“RISK MANAGEMENT USING DERIVATIVE

PRODUCTS”
A PROJECT SUBMITTED IN

FULL COMPLETION OF

MASTERS OF MANAGEMENT STUDIES

TO

TIMSR

BY

SAWAN JAIN

UNDER

PROF. Jai Kotecha

TIMSR

FULL TIME – BATCH – 2015-2017

Shyamnarayan Thakur Marg, Thakur Village,

Kandivali (East), Mumbai 400101

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 DECLARATION

I hereby declare that the project report entitled “RISK MANAGEMENT USING
DERIVATIVE PRODUCTS.” submitted to the THAKUR INSITUTE OF MANAGEMENT
STUDIES AND RESEARCH, Mumbai, is a record of the original work done by me under the
guidance of Prof. Jai Kotecha, and this project work is submitted in fulfillment of the
requirements of the degree of Masters of Management Studies. The results embodied in this
thesis have not been submitted to any other Institute or University for the award of any other
degree or diploma.

Place: Mumbai Sawan Vijaykumar Jain

Date MMS Finance

Roll No. 26

(Batch 2015-17)

Faculty Mentor: Prof. Jai Kotecha Dr. Ramakumar Ambatipudi

Designation: Assistant Professor Director

TIMSR TIMSR

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 Contents

S.No Topic Pg

1 Risk and Methods of Risk Mitigation 6

2 Forwards ,Futures & Options 11

3 Credit Default Swaps 19

4 Interest Rate Swaps 29

5 Interest Rate Options 35

6 Assets Backed Securities 39

7 Swaptions 44

8 Conclusion 47

9 References 48

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 Executive Summary

The globe saw the financial meltdown in the year 2008 and there came a need for a breed of
smart people who could understand the sophisticated yet dangerous financial tools known as
derivatives. This project highlights the various derivative products that are used to hedge a
business against the risk it can face in the form of interest rate fluctuations, currency fluctuations,
adverse market movements and a possibility of a credit default. There are Market Risk, Credit
Risk, Operational Risk and Regulatory Risk which will be hedged by using different types of
Derivative Products of Forward, Future, Option and Swaps. The project will help us to know that
how to manage/minimize/mitigate the risk associated with Finance so that the investor can take
proper decision.

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 Acknowledgements

I wish to express my gratitude to those who extended their valuable co-operation and
contribution towards the project.

I would like to thank my project guide Prof. Jai Kotecha for his valuable time and continued
assistance for the successful completion of the project.

I would also like to express gratitude to Prof. Dr. Ramakumar Ambatipudi , Director of Thakur
Institute of Management Studies And Research for facilitating this project and providing his
guidance throughout the duration of the project.

I would also like to thank the faculty and staff of the institute for their support.

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 Chapter 1 . Risk and Methods of Risk Mitigation

Risk is any uncertainty about a future event that threatens your organization's ability to
accomplish its mission. Risk management is a discipline for dealing with the possibility that
some future event will cause harm. It provides strategies, techniques, and an approach to
recognizing and confronting any threat faced by an organization in fulfilling its mission.

Risk management does not aim at risk elimination, but enables the organization to bring their
risks to manageable proportions while not severely affecting their income. This balancing act
between the risk levels and profits needs to be well planned. Two distinct viewpoints emerge -
one that is about managing risks, maximizing profitability and creating opportunity out of risks
and the other that is about minimizing risks/loss and protecting corporate assets. The
management of an organization needs to consciously decide on whether they want their risk
management function to 'manage' or 'mitigate'.

In ideal risk management, a prioritization process is followed whereby the risks with the greatest
loss and the greatest probability of occurring are handled first, and risks with lower probability of
occurrence and lower loss are handled in descending order. In practice the process can be very
difficult, and balancing between risks with a high probability of occurrence but lower loss versus
a risk with high loss but lower probability of occurrence can often be mishandled. The every day
to day business faces a variety of risks. These risks are in the form of Interest Rate Risks,
Currency fluctuation Risk , Credit Default risk, Operational Risk, Marketing risks. Considering
the financial exposure of a business, let us see how one use derivatives to hedge and protect
against these risk. Financial risk management is the practice of creating economic value in
a firm by using financial instruments to manage exposure to risk, particularly credit
risk and market risk. Other types include Foreign exchange, Shape, Volatility, Sector, Liquidity,
Inflation risks, etc. Similar to general risk management, financial risk management requires
identifying its sources, measuring it, and plans to address them. Financial risk management can
be qualitative and quantitative. As a specialization of risk management, financial risk
management focuses on when and how to hedge using financial instruments to manage costly
exposures to risk.

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In the banking sector worldwide, the Basel Accords are generally adopted by internationally
active banks for tracking, reporting and exposing operational, credit and market risks

When to use financial risk management

Finance theory (i.e., financial economics) prescribes that a firm should take on a project when it
increases shareholder value. Finance theory also shows that firm managers cannot create value
for shareholders, also called its investors, by taking on projects that shareholders could do for
themselves at the same cost. When applied to financial risk management, this implies that firm
managers should not hedge risks that investors can hedge for themselves at the same cost. This
notion was captured by the hedging irrelevance proposition: In a perfect market, the firm cannot
create value by hedging a risk when the price of bearing that risk within the firm is the same as
the price of bearing it outside of the firm. In practice, financial markets are not likely to be
perfect markets. This suggests that firm managers likely have many opportunities to create value
for shareholders using financial risk management. The trick is to determine which risks are
cheaper for the firm to manage than the shareholders. A general rule of thumb, however, is
that market risks that result in unique risks for the firm are the best candidates for financial risk
management. The concepts of financial risk management change dramatically in the international
realm. Multinational Corporations are faced with many different obstacles in overcoming these
challenges. Research by many, including Raj Aggarwal has started to disclose much of the
decisions and impacts firms must make when operating in many countries. Research has
specifically identified three kinds of foreign exchange exposure for various future time horizons,
transactions exposure[, accounting exposure, and economic exposure.

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TYPES OF RISKS

The business of banks is the business of risk. That is the primary reason of banks and financial
institutions- to consolidate, diversify, manage, bear and be paid for risk. But until recently banks
have looked at these risks as isolated exposures to be assessed and managed individually, each
leading to separate capital reserves. The ultimate measure of risk management is the capital
needed to protect the banks against each risk. Banks do not yet look at these risks and calculate
capital requirement in a consolidated or integrated manner.

Risk in lending loan is generally associated with the possibility that the realized return will be
less than the expected returns. The source of such disappointed is the failure of interest and/or
the security’s price to materialize as expected. Forces that contribute to variations in returns are
the price and interest constitutes elements of risk. Some influences are external to the firm,
cannot be controlled, and affect large number of securities. Such risk is known as systematic risk.
Economic, political and sociological changes are sources of systematic risk. While those risk
influencing the firm internally and can be controllable to large extent are known as unsystematic
risk.

