the value ofthe current
value of the created portfolio V is simply
for changes in the yield curve we shall in
dV
m
dv,
\ v
r
:^
ar,(t,)
,?o
'Jr.(t,)
lor 1 :
1, 2..... L (3)
T.,irlcs I rnti .l ,riler ilte lu.irk-(o-ntltrket
s\\.tLr rirte rs blrpoetl. Thus tlre estrmate ol
is crlculated b1
citlctrlrttit,rr rt't elujr ,ri tirc ctrrcs rritcrc thc
j-rrlu
,/ r'n
rlr.{
j
)
_1S7.S"15
-
196,+01
-
{1i,800 pe r i
o.o
:(0.0 I i
Tirble.l shorvs tlte elTect on the present value oi the D\l s\vap ol blipping each of the current
coupon swap rates in turn.
To find the hedees we must also calculate the eflect of a blip in cuch of the srvap rates to
the value ol each ol the current coupon s\\'aps. AII but the diagonal elements are zero. Table
5 gives the effect on the value of each oi the current coupon sw'aps lor a l0% move of each
swap rate.
The hedge is calculated by direct implementation of equatron (6). The srvap positions which
should be entered into are shown in millions. The siens assume that the trader is long the
fixed side oi aj DM swap. (See Table 6.)
The trader should therelore pay fixed on a 5-year currenr coupon swap *'ith a principal
of D)vlilm and pa1, fixed on a 4-1'ear current coupon swap rr,ith a principal oi DNI39m. In
prilctice the trader rvould probabl-v- not rvorrv ab0ut the other positions as these are small.
2. Delta hedging
The method descrrbed and illustrated above is called delta hedging. The idea, rve recall, is to
hedge using an approximation of the first derivative with respect to the underlying variable.
We shall discuss this method, in detail, together rvith a couple olother hedge possibilities, in
the context ol currency options, in the next chapter. The discussron will set the scene lor
much ol the marke t terminoloey of srvaptions.
It should be noted that the delta hedge is onll'a good local hedge (snrall changes); iiinterest
rates move 100 bp the hedge is not perfect. Let us now investigate how effective the hedge
is, in the example in the previous section. to a (non-parallell
move tn the yieid curve. We
shall consider t\+'o portfolios. The first consists of the naked posrtion (r.e.
only,rhe 4j year
DIVI srvap unhedged). The second port[olio consists oi the inrtial swap rogerher w'ith a shorr
position o[ tlte 5-year current coupon swap to the tune oi DM llrn and a shorr position ol
DN{i9m ol the 4-year current coupon swap.
Let us superimpose a couple olnon-parailel shiits to the yreld curve;rnd record rhe chanees
to the value oi each portlolio under these shi[ts. The first shilt represents a ffattening oi the
curve by an increase in the long-term swap rates, while the second shilt also represents a
ffattening but by a lall in short term interest rates. The shiits are shown in Table 7.
The change in value or P&L (Profit & Loss) ior both port[olios under the nvo scenarios
is given in Table 8.
First consider the yield curve shift A. Thc hedged portiolio fairs lar better, the loss is limitecl
to only DM13,000. If we had entered into all six oi the suggested hedges this figure rvould
be even closer to zero.
The second yield curve shiit did not afTect the 4- or 5-year rare and rhus the unhedged
portiolio is relatively unchanged in value. The hedged portiolio has recorded a profit mainly
because we are receiving ffoating at a relati!el1'high rate (remember
the l2-month Libor rate
lell l5 bp in this case).
As inrerest rares move. rhe hedge ol a swap position itself alters slightly. The delta hedging
excrcise abovc rvus repcated for a llat 1"1, yield curve representing a 200 bp move in most
marurities. Table 9 compares the hedges under the two yield-curve scenarios.
The 4- and 5-year hedge positions have hardly altered, the 6-month swap position has,
however. changed significantly. This change is because we are paying floating. and a floating
coupon o1"9.833% is due in 3 months'time, although the market rate is 7%.
