19 June 2000

International Swaps and Dcrivativcs Association

New York

Operations Training Course

Interest Rate and Currency Derivatives

David Mengle
Vice President
J.P. Morgan Securities Inc.
Today's schedule

Basic concepts
Interest rate and currency derivatives
Pricing, valuation, and unwinds
Structure of a derivatives business
Future value

Future Value of an amount to be received at

the end of 1 year, FV,, is the present value
today, PV, plus the interest earned on that
Using your HP,
amount at rate r,

FV, = PV, + r, PV, = PV, (l+r,) 5

The future value of $5 in 1 years time at a rate 10

of 10% = $5.50 1

hit = -5.50
So one could invest $5 now at 10% and
receive $5.50 in one year.
Compounding: Computing future value
Solving for FV when given PV, r, t

If the interest rate is constant over all Using your HP,

periods, the initial amount will compound to
a future value FV, in t periods 100

FV, = PV, (1 + r)' 10 E l

Given:
20 R
hit = -672.75

FV,, = $100 (1.1 0),O = $672.75

Discounting: Computing present value

Solving for PV, when given FV,, r, t

If you want $672.75 in 20 years time, how

much will you have to invest today at a rate Using your HP,
of 1 O%?
672.75

10 L l
20 R
hit = -100

-
 Streams of payments: Annuities
What is PV, of $10 for 5 years at lo%?

,
General formula

PV, = $10 + $10 + $10 + $10 + $10 PV-

(1.10) (1.10)*
(Available from tables
1 for PMT=$l)
= $10 [ -
1
(1.10) +
-
(1.10)~+ (1.10 (1.10)~+ (1.10)5
'k
= $10 [ Annuity factor (5 years, 10%) 1 Using your HP,

10

10 I
So, $37.90 will buy $1 0 per year for five 5
years at 1 0%.
= -37.9
Streams of payments: Annuities
What annual payment for 5 years is worth $37.90 today at lo%?

Payment = PV, + [Annuity factor (5 years, lo%)]

= $37.90 + 3.79 = $10

So, $37.90 today is equivalent to $10

per year for five years at 10%. Using your HP,

37.9
This formula is useful for caps or floors, when
calculating the annualized up-front premium. 10

7
Three forms of derivatives activity

Exchange-traded
- Futures

- Exchange-traded options

Over-the-counter (OTC)
- Swaps

- Forwards

- OTC options

Structured securities & {&-a

Interest rate risk
Situation
A U.S. bank ("Client") expects to receive a loan
repayment of US$l00 million in two years from a
domestic corporation
Loan funded with one-year US$ deposit
Client is concerned that US$ interest rates will rise

Assets Liabilities

Loan Deposit
(2-year, fixed rate) (1 -year Libor)
US$100 MM US$100 MM
 Interest rate risk
Situation

I -year 2-year
Libor Fixed Rate
Deposit Client Loan
 Forward rate agreement (FRA)
A forward contract on interest rates

*-FI-
One year from now

Libor Fixed Rate

Deposit Loan

1
m

Reference : Contract
Rate Rate
/ I
\ Forward rate,
Libor, determined I

at settlement date determined when

contract is agreed
Dealer (dealing date)
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 A$h bfk
/ @&w"
Client assumes credit exposure to Dealer (and vice
versa)
Uses of FRAs

Lock in short term borrowing costs

Hedge floating rate asset
Manage rate reset risk
Short term protection of long term investment
Seasonal borrower
Hedge funding mismatch
 Forward rate agreements
Terms

Contract amount = Notional (underlying) amount )

12x24 = 12-month rate in 12 months

Settlement date Maturity date Contract period

(Effective date)

Contract period = (Maturity - Settlement)

Underlying deposit rate is set on settlement date
Buyer hedges against rise in rates (borrower)
Seller hedges against fall in rates (lender)
FRA payout: Example

On December 15, Nervous Corporation buys

-3x6FRA
- contract (forward) rate is 10%
- settlement (effective) date is March 15

- maturity date is June 15

- contract amount (notional principal) is $100 MM

- reference rate (3-month LIBOR) on March 15 is 1 1%

What is the payout (settlement amount)?