 Market Risk
It is the risk that changes in financial market prices and risks will reduce the value of a security
or a portfolio. In other words, any adverse movement in market variables gives rise to a situation
of ‘loss’, which is the fundamental in any risk analysis. Market risk for a fund is often measured
relative to a benchmark index or portfolio, and is referred to as a “risk of tracking error” market
risk which also includes “basis risk,” a term used in risk management industry to describe the
chance of a breakdown in the relationship between price of a product, on the one hand, and the
price of the instrument used to hedge that price exposure on the other.

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  Credit Risk
Credit risk is defined by the losses in the event of a default of the borrower to repay his
obligations or in the event of a deterioration of the borrower’s credit quality. It is usually
associated with loans and investments, but it can also arise in connection with derivatives,
foreign exchange and other extensions of bank credit. Measurement of the credit risk is crucial if
the banks have to price the loan correctly or to set the appropriate limits on amount of credit
extended to any one borrower or the loss exposure it accepts from any particular counter party.

Foreign exchange risk

Market risk

Equity risk

Financial
Commodity risk
Risk
Operational
Liquidity risk
risk

Default risk

Exposure risk
Credit risk

Portfolio risk

Mark-to-Market risk
Legal risk
Recovery risk

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  Operational Risk
Operational risk is an expression of the danger of unexpected direct or indirect losses resulting
from inadequate or failed internal processes, people and systems or from external events. This
risk signifies that for an organization to continue its operations, some external events like natural
disasters, political and military turmoil, not directly connected with the organization may affect
its well -being.

 Legal and regulatory Risk

Legal risk arises for a whole of variety of reasons. For example, the counter party might lack the
legal or regulatory authority to engage in a transaction. Legal risks usually only become apparent
when a counter party, or an investor, loses money on a transaction and decides to sue the bank to
avoid meeting its obligations. Another aspect of regulatory risk is the potential impact of a
change in tax law on the market value of a position.

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 CHAPTER 2. Forwards, Futures & Options

Forward Contract:

A cash market transaction in which delivery of the commodity is deferred until after the contract
has been made. Although the delivery is made in the future, the price is determined on the initial
trade date

Whenever a customer books a forward contract he has to be absolutely sure about the date of
receipt of the payment for his exports or he can give the bank a time period of 7 to 8 days within
which he expects to receive his payments for which he would book the rates with the bank. Now
if there arises a case if the payment is not received according to date fixed earlier or if the
payment gets delayed and is not received within the time period given to the bank the forward
contract gets cancelled and the export would be booked at the current market rates thus defeating
the purpose of booking the contract as the customer gets exposed to the market risk. Also the
RBI has relaxed the norms for the customer that a customer is given the time period of 7 days
within which the payment can be done after the date of the forward contract, the forward contract
would be valid and no cancellation charges are charged as it is done in the previous case.

Also if a customer has booked a contract at a rate for example at Rs 46.5 per dollar at a certain
date and as the time passes and if there arises a case where the current market rates are higher
than the booked rates(we are talking about the export forward contract) then the customer has the
freedom to cancel the contract and avail of the current market rates and earn the potential profits
from the transaction .this requires a keen understanding of the rates and current economic
activities which could as hint towards movements of the rates in the upward or downward
direction.

How a forward contract works

Suppose that Bob wants to buy a house a year from now. At the same time, suppose that Andy
currently owns a $100,000 house that he wishes to sell a year from now. Both parties could enter
into a forward contract with each other. Suppose that they both agree on the sale price in one
year's time of $104,000 (more below on why the sale price should be this amount). Andy and

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Bob have entered into a forward contract. Bob, because he is buying the underlying, is said to
have entered a long forward contract. Conversely, Andy will have the short forward contract.

At the end of one year, suppose that the current market valuation of Andy's house is $110,000.
Then, because Andy is obliged to sell to Bob for only $104,000, Bob will make a profit of
$6,000. To see why this is so, one needs only to recognize that Bob can buy from Andy for
$104,000 and immediately sell to the market for $110,000. Bob has made the difference in profit.
In contrast, Andy has made a potential loss of $6,000, and an actual profit of $4,000.

The similar situation works among currency forwards, where one party opens a forward contract
to buy or sell a currency (ex. a contract to buy Canadian dollars) to expire/settle at a future date,
as they do not wish to be exposed to exchange rate/currency risk over a period of time. As the
exchange rate between U.S. dollars and Canadian dollars fluctuates between the trade date and
the earlier of the date at which the contract is closed or the expiration date, one party gains and
the counterparty loses as one currency strengthens against the other. Sometimes, the buy forward
is opened because the investor will actually need Canadian dollars at a future date such as to pay
a debt owed that is denominated in Canadian dollars. Other times, the party opening a forward
does so, not because they need Canadian dollars nor because they are hedging currency risk, but
because they are speculating on the currency, expecting the exchange rate to move favorably to
generate a gain on closing the contract.

In a currency forward, the notional amounts of currencies are specified (ex: a contract to buy
$100 million Canadian dollars equivalent to, say $114.4 million USD at the current rate—these
two amounts are called the notional amount(s)). While the notional amount or reference amount
may be a large number, the cost or margin requirement to command or open such a contract is
considerably less that that amount, which refers to the leverage created, which is typical
in derivative contracts.

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Relationship between the forward price and the expected future spot price

The market's opinion about what the spot price of an asset will be in the future is the expected
future spot price. Hence, a key question is whether or not the current forward price actually
predicts the respective spot price in the future. There are a number of different hypotheses which
try to explain the relationship between the current forward price, F0 and the expected future spot
price, E(ST).

13
The economists John Maynard Keynes and John Hicks argued that in general, the natural
hedgers of a commodity are those who wish to sell the commodity at a future point in time.Thus,
hedgers will collectively hold a net short position in the forward market. The other side of these
contracts are held by speculators, who must therefore hold a net long position. Hedgers are
interested in reducing risk, and thus will accept losing money on their forward contracts.
Speculators on the other hand, are interested in making a profit, and will hence only enter the
contracts if they expect to make money. Thus, if speculators are holding a net long position, it
must be the case that the expected future spot price is greater than the forward price.

In other words, the expected payoff to the speculator at maturity is:

E(ST − K) = E(ST) − K, where K is the delivery price at maturity
Thus, if the speculators expect to profit,
E(ST) − K > 0
E(ST) > K
E(ST) > F0, as K = F0 when they enter the contract
This market situation, where E(ST) > F0, is referred to as normal
backwardation. Since, forward/futures prices converge with the spot price at
maturity (see Basis), normal backwardation implies that futures prices for a
certain maturity are increasing over time. The opposite situation,
where E(ST) < F0, is referred to as contango. Likewise, contango implies that
futures prices for a certain maturity are falling over time.

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Future Contracts:
A futures contract is a standardized contract to buy or sell a specified commodity of
standardized quality at a certain date in the future and at a market-determined price (the futures
price). The contracts are traded on a futures exchange. Futures contracts are not "direct"
securities like stocks, bonds, rights or warrants. They are still securities, however, though they
are a type of derivative contract.

The price is determined by the instantaneous equilibrium between the forces of supply and
demand among competing buy and sell orders on the exchange at the time of the purchase or sale
of the contract.