The concepr of a change in a hedge caused by movement oi the underiving is reiatei to
rhe gamma oia porriolio Swaps have practicaily zero
qamma,
while options have, in generai,
non-zero samma. We shall study this concept in depth by looking at currencv options in
Chapter
I
and apply this to swaption hedging in Chapter
l.
5. The Black-Scholes pricing formula for European-style options
We shall initially develop the Black-Scholes lormula in order to price European-style optioits
on srocks which pay no dividend. The lormula will then be extended to consider European-
style options on indices and currency options. We will then progress on to interest rrte and
bond options and finally explode the complexities oi exotrc options.
In order to be able to pnce options on stocks we shall assume:
(l) The risk free rate is deterministic (usually constant).
(2) The underlying stock price follows a log-normal random walk*.
'
It is oflen questioned why a (normal) random walk rs not used. II we were to use a normal random walk it wouid
be possible to obtain negarive srock pricesl The log-normal distribution ensures that the stock price is al*'ays
non-negative.
European-style options on stock
(no
dividends)
Let the stock price S be some function of time and a random component:
S
:
f (time, random component)
(We shall assume the random component is a Weiner process.)
The cost of the optron is some other function of the stock price and time:
g:g(time,S)
Now construct a portfolio ol the stock and option in such a way as to eliminate the random
component from the formula of the portfolio's return. Since the portfolio's return is in-
dependent of a random component it should be equal to the risk-free rate. Then by lto's
Lemma:
Equation (l) is the heat equation rvhich models heat ffow.
We know that ior a European call when t
:
0, C
:
max(S
-
K, 0) Thus the solution ro
(l) ior a call is:
C: SN(d,)
-
Ke-"N(d:)
where:
CC
-+rS At
^
o-L
S'-
:
rC
AS'
('.5)
(l)
aL o-
as2
r"
(!)
*
\K/
/')\
d::dr-oJl
Nrxr: I
ls-,":6t
J
_,
J2"
For a European put P
=
max(K
-
S,0) and so the solution to (1) for a put is:
dr:
oJl
P: Ke-"N(-dr)
-
SN(-dr)
An approximation for N(x)
To calculate N(x) by evaluating the integral numerically would
a number of approximarions exist. One such approximation is
(3)
take a long time. Fortunarely
given belorv.
Remember, S, K must be quoted in American stvle; r, I nrust bi in continuous comnounded
form.
Lf!) *(,-r*a)'
\K/ \
2/
d,=
=
0.188
oJt
dz=dr
-oJr=0.025
Using the approximation referred to above:
N(dr)
:
0.5745 N(d2)
:
0.5100
Thus by equation (4):
c
=
SN(dr)e-r'- Ke-"N1dri
=
0.2855
-
0.2492
=
0.0364
The cost of the option is 3.64 cents per DM or 6.l9oh up-front (3.641K).
Example 2
Assuming the following price a put on
Ucall
on US$ with a strike of 1.60 and maturity of 3
monthsl
Spot
:
1.67 SIL
US$ risk-free rate
:
9.7% (annual)
I risk-free rate
:
l4.5oh (annual)
Volatility :9Yo
S
:
1.67
K
:
1.60
t
:
0.25 (3 months, not 3 years)
r
:
0.0926
l'
:
0.1354
o
=
0.09
dr
:
0.73614 d2
:
0.69114
N(-d,)
:
0.23083 N(-dz)
=
0.24475
hence replacing values in equation (5) the cost of the put is I cent per I or 0.624" up front.
Note. This option is quite inexpensive because the strike, K, is much less than the spot S and
the implied forward for the 3-month period.
European-style options on stock indices
Equations (2)and (3) can be adjusted to price European-style options on stock indices:
C
:
Se-q'N(d,)- Ke-"N(d2) (6)
The formula lor a European style put is:
P: Ke-"N(-dr)- Se-q'N(-d,) (7)
where:
S is equal ro the value of the index, o is equal to the volatility ol the index, q to the average
annualised yield on the index during the life of the option. In calculating q, oniy dividends
rvhere the ex-dividend date is during the life of the option should be included.
