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 openup 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 workedthrough examples and stepbystep 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 sellproclaimed derivatives specialist houses, with more aspirations
than technical resources. gasping for breath. And while the lesser securities houses are trying
to muscletn with a metoo marketing hype, the corporate treasurers and fund managers are
beine rrppedoff 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 overpriced (ior new products, offmarket 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 Blackscholes 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 BlackScholes
modei which was developed lor shortdate equity options. The modified BIackScholes models
work well for simple interest rate options such as caps, floors, collars and European options
on zerocoupon bonds. Howeuer,
for
more compler options and swaptions, the modified
BlqckScholes 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 yreldcurve plavs such as the Liborinarrears swap (which is a pla1, on rhe impiieci
forward rates by having Libor set say, 6months in arrears). and the ipread swap (which
enables. lor example, one party to pay the 5year swap rate and receive the 10year rite, both
reset semiannualll', or the counterpartv could even pay the seconci ieg in 5rnonth Libcr).
We examine how the diversity ol new products can be used to tailor very precise
riskrew,aro
profiles anci create acided value.
13. Risk management of complex diffs
Let tts now perfornr indepth anulyric,s ol'inile.r lilJ'ercntiul s*'apsthe 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'.
6month Libor or the 51'ear swap rate.
Example
CHFUSS indcr
Base currency':
Face value:
Stirr datc:
End date:
Frequeno':
Receive:
Pav:
differential swap
USS
USS200m
5 Aug l99l
5 Aug i996
Semiannual
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 i1 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 ith hedging instrumenr,
Y, rs the additronal short position in the irh hedging instrument:
a, and b' be the limits on the sensitivity o[ the portiolio value to changes in the
rnterest rate in the ith 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 ith 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 nonnegative 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 nonparallel rate movernents.
This is shown to have some weakness in that it only looks at the variance of cash flows about
one point in trmethe durationand 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. Iimarkromarker 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 marktomarket 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) Correlationhow well the value ol the hedge tracks the value of ihe target hedged
position; and,
(2) Costthe 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 difficultif not impossibleto 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 oflopen swap positions as quickly as possible rvith offsetting
swaps which are structured as hedges.
For some books such as the CS book, where the bidoffer 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 tradeoff 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 5year ontherun 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 710 year range. Hedging a 3year DM sivap with IOvear Bunds
therelore exposes the swap book to greater interest rate risk than il 31'ear Bunds were
available.
Interest rate futures are advantageous for several reasons. Futures olten are more Iiquid
than government bonds and have lorver bidask 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 3month, l0year 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
PaYUr /.
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;semiannual
il' coupons are exchanged
on a semiannual 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 payout 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 payouts 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 payouts 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,)###BOT_TEXT###quot;'
_/
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)
,
(,