In many cases, the underlying asset to a futures contract may not be traditional "commodities" at
all – that is, for financial futures, the underlying asset or item can
be currencies, securities or financial instruments and intangible assets or referenced items such
as stock indexes and interest rates.

The future date is called the delivery date or final settlement date. The official price of the
futures contract at the end of a day's trading session on the exchange is called the settlement
price for that day of business on the exchange.

A futures contract gives the holder the obligation to make or take delivery under the terms of the
contract, whereas an option grants the buyer the right, butnot the obligation, to establish a
position previously held by the seller of the option. In other words, the owner of an options
contract may exercise the contract, but both parties of a "futures contract" must fulfill the
contract on the settlement date. The seller delivers the underlying asset to the buyer, or, if it is a
cash-settled futures contract, then cash is transferred from the futures trader who sustained a loss
to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a
futures position has to offset his/her position by either selling a long position or buying back
(covering) a short position, effectively closing out the futures position and its contract
obligations.

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Margin
To minimize credit risk to the exchange, traders must post a margin or a performance bond,
typically 5%-15% of the contract's value.

To minimize counterparty risk to traders, trades executed on regulated futures exchanges are
guaranteed by a clearing house. The clearing house becomes the buyer to each seller, and the
seller to each buyer, so that in the event of a counterparty default the clearer assumes the risk of
loss. This enables traders to transact without performing due diligence on their counterparty.

Margin requirements are waived or reduced in some cases for hedgers who have physical
ownership of the covered commodity or spread traders who have offsetting contracts balancing
the position.
Clearing margin are financial safeguards to ensure that companies or corporations perform on
their customers' open futures and options contracts. Clearing margins are distinct from customer
margins that individual buyers and sellers of futures and options contracts are required to deposit
with brokers.

Customer margin Within the futures industry, financial guarantees required of both buyers and
sellers of futures contracts and sellers of options contracts to ensure fulfillment of contract
obligations. Futures Commission Merchants are responsible for overseeing customer margin
accounts. Margins are determined on the basis of market risk and contract value. Also referred to
as performance bond margin.

Initial margin is the equity required to initiate a futures position. This is a type of performance
bond. The maximum exposure is not limited to the amount of the initial margin, however the
initial margin requirement is calculated based on the maximum estimated change in contract
value within a trading day. Initial margin is set by the exchange.

If a position involves an exchange-traded product, the amount or percentage of initial margin is

set by the exchange concerned.

In case of loss or if the value of the initial margin is being eroded, the broker will make a margin
call in order to restore the amount of initial margin available. Often referred to as “variation
margin”, margin called for this reason is usually done on a daily basis, however, in times of high
volatility a broker can make a margin call or calls intra-day.

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Calls for margin are usually expected to be paid and received on the same day. If not, the broker
has the right to close sufficient positions to meet the amount called by way of margin. After the
position is closed-out the client is liable for any resulting deficit in the client’s account.

Some U.S. exchanges also use the term “maintenance margin”, which in effect defines by how
much the value of the initial margin can reduce before a margin call is made. However, most
non-US brokers only use the term “initial margin” and “variation margin”.

The Initial Margin requirement is established by the Futures exchange, in contrast to other
securities Initial Margin (which is set by the Federal Reserve in the U.S. Markets).

A futures account is marked to market daily. If the margin drops below the margin maintenance
requirement established by the exchange listing the futures, a margin call will be issued to bring
the account back up to the required level.
Maintenance margin A set minimum margin per outstanding futures contract that a customer
must maintain in his margin account.

Margin-equity ratio is a term used by speculators, representing the amount of their trading
capital that is being held as margin at any particular time. The low margin requirements of
futures results in substantial leverage of the investment. However, the exchanges require a
minimum amount that varies depending on the contract and the trader. The broker may set the
requirement higher, but may not set it lower. A trader, of course, can set it above that, if he
doesn't want to be subject to margin calls.

Performance bond margin The amount of money deposited by both a buyer and seller of a
futures contract or an options seller to ensure performance of the term of the contract. Margin in
commodities is not a payment of equity or down payment on the commodity itself, but rather it is
a security deposit.

Return on margin (ROM) is often used to judge performance because it represents the gain or
loss compared to the exchange’s perceived risk as reflected in required margin. ROM may be
calculated (realized return) / (initial margin). The Annualized ROM is equal to
(ROM+1)(year/trade_duration)-1. For example if a trader earns 10% on margin in two months, that
would be about 77% annualized.
Settlement is the act of consummating the contract, and can be done in one of two ways, as
specified per type of futures contract:

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 Physical delivery - the amount specified of the underlying asset of the contract is delivered
by the seller of the contract to the exchange, and by the exchange to the buyers of the
contract. Physical delivery is common with commodities and bonds. In practice, it occurs
only on a minority of contracts. Most are cancelled out by purchasing a covering position -
that is, buying a contract to cancel out an earlier sale (covering a short), or selling a contract
to liquidate an earlier purchase (covering a long). The Nymex crude futures contract uses this
method of settlement upon expiration
 Cash settlement - a cash payment is made based on the underlying reference rate, such as a
short term interest rate index such as Euribor, or the closing value of a stock market index.
The parties settle by paying/receiving the loss/gain related to the contract in cash when the
contract expires.Cash settled futures are those that, as a practical matter, could not be settled
by delivery of the referenced item -

Expiry (or Expiration in the U.S.) is the time and the day that a particular delivery month of a
futures contract stops trading, as well as the final settlement price for that contract. For many
equity index and interest rate futures contracts (as well as for most equity options), this happens
on the third Friday of certain trading months. On this day the t+1 futures contract becomes
the t futures contract. For example, for most CME and CBOT contracts, at the expiration of the
December contract, the March futures become the nearest contract. This is an exciting time for
arbitrage desks, which try to make quick profits during the short period (perhaps 30 minutes)
during which the underlying cash price and the futures price sometimes struggle to converge. At
this moment the futures and the underlying assets are extremely liquid and any disparity between
an index and an underlying asset is quickly traded by arbitrageurs. At this moment also, the
increase in volume is caused by traders rolling over positions to the next contract or, in the case
of equity index futures, purchasing underlying components of those indexes to hedge against
current index positions. On the expiry date, a European equity arbitrage trading desk in London
or Frankfurt will see positions expire in as many as eight major markets almost every half an
hour.