FRA payout
Settlement sum

Cash-settled: One party makes net payment to other

Paid at settlement date, not maturitydate
Settlement sum is present value of interest that would be
paid on notional amount at maturity date
FRA payout formula
"FRABBA" terms

/L - R) x DxA
Settlement sum =
(B x 100) + (L x D)
L = Reference Rate
R = Contract Rate
D = Days in Contract Period
A = Notional Principal
FRA payout

On December 15, Nervous buys 3 x 6 FRA @ lo%, effective date is

March 15, maturity date is June 15, notional principal is $100 MM,
and 3 month LIBOR on March 15 is 1 1%

/L-R) x D x A
Settlement sum =
(B x l o o ) + ( L x D )
Where do forward rates come from?
Yield curves

Par curve: Yields on full coupon bonds (which pay

periodic interest), from which we can derive...
Zero coupon (or spot) curve: Yields on zero coupon
bonds (which pay interest only at maturity), which
imply...
Forward curve: Yields expected to prevail in future
periods
- The market's best estimate of future zero coupon

yields
Where do forward rates come from?
No-arbitrage conditions

Assume following zero coupon rates:

- One-year: 6%

- Two-year: 7%

Choices:
- Invest $100 for two years at two-year rate

- Invest $100 for one year at one-year rate,

then reinvest proceeds at forward rate

What forward rate could you lock in today for
one year from now?
 Where do forward rates come from?
No-arbitrage conditions

Arbitrage occurs if one investment choice guarantees profit

compared with other investment choice

What one-year rate, one

year from now (1 2x24
forward rate), would make
6.00% $106.00 grow to $1 14.49?
X.XX% = R12x24
= 8.01 %

Today 1 year 2 years

Where do forward rates come from?
No-arbitrage conditions

Value of two-year investment after two years (237%:

- $100(1+.07)(1+.07) = $100(1 .07)2= $1 14.49

Value of one-year investment after one year @6%:

-$100(1.06) = $106.00
-Rate at which you reinvest $106.00 must lead to
$1 14.49 after one year
-Implies 12x24 forward rate of 8.0 1%
$100(1.0600)(1.080 1) = $1 14.49
Otherwise, arbitrage is possible
Another forward rate calculation

3-year zero rate is 10%

1-year zero rate is 6%
What is the 2 year rate, 1 year forward (12x36)?

+ R,,~36 )2 * (1 + .06) = (1 + .
+ R12x36) -
- 1.25566

+ R,,x36 = 1.120563
R12x36 = '
120563

So 12x36 forward rate is 12.06%

Yet another forward rate calculation
Libor less than one year

When calculating rates for

periods of less than one year, 2-MO 5.5400 %
use simple interest
What is the market's view of 3- 5-MO 5.7700% 5.9418%
month Libor beginning in 3
months?
6-MO
9-MO
1-YR
3
5.8252 %
5.9780 %
6.1244%

3x6 forward rate is 5.94%.

Why?
 Calculating the implied 3x6 forward rate
Multiply each rate by
Given: fraction of year
(days13 60)
- Six-month Libor is 5.8252%

So 3x6 forward rate is 5.94%

Now let's all try it
Please get out your HPs. ..

Assume:
- 6-month Libor is 5.83%

- 12-month Libor is 6.12%

- 2-year zero coupon rate is 6.53%

Find:
- 12x24 forward rate

- 6x 12 forward rate
 Find the 12x24 forward,rate
Libor greater than one year
Using your HP,
Assume:
- 12-month Libor is 6.12%
1.0653
- 2-year zero coupon rate is 6.53%

2
(1.0612) * (1 + RI2,,, ) = (1 .0653)2
1.0612
(1 + R12x24)
= (1 .0653)21 1.06 12

+ R~2x24= 1.0694 El
0694 .0694
R1 2x24 =

So 12x24 forward rate is 6.94%

 Find the 6x12 forward rate
Libor less than one year
Using your HP,
Assume:
-6-month Libor is 5.83% 1.0612 Fl
- 12-month Libor is 6.12% .0583

1
So 6x12 forward rate is 6.23% 2
.0623
Futures contracts
An alternative to forward contracts

Institutional features that promote liquidity

- Standardized contracts

- Organized exchanges

Institutional features that reduce credit ri

- Clearinghouse is counterparty -
- Daily settlement (mark to market)-%+

- Margin requirements - W 9@ $
- Loss-sharing arrangements
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