Note. Equations (6) and (7) are the same as (3) and (4) but with f replaced by q.
FII\AI{CIAL
ENGINEERING
&
RISK MANAGEMEI{T
INDEX
coMpr.-rrER
prsKETrE
(. .DOC) / CHAPTER TITLE Pages
FII.{-ENGN.DOC
COVER
DEDICATION
CONTENTS
CONTENTS
(I-8)
PREFACE
(9-lo)
INTRODUC
(1) INTRODUCTTON TO DERTVATTVES
(10/A-F)
SWAPS
(2\ SWAPS
(11-42)
i. Swap Mechanics
2. Why Use Swap Products?
3. Benefits of Swaps versus Bonds and Futures
4. Pricing Swaps
5. Swap Market Rates
6. Mark-to-Market of Swap Positions
7. Zero Coupon Swap Valuation
8. 1+i Analysis
9. Basis Swaps
10. Arrears Swaps
1 1. Cross-Currency Basis Swaps
12. Yield-Curve Swaps
13. Index/Quanto Swaps
14. Risk Management of Complex Diffs
(1)
S\\'APACCT
1. P&L-and Balance-Sheet Considerations
2. Mant-to-:l,rturket -.methodologies
3. Discounting method
4. Evaluation
TAXATION
(17) TAXATTON
1. Forwards & Futures
2. Options
3. Swaps
4. Tax Planning
(xxx-xxx)
SWAPCRDT
(18) SWAP CREDTT POLTCY
(37s-383)
1. Credit Risks on Swaps
2. Netting of Counterparty Exposures
3. Credit Policy for Swaps
4. Counterparty Credit Limits
5. Active Credit Management
REGULATS
(19) REGULATORY TMPACT
1. Securities and Banking Regulations
2. Capital Adequacy
Afterword -mentiort of the Strategic Report "Financial lingtneering - Risk Management in Practice"
Appendix - Formulae and mathematical models
- The'Greeks'
435
(s)
Euromoney Strategic Report
Financial Engineering
- Risk Management in Practice
DRAFT INDEX
*:extra/newmatenal
FIN.ENGN.DOC
CO\IER
DEDICATION
CONTENTS
CONTENTS
PREFACE
INTRODUC
(l) TNTRODUCTTON TO DERTVATTVES
FOREX
(2)* FORETGN EXCHANGE
1. Forward Foreign Exchange Contracts
2. Currency Discounts and Premiums
3. Trading & Opportunities
4. Hard and Soft Currencies
5. Currency Blocs and Snake
6. Deposits and Loans
(1-8)
(e-10)
(10/A-r)
SWAPS
(3) SWAPS
(ll-42)