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 Chapter 3. Credit Default Swaps

A credit default swap (CDS) is a swap contract in which the protection buyer of the CDS
makes a series of payments to the protection seller and, in exchange, receives a payoff if a credit
instrument (typically a bond or loan) undergoes a 'Credit Event' (often described as a default)
defined as events such as 'failure to pay', restructuring, bankruptcy or even downgrade of credit
rating (less common). [1] CDS contracts have been compared with insurance, because the buyer
pays a premium and, in return, receives a sum of money if one of the events specified in the
contract occurs. However, there are a number of differences between CDS and insurance, for
example:

 The buyer of a CDS does not need to own the underlying security or other form of credit
exposure; in fact the buyer does not even have to suffer a loss from the default
event.[2][3][4][5] In contrast, to purchase insurance, the insured is generally expected to have
an insurable interest such as owning a debt obligation;
 the seller need not be a regulated entity;
 the seller is not required to maintain any reserves to pay off buyers, although major CDS
dealers are subject to bank capital requirements;
 insurers manage risk primarily by setting loss reserves based on the Law of large
numbers, while dealers in CDS manage risk primarily by means of offsetting CDS
(hedging) with other dealers and transactions in underlying bond markets;
 in the United States CDS contracts are generally subject to mark to market accounting,
introducing income statement and balance sheet volatility that would not be present in an
insurance contract;
 Hedge accounting may not be available under US Generally Accepted Accounting
Principles (GAAP) unless the requirements of FAS 133 are met. In practice this rarely
happens.

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However the most important difference between CDS and Insurance is simply that an insurance
contract provides an indemnity against the losses actually suffered by the policy holder, whereas
the CDS provides an equal payout to all holders, calculated using an agreed, market-wide
method.

There are also important differences in the approaches used to pricing. The cost of insurance is
based on actuarial analysis. CDSs are derivatives whose cost is determined using financial
models and by arbitrage relationships with other credit market instruments such as loans and
bonds from the same 'Reference Entity' to which the CDS contract refers.

Insurance contracts require the disclosure of all risks involved. CDSs have no such requirement,
and, as we have seen in the recent past, many of the risks are unknown or unknowable. Most
significantly, unlike insurance companies, sellers of CDSs are not required to maintain any
capital reserves to guarantee payment of claims. In that respect, a CDS is an insurance that
insures nothing.
A "credit default swap" (CDS) is a credit derivative contract between two counterparties. The
buyer makes periodic payments to the seller, and in return receives a payoff if an
underlying financial instrument defaults.

As an example, imagine that an investor buys a CDS from AAA-Bank, where the reference
entity is Risky Corp. The investor will make regular payments to AAA-Bank, and if Risky Corp
defaults on its debt (i.e., misses a coupon payment or does not repay it), the investor will receive
a one-time payment from AAA-Bank, and the CDS contract is terminated. If the investor
actually owns Risky Corp debt, the CDS can be thought of as hedging. But investors can also
buy CDS contracts referencing Risky Corp debt without actually owning any Risky Corp debt.
This may be done for speculative purposes, to bet against the solvency of Risky Corp in a
gamble to make money if it fails, or to hedge investments in other companies whose fortunes are
expected to be similar to those of Risky.

If the reference entity (Risky Corp) defaults, one of two things can happen:

 Either the investor delivers a defaulted asset to AAA-Bank for a payment of the par value.
This is known as physical settlement.
 Or AAA-Bank pays the investor the difference between the par value and the market price of
a specified debt obligation (even if Risky Corp defaults, there is usually some recovery, i.e.,
not all your money will be lost.) This is known as cash settlement.

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The "spread" of a CDS is the annual amount the protection buyer must pay the protection seller
over the length of the contract, expressed as a percentage of the notional amount. For example, if
the CDS spread of Risky Corp is 50 basis points, or 0.5% (1 basis point = 0.01%), then an
investor buying $10 million worth of protection from AAA-Bank must pay the bank $50,000 per
year. These payments continue until either the CDS contract expires or Risky Corp defaults.

All things being equal, at any given time, if the maturity of two credit default swaps is the same,
then the CDS associated with a company with a higher CDS spread is considered more likely to
default by the market, since a higher fee is being charged to protect against this happening.
However, factors such as liquidity and estimated loss given default can affect the comparison.

Credit spread rates and credit ratings of the underlying or reference obligations are considered
among money managers to be the best indicators of the likelihood of sellers of CDSs having to
perform under these contracts.

Uses
Credit default swaps can be used by investors for speculation, hedging and arbitrage.

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Speculation
Credit default swaps allow investors to speculate on changes in CDS spreads of single names or
of market indices such as the North American CDX index or the European iTraxx index. An
investor might believe that an entity's CDS spreads are too high or too low, relative to the entity's
bond yields, and attempt to profit from that view by entering into a trade, known as a basis trade,
that combines a CDS with a cash bond and an interest-rate swap. Finally, an investor might
speculate on an entity's credit quality, since generally CDS spreads will increase as credit-
worthiness declines, and decline as credit-worthiness increases. The investor might therefore buy
CDS protection on a company to speculate that it is about to default. Alternatively, the investor
might sell protection if it thinks that the company's creditworthiness might improve.

For example, a hedge fund believes that Risky Corp will soon default on its debt. Therefore, it
buys $10 million worth of CDS protection for two years from AAA-Bank, with Risky Corp as
the reference entity, at a spread of 500 basis points (=5%) per annum.

 If Risky Corp does indeed default after, say, one year, then the hedge fund will have paid
$500,000 to AAA-Bank, but will then receive $10 million (assuming zero recovery rate, and
that AAA-Bank has the liquidity to cover the loss), thereby making a profit. AAA-Bank, and
its investors, will incur a $9.5 million loss unless the bank has somehow offset the position
before the default.

 However, if Risky Corp does not default, then the CDS contract will run for two years, and
the hedge fund will have ended up paying $1 million, without any return, thereby making a
loss.
Note that there is a third possibility in the above scenario; the hedge fund could decide to
liquidate its position after a certain period of time in an attempt to lock in its gains or losses. For
example:

 After 1 year, the market now considers Risky Corp more likely to default, so its CDS spread
has widened from 500 to 1500 basis points. The hedge fund may choose to sell $10 million
worth of protection for 1 year to AAA-Bank at this higher rate. Therefore over the two years
the hedge fund will pay the bank 2 * 5% * $10 million = $1 million, but will receive 1 * 15%
* $10 million = $1.5 million, giving a total profit of $500,000.

22
 In another scenario, after one year the market now considers Risky much less likely to
default, so its CDS spread has tightened from 500 to 250 basis points. Again, the hedge fund
may choose to sell $10 million worth of protection for 1 year to AAA-Bank at this lower
spread. Therefore over the two years the hedge fund will pay the bank 2 * 5% * $10 million
= $1 million, but will receive 1 * 2.5% * $10 million = $250,000, giving a total loss of
$750,000. This loss is smaller than the $1 million loss that would have occurred if the second
transaction had not been entered into.
Transactions such as these do not even have to be entered into over the long-term. If Risky
Corp's CDS spread had widened by just a couple of basis points over the course of one day, the
hedge fund could have entered into an offsetting contract immediately and made a small profit
over the life of the two CDS contracts.

Hedging
Credit default swaps are often used to manage the credit risk (i.e., the risk of default) which
arises from holding debt. Typically, the holder of, for example, a corporate bond may hedge their
exposure by entering into a CDS contract as the buyer of protection. If the bond goes into
default, the proceeds from the CDS contract will cancel out the losses on the underlying bond.