Assets Liabilities

U.S. Agency Note Deposit

(5-year fixed @6.5%) (1-year Libor)
US$100 MM US$lOO MM
 Interest rate swap

Fixed Rate
(6.5%)

-0
Libor

Deposit Client Agency Note

Libor . Swap
Rate

..
... (6.1%)

Dealer

Net Funding Cost: 5-Year Swap Rate = 6.1%

Interest rate swaps
Definitions

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
Swap cash flows

Time De~osit Swap &t

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)

At inception, PV(F1oating Rate Leg) = PV(Fixed Rate Leg)

Swap spreads
Often quoted as spreads over Treasury rates

Client 5-Year U.S. Treasury rate = 5.70%

5-Year Swap Spread = 0.39%/0.42%

m 5-Year Swap Rate = 6.09%/6.12%

Libor :
If Dealer pays fixed, swap rate is 6.09%
m

rn
If Dealer receives fixed, swap rate is 6.12%
But, swap rates increasingly used by market
Dealer
participants as benchmark rate instead of
treasury rates
Applications of interest rate swaps

Hedge an asset or liability

Modify an existing cash flow
Decrease borrowing cost
Increase investment yield
Guarantee liquidity
- CP program is only source of borrowing
- CP suits floating rate asset structure

- Access fixed market and swap into CP

Access markets not otherwise available

- Low-rated corporation with no access to long term fixed rate funding borrows

floating and swaps into fixed

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 ar
sell a specified amount (contract amount) of the
underlying asset at a predetermined price (strike price) at a
stated time (maturity date).
Call option - option to buy
- Interest rate cap

Put option - option to sell hei-&%

- Interest rate floor

Option buyer or holder (long)

Option seller or writer (short)
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

European option can only be exercised at expiry

American option can be exercised any time up to expiry
 Option payoffs

10

0
q/,
Gain +

..........................

90
I I
100
Premiuni = 10
Strike = 100

I
Gain +

8; ...dl
I
Premium = 8
Strike = 100

Sell
..........................
I I

-1 0
BUY / y.
0
1.
1.

ilu: i 0
Loss -
Break even
at 110
I
Loss -
Break even
at 92

Call option Put option

Payment = max (Price-Strike,O) Payment = max (Strike-Price,O)

 Options
Interest rate cap

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

Up-front premium
- - (on Trade Date)
Libor
Deposit 4 Client Dealer
C Max (L-Strike,O) -
(on each Payment Date)
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.
 Underlying exposure before cap

US$ million Underlying

Exposure

Interest Expense
on US$100 MM
Interest rate cap on US$ LIbor
-

Net cap payout

Cap Rate (Strike) = 6.0%
Notional Amount = $100,000,000
US$ million

-- I [(Libor-6.0%) - 0.40%]
Out of the Money 1
- & w ~ I
I
4.50 5.50 I 1 5 0 7.50 US$ Libor (%)

-- I
I
In the Money -
w e
I
6.00 Up-front Premium = 180 bp = $1,800,000
Annualized Premium = 40 bp = $400,000
 Interest rate cap on US$ Libor
Cap Strike = 6.0%
million
Annualized Premium =

Interest Expense
on US$100 MM
I

Exposure

5.06 6.00 7.00

US$ Libor (%)

Capped Funding Cost = 6.00% +.40% = 6.40%

 Calculating the annualized premium
What annual payment for 5 years is worth 180 bp today at 6%?

When you pay the option premium, you

pay up front as a lump sum
But to determine the effective cap Using your HP,
protection, you might want to express
i 80
the premium on an annual basis
6 El
Use the annuity formula to convert the
lump sum into a stream of payments
5 R
The annual equivalent of $1.8 million
p
1 = 42.73

up front is $427.3 14 per year for five

years
 Interest rate collar

US$ million

Interest Expense
on US$100 MM
I / Collared
Exposure

Cap Strike = 6.0%

It / / Floor Strike = 5.0%

Net Premium = 0

4.0 5 .O 6.0
US$ Libor (%)
5.0% < Collared Funding Cost < 6.0%
Foreign exchange basics