1. Swap Mechanics
2. Why Use Swap Products?
3. Benefits of Swaps versus Bonds and Futures
4. Pricing Swaps
5. Swap Market Rates
6. Mark-to-Market of Swap Positions
7. Zero Coupon Srvap Valuation
8. i+i Analysis
9. Basis Swaps
10. Arrears Swaps
1 1. Cross-Currency Basis Swaps
12. Yield-Curve Swaps
13. Index/Quanto Swaps
14. Risk Management of Complex Diffs
(D
OPT]ONS
(e) oPTroNS
(89-133)
1. Notation & Basic Definitions
2. PayoffDiagrams
3. Variables which affect the price of a stock option
4. Assumptions made in the Black-Scholes and Binomial models
5. The Black-Scholes Pricing Formula for European-Sryle Options
6. Plotting the value of European-options prior to maturity
7. A Diffusion Model for American - Style Options
8. Volatility
9. Interest Rate Options
10. Derivatives of Cost (the Greeks)
I i. Hedgrng and the importance of the delta and gamma
12. Options Portfolios
13 Trading Volatility
SWAPTION
(10) swAP oPTroNS
(lsl-1s8/A-r)
1. 'Swap Derivatives'
2. Capsffloors
3. Yield-Curve Caps/Floors
- strucruring & Pricing
4. Complex/QuantoCapslFloors
5. Swaptions
6. Risks
7. Option Valuation Issues
cT.TRRENCY
(134-150)
(11)CURRENCY OPTION PRICING,asan Introduction to Interest Rate Options
1. Factors Affecting the Price of a Currency Option
Interest rate differentials
Volatility
Intrinsic value and Time value
2. A Brief Derivation of the Black-Scholes Model
3. American Options and the Binomial Tree Approximation
4. Interest-Rate Options
INTOPTS
(r2) PRTCING OPTTONS ON TNTEREST RATES (1s9-175)
1. Caps and Floors
2. European Swaptions
3. Modelling the Term Structure
4. Pricing European Swaptions Using An Interest Rate Tree
5. American Style Swaptions
6. In-The-Money and Out-Of-The-Money Srvaptions
(Ir)
SWAPACCT
(r8) ACCOUNTING
(361-371)
i P&L and Balance-Sheet Crinsiderations
2. Mark-tolMarket methodologies
3. Discodnting method
4. Evaluation
RISKMANG
(19) RrSK MAr.{AGEMENT
(315-347)
1. Introduction
2. Srvap Risk Management System Objectives
3. The Cash Book
4. Managing Fixed and Floating Rate Exposures
5. Implementation - In Theory & Practice
Appendix l. Zero CouPon SwaPCurve
Appendix II. Sample of Risk Management Report
to do...delta sensitivity and graph !t!t?l???/lll
NEWRISK
(20)* RISK MANAGEMEI.IT REPORTS
(348-360)
1. Introduction
2. Reserves Policy
3. fusk Profiles
- Yield Curve fusks
- Spread Risks and Mismatches/Gaps
- Basis risks
- Delta (Portfolio Equivalents)
- Theta (Time Decay)
- Gamma (Bond Convexiry,;
- Vega (Volatility Changes)
4. Exposure RePorts
5. P&L'. Mark-To-Market
6. Sensitivities: derivatives
hedges
7. Management RePorts
8. Trader Limits & Performance Measurements
g.
Pricing and
Quality
of market data used for Evaluation & M-T-M
10. Short-term Book Management
1 l. Checks & Controls - Monitor & Authorise
- Procedures & ComPliance
- Deal Confirmations and Settlements
(v)
TAXATION
(25)* TAX TREATMENT OF DERfVATIYES - Coopers & Lybrand
Tax relief for Reserves & Provisions
- Taking advantage of timing tax cash-flows
Deferrin g i ncome, bringtn g forward costs/expenses
Tax avoidance
(not evasion) schemes
(involving Capital Gains
tax treatment instead of taxation of profits at less favourable
Corporation Tax levels e.g. creating culrency gains/losses vs
'.wer interest rate currency on New Issues, etc.)
TAXANON
(26) TAX PLANNING
(xxx-xxx)
1. Forwards & Futures
2. Options
3. Swaps
4. Tax Planning
SWAPCRDT
(27) SWAP CREDTT POLTCY (37s-383)
1. Credit Risks on Swaps
2. Netting of Counterparty Exposures
3. Credit Policy for Swaps
4. Counterparty Credit Limits
5. Active Credit Management
REGI'LATS
(28) REGULATORY TMPACT
1. Securities and Banking Regulations
2. Capital Adequacy
LEGAI
(29)* LEGAL - Rogers & Wells
Global Trading and Booking Transactions
Using legal and regulatory
jurisdiction
of different countries
Obligation on parties to ensure counterparties transactgd-wrthin therr powers
D(rcUMENT
(30)* STANDARD DOCUMENTATION
Master Agreements & Confirmations
ISDA
Appendix - Formulae and mathematical models
-
*Futures
& Options Strategy Chart
- The'Greeks'
-
*ISDA
Report on Swaps Accounting and Reporting ...prmission ?!?!...
*Glossary
!?
(!T)