Pension fund example: A pension fund owns $10 million of a five-year bond issued by Risky
Corp. In order to manage the risk of losing money if Risky Corp defaults on its debt, the pension
fund buys a CDS from Derivative Bank in a notional amount of $10 million. The CDS trades at
200 basis points (200 basis points = 2.00 percent). In return for this credit protection, the pension
fund pays 2% of $10 million ($200,000) per annum in quarterly installments of $50,000 to
Derivative Bank.

 If Risky Corporation does not default on its bond payments, the pension fund makes
quarterly payments to Derivative Bank for 5 years and receives its $10 million back after five
years from Risky Corp. Though the protection payments totaling $1 million reduce
investment returns for the pension fund, its risk of loss due to Risky Corp defaulting on the
bond is eliminated.
 If Risky Corporation defaults on its debt three years into the CDS contract, the pension fund
would stop paying the quarterly premium, and Derivative Bank would ensure that the

23
 pension fund is refunded for its loss of $10 million (either by physical or cash settlement -
see above). The pension fund still loses the $600,000 it has paid over three years, but without
the CDS contract it would have lost the entire $10 million.
Hedging issues related to banks and corporations subject to taxation or using US GAAP for
financial reporting: While the economics of entering into a CDS contract to hedge the credit risk
in an asset are the same for a pension fund, a bank and a corporation, there are two significant
practical differences in how hedges using CDS contracts affect banks and corporations compared
with pension plans:

Taxes: For tax purposes, the loss incurred on the Risky Corp.'s debt may be treated very
differently from the payout by Derivative Bank to either a corporation or a bank. If the loss on
the asset is taxed at a different rate from the profit made on the hedge, then the amount of the
CDS swap needed to create a hedge of the Risky Corp.'s debt to the bank or corporation will
differ from the [principal] amount of the debt. See Tax Treatment following.

 Financial reporting treatment may not parallel the economic effects. For example, GAAP
generally require that Credit Default Swaps be reported on a mark to market basis, and assets
that are held for investment, such as a commercial loan or bonds, be reported at cost unless a
probable and significant loss is expected. Thus, hedging a commercial loan using a CDS can
induce considerable volatility into the income statement and balance sheet as the CDS
changes value over its life due to market conditions and due to the tendency for shorter dated
CDS to sell at lower prices than longer dated CDS. Clearly, one can try to account for the
CDS as a hedge under FASB 133 but in practice that can prove very difficult unless the risky
asset owned by the bank or corporation is exactly the same as the Reference Obligation used
for the particular CDS that was bought.
 What exactly went wrong when the global meltdown took place?

The Derivatives Chernobyl

 The latest jolt to the massive derivatives edifice came with the collapse of Bear Stearns
on March 16, 2008. Bear Stearns helped fuel the explosive growth in the credit derivative
market, where banks, hedge funds and other investors have engaged in $45 trillion worth
of bets on the credit-worthiness of companies and countries. Before it collapsed, Bear
was the counterparty to $13 trillion in derivative trades. On March 14, 2008, Bear's
ratings were downgraded by Moody's, a major rating agency; and on March 16, the

24
 brokerage was bought by JPMorgan for pennies on the dollar, a token buyout designed to
avoid the legal complications of bankruptcy. The deal was backed by a $29 billion “non-
recourse” loan from the Federal Reserve. “Non-recourse” meant that the Fed got only
Bear's shaky paper assets as collateral. If those proved to be worthless, JPM was off the
hook. It was an unprecedented move, of questionable legality; but it was said to be
justified because, as one headline put it, “Fed's Rescue of Bear Halted Derivatives
Chernobyl.” The notion either that Bear was “rescued” or that the Chernobyl was halted,
however, was grossly misleading. The CEOs managed to salvage their enormous
bonuses, but it was a “bailout” only for JPM and Bear's creditors. For the shareholders, it
was a wipeout. Their stock initially dropped from $156 to $2, and 30 percent of it was
held by the employees. Another big chunk was held by the pension funds of teachers and
other public servants. The share price was later raised to $10 a share in response to
shareholder outrage, but the shareholders were still essentially wiped out; and the fact
that one Wall Street bank had to be fed to the lions to rescue the others hardly inspires a
feeling of confidence. Neutron bombs are not so easily contained.

 The Bear Stearns hit from the derivatives iceberg followed an earlier one in January,
when global markets took their worst tumble since September 11, 2001. Commentators
were asking if this was “the big one” - a 1929-style crash; and it probably would have
been if deft market manipulations had not swiftly covered over the approaching
catastrophe. The precipitous drop was blamed on the threat of downgrades in the ratings
of two major monoline insurers, Ambac and MBIA, followed by a $7.2 billion loss in
derivative trades by Societe Generale, France's second-largest bank. Like Bear Stearns,
the monolines serve as counterparties in a web of credit default swaps, and a downgrade
in their ratings would jeopardize the whole shaky derivatives edifice. Without the
monoline insurers' traiple-A seal, billions of dollars worth of triple-A investments would
revert to junk bonds. Many institutional investors (pension funds, municipal governments
and the like) have a fiduciary duty to invest in only the “safest” triple-A
bonds. Downgraded bonds therefore get dumped on the market, jeopardizing the banks
that are still holding billions of dollars worth of these bonds. The downgrade of Ambac in
January signaled a simultaneous downgrade of bonds from over 100,000 municipalities
and institutions, totaling more than $500 billion.

 Institutional investors have lost a good deal of money in all this, but the real calamity is
to the banks. The institutional investors that formerly bought mortgage-backed bonds
stopped buying them in 2007, when the housing market slumped. But the big investment
houses that were selling them have billions' worth left on their books, and it is these
banks that particularly stand to lose as the derivative Chernobyl implodes.

25
 A Parade of Bailout Schemes

 Now that some highly leveraged banks and hedge funds have had to lay their cards on the
table and expose their worthless hands, these avid free marketers are crying out for
government intervention to save them from monumental losses, while preserving the
monumental gains raked in when their bluff was still good. In response to their pleas, the
men behind the curtain have scrambled to devise various bailout schemes; but the
schemes have been bandaids at best. To bail out a $681 trillion derivative scheme with
taxpayer money is obviously impossible. As Michael Panzer observed on
SeekingAlpha.com
 As the slow-motion train wreck in our financial system continues to unfold, there are
going to be plenty of ill-conceived rescue attempts and dubious turnaround plans, as well
as propagandizing, dissembling and scheming by banks, regulators and politicians. This
is all happening in an effort to try and buy time or to figure out how the losses can be
dumped onto the lap of some patsy (e.g., the taxpayer).
 The idea seems to be to keep the violins playing while the Big Money Boys slip into the
mist and man the lifeboats. As was pointed out in a blog called “Jesse's Café Americain”
concerning the bailout of Ambac:
 It seems that the real heart of the problem is that AMBAC was being used as a "cover" by
the banks which originated these bundles of mortgages to get their mispriced ratings.
Now that the mortgages are failing and the banks are stuck with them, AMBAC cannot
possibly pay, they cannot cover the debt. And the banks don't wish to mark these CDOs
[collateralized debt obligations] to market [downgrade them to their real market value]
because they are probably at best worth 60 cents on the dollar, but are being held by the
banks on balance at roughly par. That's a 40 percent haircut on enough debt to sink every
bank involved in this situation .Indeed for all intents and purposes if marked to market
banks are now insolvent. So, the banks will provide capital to AMBAC . . . [but] it's just a
game of passing money around.So why are the banks engaging in this charade? This
looks like an attempt to extend the payouts on a vast Ponzi scheme gone bad that is
starting to collapse.
 The banks will therefore no doubt be looking for one bailout after another from the only
pocket deeper than their own, the U.S. government's. But if the federal government
acquiesces, it too could be dragged into the voracious debt cyclone of the mortgage mess.
The federal government's triple A rating is already in jeopardy, due to its gargantuan $9
trillion debt. Before the government agrees to bail out the banks, it should insist on some
adequate quid pro quo. In England, the government agreed to bail out bankrupt mortgage
bank Northern Rock, but only in return for the bank's stock. On March 31, 2008, The
London Daily Telegraph reported that Federal Reserve strategists were eyeing the