Quotation conventions
- Foreign currency1USD
Deutschmark (DEM), Swiss franc (CHF), Canadian dollar (CAD)
- USDIForeign currency
British pound sterling (GBP), Australian dollar (AUD)
If the DEMIUSD exchange rate rises from 1.75 to 1.80,
- The USD has appreciated of because $1 can now buy more DEM
- The DEM has depreciated because it now takes more DEM to buy

$1

Spot versus forward FX transactions

- Spot FX involves settlement in two days
- Forward FX involves settlement at an agreed-upon future date
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

Assets Liabilities

Note Deposit
(1-year, fixed rate) (1-year @ 1-year DM Libor)
US$100 MM @5.90% DM180 MM 633.95%
 Currency forward

One year from now:

-I -
US$105.90 M M DM 187.11 MM
Note Client Deposit

Note: Currency forwards are

US$105.90 MM

normally pltysically-settled, that

is, each party makes a currency
payment to the other
. I *

Dealer
DM 187.11 MM

Spot rate = 1.800

Forward,rate = 1.767
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
 Interest rate parity
Two ways to get to the same result...

Money rates (1-year) Exchange rates

US$ Libor = 5.90% Spot: 1300
DM Libor = 3.95% 1-year forward: 1.767.
General formula for forward exchange rate

In the previous example:

US$lOO MM x (1 + 5.90%) x FWD = US$100 MM x SPOT x (1+ 3.95%)
. . (1 + 5.90%) x FWD = SPOT x (l+ 3.95%)
. . FWD = SPOT x (1+ 3.95%)/(1 + 5.90%)

Generally, for currencies quoted in Currency/US$:

FWD = SPOT x [(I+ F+,,)/(l + Rus,)]

For currencies quoted in US$/Currency:

 Find the GBPIUSD 12-month forward
Remember, GBPIUSD is quoted in USD terms...

Assume: Using your HP,

- 12-month GBP Libor is 7.44%

- 12-month USD libor is 5.90% 1.059 Fl

- Spot USDIGBP is 1.6300

FWD = SPOT * [(I +R,,,)/(l+&,,)]

1.0744 Fl
FWD = (1.6300) * [(I .0590)/(1.0744)] 1.6300 Fl
FWD = (1.6300) * (.9857) 1.6066

FWD = 1.6066
Emerging markets considerations
Situation

A U.S. corporation owns a Korean subsidiary

- Subsidiary pays periodic Korean won dividend to parent
- Parent exposed to depreciation of KRW

But, no onshore KRWIUSD forward contract

available
- Korea liberalized currency rules in April 1999
- But, continuing limitations on KRW borrowing by
nonresidents make it difficult for foreign institutions to
settle forwards in KRW
Solution: Synthetic ('non-deliverable') forward

NDF contract cash-settled offshore, in US$ fl w&3

Settlement amount equal to US$ value of local currency
depreciation or appreciation

US$ Onshore spot market

KRW
* Local bank
Subsidiary
<
US$
Characteristics of non-deliverable forwards

Why use NDFs?

- Capital or convertibility controls might prevent dealing onshore
- Even if there are no restrictions on onshore dealing,
- Offshore market might be more liquid

- Counterparty risk or settlement risk might be lower offshore

- Less risk of capital controls or regulatory risk offshore

Risks of NDFs
- Basis risk between onshore and offshore rate movements
- Local government opposition to NDF

Expectations of depreciation of controlled currency might

lead to differences'between onshore and NDF rates
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$)

Assets Liabilities

Loans Note
(5-year, fixed rate) (5-year, fixed-rate)
US$100MM (236.8% DM180 MM @4.8%
Currency risk

US$ Loans

US$
Interest
,
German Bank
I US$lOO
million

German bank exposed to rising

deutschmark

A
DM DM 180
Interest million
V

DM Note
Currency swap
$ I00 million

US$ Loans DM 180 million

A Initial principal exchange

US$lOO
million
V

German Bank Dealer

A
DM 180
million

DM Note
Currency swap

US$ Loans

6.8%

I
German Bank 4
6.1% (US$)
w. Dealer
4.8% (DM)
Payments during swap

4.8%

DM Note
Currency swap

US$ Loans

US$l 00
m~ll~on
v
Dealer
German Bank
-
f--
A

I
DM Note
DM 180
million Final principal exchange
US$100 million

DM 180 million
Currency swap
$ I00 million

US$ Loans DM 180 million

Initial principal exchange

6.8%

V
6.1% (US$) -_
7
Dealer
German Bank 4
4.8% (DM) -~
A
.- Payments during swap

4.8%
Final principal exchange
V
US$100 million

DM Note DM 180 million

Currency risk
Situation

German bank wants to lend in U.S.