26
 nationalizations that saved Norway, Sweden and Finland from a banking crisis from 1991
to 1993. In Norway, according to one Norwegian adviser, “The law was amended so that
we could take 100 percent control of any bank where its equity had fallen below zero.” If
their assets were “marked to market,” some major Wall Street banks could already be in
that category.

Benjamin Franklin's Solution

 Nationalization has traditionally had a bad name in the United States, but it could be an
attractive alternative for the American people and our representative government as
well. Turning bankrupt Wall Street banks into public institutions might allow the
government to get out of the debt cyclone by undoing what got us into it. Instead of
robbing Peter to pay Paul, flapping around in a sea of debt trying to stay afloat by
creating more debt, the government could address the problem at its source: it could
restore the right to create money to Congress, the public body to which that solemn duty
was delegated under the Constitution.
 The most brilliant banking model in our national history was established in the first half
of the eighteenth century, in Benjamin Franklin's home province of Pennsylvania. The
local government created its own bank, which issued money and lent it to farmers at a
modest interest. The provincial government created enough extra money to cover the
interest not created in the original loans, spending it into the economy on public
services. The bank was publicly owned, and the bankers it employed were public
servants. The interest generated on its loans was sufficient to fund the government
without taxes; and because the newly issued money came back to the government, the
result was not inflationary.7 The Pennsylvania banking scheme was a sensible and highly
workable system that was a product of American ingenuity but that never got a chance to
prove itself after the colonies became a nation. It was an ironic twist, since according to
Benjamin Franklin and others, restoring the power to create their own currency was a
chief reason the colonists fought for independence. The bankers' money-creating machine
has had two centuries of empirical testing and has proven to be a failure. It is time the
sovereign right to create money is taken from a private banking elite and restored to the
American people to whom it properly belongs.

27
Risk:
When entering into a CDS, both the buyer and seller of credit protection take on counterparty
risk. Examples of counter party risks:

 The buyer takes the risk that the seller will default. If Derivative Bank and Risky Corp.
default simultaneously ("double default"), the buyer loses its protection against default by the
reference entity. If Derivative Bank defaults but Risky Corp. does not, the buyer might need
to replace the defaulted CDS at a higher cost.
 The seller takes the risk that the buyer will default on the contract, depriving the seller of the
expected revenue stream. More important, a seller normally limits its risk by buying
offsetting protection from another party - that is, it hedges its exposure. If the original buyer
drops out, the seller squares its position by either unwinding the hedge transaction or by
selling a new CDS to a third party. Depending on market conditions, that may be at a lower
price than the original CDS and may therefore involve a loss to the seller.

In the future, as CDS are moving to becoming an Exchange Traded product, traded and settled
via a central exchange ICE TCC, there will no longer be 'counterparty risk', as the risk of the
counterparty will be held with the central exchange/ clearing house ICE TCC.
As is true with other forms of over-the-counter derivative, CDS might involve liquidity risk. If
one or both parties to a CDS contract must post collateral(which is common), there can be
margin calls requiring the posting of additional collateral. The required collateral is agreed on by
the parties when the CDS is first issued.

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 CHAPTER 4: INTEREST RATE SWAPS

An interest rate swap is a derivative in which one party exchanges a stream

of interest payments for another party's stream of cash flows. Interest rate swaps can be used
by hedgers to manage their fixed or floating assets and liabilities. Unlike corporate bonds,
interest rate swaps do not involve risk on the principal amount[1]. They can also be used by
speculators to replicate unfunded bond exposures to profit from changes in interest rates. Interest
rate swaps are very popular and highly liquid instruments

In an interest rate swap, each counterparty agrees to pay either a fixed or floating rate
denominated in a particular currency to the other counterparty. The fixed or floating rate is
multiplied by a notional principal amount (say, USD 1 million). This notional amount is
generally not exchanged between counterparties, but is used only for calculating the size of
cashflows to be exchanged.

29
The most common interest rate swap is one where one counterparty A pays a fixed rate (the swap
rate) to counterparty B, while receiving a floating rate (usually pegged to a reference rate such
as LIBOR).

A pays fixed rate to B (A receives variable rate)

B pays variable rate to A (B receives fixed rate).

Consider the following swap in which Party A agrees to pay Party B periodic fixed interest rate
payments of 8.65%, in exchange for periodic variable interest rate payments of LIBOR +
70 bps (0.70%). Note that there is no exchange of the principal amounts and that the interest
rates are on a "notional" (i.e. imaginary) principal amount. Also note that the interest payments
are settled in net (e.g. Party A pays (LIBOR + 1.50%)+8.65% - (LIBOR+0.70%) = 9.45% net.
The fixed rate (8.65% in this example) is referred to as the swap rate.

At the point of initiation of the swap, the swap is priced so that it has a net present value of zero.
If one party wants to pay 50 bps above the par swap rate, the other party has to pay
approximately 50 bps over LIBOR to compensate for this.

Being OTC instruments interest rate swaps can come in a huge number of varieties and can be
structured to meet the specific needs of the counterparties. By far the most common are fixed-
for-floating, fixed-for-fixed or floating-for-floating. The legs of the swap can be in the same
currency or in different currencies. (A single-currency fixed-for-fixed rate swap is generally not
possible; since the entire cash-flow stream can be predicted at the outset there would be no
reason to maintain a swap contract as the two parties could just settle for the difference between
the present values of the two fixed streams; the only exceptions would be where the notional
amount on one leg is uncertain or other esoteric uncertainty is introduced).

30
Fixed-for-floating rate swap, same currency
Party B pays/receives fixed interest in currency A to receive/pay floating rate in currency A
indexed to X on a notional amount N for a term of T years. For example, you pay fixed 5.32%
monthly to receive USD 1M Libor monthly on a notional USD 1 million for 3 years. The party
that pays fixed and receives floating coupon rates is said to be long the interest swap. Interest
rate swaps are simply the exchange of one set of cash flows for another.
Fixed-for-floating swaps in same currency are used to convert a fixed rate asset/liability to a
floating rate asset/liability or vice versa. For example, if a company has a fixed rate USD 10
million loan at 5.3% paid monthly and a floating rate investment of USD 10 million that returns
USD 1M Libor +25 bps monthly, it may enter into a fixed-for-floating swap. In this swap, the
company would pay a floating rate of USD 1M Libor+25 bps and receive a 5.5% fixed rate,
locking in 20bps profit.

Fixed-for-floating rate swap, different currencies

Party P pays/receives fixed interest in currency A to receive/pay floating rate in currency B
indexed to X on a notional N at an initial exchange rate of FX for a tenure of T years. For
example, you pay fixed 5.32% on the USD notional 10 million quarterly to receive JPY 3M

31
(TIBOR) monthly on a JPY notional 1.2 billion (at an initial exchange rate of USD/JPY 120) for
3 years. For nondeliverable swaps, the USD equivalent of JPY interest will be paid/received
(according to the FX rate on the FX fixing date for the interest payment day). No initial exchange
of the notional amount occurs unless the Fx fixing date and the swap start date fall in the future.

Fixed-for-floating swaps in different currencies are used to convert a fixed rate asset/liability in
one currency to a floating rate asset/liability in a different currency, or vice versa. For example,
if a company has a fixed rate USD 10 million loan at 5.3% paid monthly and a floating rate
investment of JPY 1.2 billion that returns JPY 1M Libor +50 bps monthly, and wants to lock in
the profit in USD as they expect the JPY 1M Libor to go down or USDJPY to go up (JPY
depreciate against USD), then they may enter into a Fixed-Floating swap in different currency
where the company pays floating JPY 1M Libor+50 bps and receives 5.6% fixed rate, locking in
30bps profit against the interest rate and the forex exposure.

Floating-for-floating rate swap, same currency

Party P pays/receives floating interest in currency A Indexed to X to receive/pay floating rate in
currency A indexed to Y on a notional N for a tenure of T years. For example, you pay JPY 1M
LIBOR monthly to receive JPY 1M TIBOR monthly on a notional JPY 1 billion for 3 years.

32
Floating-for-floating rate swaps are used to hedge against or speculate on the spread between the
two indexes widening or narrowing. For example, if a company has a floating rate loan at JPY
1M LIBOR and the company has an investment that returns JPY 1M TIBOR + 30 bps and
currently the JPY 1M TIBOR = JPY 1M LIBOR + 10bps. At the moment, this company has a
net profit of 40 bps. If the company thinks JPY 1M TIBOR is going to come down (relative to
the LIBOR) or JPY 1M LIBOR is going to increase in the future (relative to the TIBOR) and
wants to insulate from this risk, they can enter into a float-float swap in same currency where
they pay, say, JPY TIBOR + 30 bps and receive JPY LIBOR + 35 bps. With this, they have
effectively locked in a 35 bps profit instead of running with a current 40 bps gain and index risk.
The 5 bps difference (w.r.t. the current rate difference) comes from the swap cost which includes
the market expectations of the future rate difference between these two indices and the bid/offer
spread which is the swap commission for the swap dealer.

Floating-for-floating rate swaps are also seen where both sides reference the same index, but on
different payment dates, or use different business day conventions. These have almost no use for
speculation, but can be vital for asset-liability management. An example would be swapping 3M
LIBOR being paid with prior non-business day convention, quarterly on JAJO (i.e. Jan, Apr, Jul,
Oct) 30, into FMAN (i.e. Feb, May, Aug, Nov) 28 modified following.

Floating-for-floating rate swap, different currencies

Party P pays/receives floating interest in currency A indexed to X to receive/pay floating rate in
currency B indexed to Y on a notional N at an initial exchange rate of FX for a tenure of T years.
For example, you pay floating USD 1M LIBOR on the USD notional 10 million quarterly to
receive JPY 3M TIBOR monthly on a JPY notional 1.2 billion (at an initial exchange rate of
USDJPY 120) for 4 years.
To explain the use of this type of swap, consider a US company operating in Japan. To fund their
Japanese growth, they need JPY 10 billion. The easiest option for the company is to issue debt in
Japan. As the company might be new in the Japanese market without a well known reputation
among the Japanese investors, this can be an expensive option. Added on top of this, the
company might not have appropriate debt issuance program in Japan and they might lack
sophisticated treasury operation in Japan. To overcome the above problems, it can issue USD
debt and convert to JPY in the FX market. Although this option solves the first problem, it
introduces two new risks to the company:

33
  FX risk. If this USDJPY spot goes up at the maturity of the debt, then when the company
converts the JPY to USD to pay back its matured debt, it receives less USD and suffers a
loss.
 USD and JPY interest rate risk. If the JPY rates come down, the return on the investment
in Japan might go down and this introduces an interest rate risk component.
The first exposure in the above can be hedged using long dated FX forward contracts but this
introduces a new risk where the implied rate from the FX spot and the FX forward is a fixed rate
but the JPY investment returns a floating rate. Although there are several alternatives to hedge
both the exposures effectively without introducing new risks, the easiest and the most cost
effective alternative would be to use a floating-for-floating swap in different currencies. In this,
the company raises USD by issuing USD Debt and swaps it to JPY. It receives USD floating rate
(so matching the interest payments on the USD Debt) and pays JPY floating rate matching the
returns on the JPY investment.

Fixed-for-fixed rate swap, different currencies

Party P pays/receives fixed interest in currency A to receive/pay fixed rate in currency B for a
term of T years. For example, you pay JPY 1.6% on a JPY notional of 1.2 billion and receive
USD 5.36% on the USD equivalent notional of 10 million at an initial exchange rate of USDJPY
120.

Other variations

A number of other variations are possible, although far less common. Mostly tweaks are made to
ensure that a bond is hedged "perfectly", so that all the interest payments received are exactly
offset by the swap. This can lead to swaps where principal is paid on one or more legs, rather
than just interest (for example to hedge a coupon strip), or where the balance of the swap is
automatically adjusted to match that of a prepaying bond (such as RMBS Residential mortgage-
backed security).

34
 CHAPTER 5 : INTEREST RATE OPTIONS

An interest rate cap is a derivative in which the buyer receives payments at the end of each
period in which the interest rate exceeds the agreed strike price. An example of a cap would be
an agreement to receive a payment for each month the LIBOR rate exceeds 2.5%.

The interest rate cap can be analyzed as a series of European call options or caplets which exist
for each period the cap agreement is in existence.

In mathematical terms, a caplet payoff on a rate L struck at K is

where N is the notional value exchanged and α is the day count fraction corresponding to
the period to which L applies. For example suppose you own a caplet on the six
month USDLIBOR rate with an expiry of 1st of February 2007 struck at 2.5% with a
notional of 1 million dollars. Then if the USD LIBOR rate sets at 3% on 1st of February
you receive . Customarily the
payment is made at the end of the rate period, in this case on the 1st of August.