Will fund by borrowing in DM at DM Libor
Exposed to rising DM (falling US$)
Exposed to DM interest rates

Assets Liabilities

Loans Deposits
(5-year, fixed rate) (1 -year)
US$lOO MM 636.8% DM 180 MM @DM Libor

m &&
Uses for currency swaps

Access to foreign currency and capital markets

without purchasing underlying cash instruments
Arbitrage by purchasing "cheap" assets in one
currency and swapping into another
- Lower funding cost, or
- Increase investment yield

Diversify currency risk without changing

underlying asset portfolio
Currency risk
I

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)

Assets Liabilities

Loans Note
(5-year, fixed rate) (5-year, fixed rate)
US$100MM @6.8% DM180MM @4.8%
Currency options
ProfitfLoss
US$ Put
(DM million)

\
\
\
\
\

-----

Strike = 1.80 DM/US$

Up-front premium = 270 bp
Annual Premium = 60 bp

US$ Put = DM Call

Variations on swap and options contracts

Types of contracts
- Basis swaps
- Options on swaps (swaptions)

Structured notes
Underlying risks
- Credit derivatives
- Commodity derivatives
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

Assets Liabilities

Loans Deposits
(Prime Rate) (3-month Libor)
US$100 MM US$100 MM
Solution: Basis swap

Definition: An interest rate swap in which both

payments involve floating rates
Purpose: To lock-in spread between assets &
liabilities
 Basis swap

Libor, Prime
Rate
Deposits Client Loans

rn

rn

Libor
f Prime -
' 2.75%

Dealer
 Cross-currency basis swap

DM Libor US$ Libor + 50

German
DM
Deposits Loans

.
DM Libor : US$ Libor
+ 10

Dealer

Swap includes initial and final principal exchanges

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
Solution: Swap option

A swap option (swaption) is an option on a fonvard-

starting swap
- Can also be an option to cancel an existing swap in the future

Gives the holder the right, not the obligation, to enter into
a swap contract in the future
- Combines an option contract with a swap contract

Single option on a long-term fixed rate

- In contrast to caps, which are series of options on short-term rates
 Types of swap options

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.
Structured securities
Basic function

Fixed
income 1
I
Derivative
Structured
Structured securities
Basic structure

Coupon plus swap

Investor Issuer

- Embedding a swap into security

- Most often used by investors to

obtain desire return profile Dealer

 Using structured securities
Yield curve note

7.38% + (R(10)-R(2))
Investor 4 Issuer
.
I 4
2-year rate I I 10-year rate

Goal: To express a view that the

yield curve will steepen, but
without having to roll over bond
positions for two years .
L l Dealer
Credit (default) swaps
The 'plain vanilla' of credit derivatives

a
Protection buyer
X bp per annum
*
I Protection seller

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
Total return swaps

LIBOR + X bp p.a.
TR Receiver TR Payer
TR of reference
obligation

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 TRLReceiver if total return is positive
- TR Receiver pays TR Payer if total return is negative
 Commodity options: Put option on gold
Net option payment Revenues
(US$/oz.) (US$MM)
28.0.-

27.0-

Sell put

26.0--

I I
I Price
50 255 260
/ Buy put
/

I I I I
I

240 250 260 270 Price

Option payoff Combined exposure

(per ounce of underlying) (Gold sales revenues on
100,000 ounces)
 Commodity swap

Fixed
Shipping
Company 4 Producer
Floating fuel Floating
oil price crude price A

Floating fuel Floating

oil price crude price

v
Fuel Oil
Supplier Market
Average price ('Asian') options

Description
- Payoff is the strike compared with the average commodity price
over a specified period (e.g., monthly averages with monthly
settlements)
- Most commonly used commodity option structure

Motivation
- Useful in markets in which participants buy or sell on a continuous
basis
- Less expensive than American or European options because
volatility of average price is less than volatility of daily price
d.p +