Valuation of interest rate caps

Black
The simplest and most common valuation of interest rate caplets is via the Black model. Under
this model we assume that the underlying rate is distributed log-normally with volatility σ. Under
this model, a caplet on a LIBOR expiring at t and paying at T has present value

35
 where
P(0,T) is today's discount factor for T
F is the forward price of the rate. For LIBOR rates this is equal to
K is the strike

and

Notice that there is a one-to-one mapping between the volatility and the present value of the
option. Because all the other terms arising in the equation are indisputable, there is no ambiguity
in quoting the price of a caplet simply by quoting its volatility. This is what happens in the
market. The volatility is known as the "Black vol" or implied vol.

As a bond put
It can be shown that a cap on a LIBOR from t to T is equivalent to a multiple of a t-expiry put on
a T-maturity bond. Thus if we have an interest rate model in which we are able to value bond
puts, we can value interest rate caps. Similarly a floor is equivalent to a certain bond call. Several
popular short rate models, such as the Hull-White model have this degree of tractability. Thus we
can value caps and floors in those models.

What about Collars?

Interest rate collar
…the simultaneous purchase of an interest rate cap and sale of an interest rate floor on the same
index for the same maturity and notional principal amount.

 The cap rate is set above the floor rate.

 The objective of the buyer of a collar is to protect against rising interest rates.
 The purchase of the cap protects against rising rates while the sale of the floor generates
premium income.
 A collar creates a band within which the buyer’s effective interest rate fluctuates.

36
And Reverse Collars?
…buying an interest rate floor and simultaneously selling an interest rate cap.

 The objective is to protect the bank from falling interest rates.

 The buyer selects the index rate and matches the maturity and notional principal amounts for
the floor and cap.
 Buyers can construct zero cost reverse collars when it is possible to find floor and cap rates
with the same premiums that provide an acceptable band.

The size of cap and floor premiums are determined by a wide range of factors

 The relationship between the strike rate and the prevailing 3-month LIBOR premiums are
highest for in the money options and lower for at the money and out of the money
options.
 Premiums increase with maturity.
 The option seller must be compensated more for committing to a fixed-rate for a longer
period of time.

Prevailing economic conditions, the shape of the yield curve, and the volatility of interest rates.

 Up sloping yield curve -- caps will be more expensive than floors.

 The steeper is the slope of the yield curve, ceteris paribus, the greater are the cap
premiums.
 Floor premiums reveal the opposite relationship.

Valuation of CMS Caps

Caps based on an underlying rate LIBOR (like a Constant Maturity Swap Rate) cannot be valued
using simple techniques described above. The methodology for valuation of CMS Caps and
Floors can be referenced in more advanced papers.

37
Implied Volatilities

 An important consideration is cap and floor volatilities. Caps consist of caplets with
volatilities dependent on the corresponding forward LIBOR rate. But caps can be
represented by a "flat volatility", so the net of the caplets still comes out to be the
same. (15%,20%,....,12%) ---> (16.5%,16.5%,. ,16.5%)
 So one cap can be priced at one vol.
 Another important relationship is that if the fixed swap rate is equal to the strike of
the caps and floors, then we have the following put-call parity: Cap-Floor = Swap.
 Caps and floors have the same implied vol too for a given strike.
 Imagine a cap with 20% and floor with 30%. Long cap, short floor gives a swap with
no vol. Now, interchange the vols. Cap price goes up, floor price goes down. But the
net price of the swap is unchanged. So, if a cap has x vol, floor is forced to have x vol
else you have arbitrage.
 A Cap at strike 0% equals the price of a floating leg (just as a call at strike 0 is
equivalent to holding a stock) regardless of volatility.

CHAPTER 6: ASSET BACKED SECURITIES

38
An asset-backed security is a security whose value and income payments are derived from and
collateralized (or "backed") by a specified pool of underlying assets. The pool of assets is
typically a group of small and illiquid assets that are unable to be sold individually. Pooling the
assets into financial instruments allows them to be sold to general investors, a process
called securitization, and allows the risk of investing in the underlying assets to be diversified
because each security will represent a fraction of the total value of the diverse pool of underlying
assets. The pools of underlying assets can include common payments from credit cards, auto
loans, and mortgage loans, to esoteric cash flows from aircraft leases, royalty payments and
movie revenues.

Often a separate institution, called a special purpose vehicle, is created to handle the
securitization of asset backed securities. The special purpose vehicle, which creates and sells the
securities, uses the proceeds of the sale to pay back the bank that created, or originated, the
underlying assets. The special purpose vehicle is responsible for "bundling" the underlying assets
into a specified pool that will fit the risk preferences and other needs of investors who might
want to buy the securities, for managing credit risk—often by transferring it to an insurance
company after paying a premium—and for distributing payments from the securities. As long as
the credit risk of the underlying assets is transferred to another institution, the originating bank
removes the value of the underlying assets from its balance sheet and receives cash in return as
the asset backed securities are sold, a transaction which can improve its credit rating and reduce
the amount of capital that it needs. In this case, a credit rating of the asset backed securities
would be based only on the assets and liabilities of the special purpose vehicle, and this rating
could be higher than if the originating bank issued the securities because the risk of the asset
backed securities would no longer be associated with other risks that the originating bank might
bear. A higher credit rating could allow the special purpose vehicle and, by extension, the
originating institution to pay a lower interest rate (that is, charge a higher price) on the asset-
backed securities than if the originating institution borrowed funds or issued bonds.

Thus, one incentive for banks to create securitized assets is to remove risky assets from their
balance sheet by having another institution assume the credit risk, so that they (the banks)
receive cash in return. This allows banks to invest more of their capital in new loans or other
assets and possibly have a lower capital requirement

39
Advantages and disadvantages
A significant advantage of asset-backed securities for loan originators (with associated
disadvantages for investors) is that they bring together a pool of financial assets that otherwise
could not easily be traded in their existing form. By pooling together a large portfolio of these
illiquid assets they can be converted into instruments that may be offered and sold freely in the
capital markets. The tranching of these securities into instruments with theoretically different
risk/return profiles facilitates marketing of the bonds to investors with different risk appetites and
investing time horizons.

Asset backed securities provide originators with the following advantages, each of which directly
adds to investor risk:

 Selling these financial assets to the pools reduces their risk-weighted assets and thereby frees
up their capital, enabling them to originate still more loans.
 Asset-backed securities lower their risk. In a worst-case scenario where the pool of assets
performs very badly, "the owner of ABS (which is either the issuer, or the guarantor, or the
re-modeler, or the guarantor of the last resort) might pay the price of bankruptcy rather than
the originator." In case the originator or the issuer is made to pay the price of the same, it
amounts to re-inventing of the lending practices, restructuring from other profitable avenues
of the functioning of the originator as well as the norms of the issuance of the same and
consolidation in the form of either merger or benchmarking (internal same sector, external
different sector).

This risk is measured and contained by the lender of last resort from time to time auctions and
other Instruments that are used to re-inject the same bad loans held over a longer time duration to
the appropriate buyers over a period of time based on the instruments available for the bank to
carry out its business as per the business charter or the licensings granted to the specific banks.
The risk can also be diversified by using the alternate geographies, or alternate vehicles of
investments and alternate division of the bank, depending on the type and magnitude of the risk.

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The exposure to these refinanced loans and other types of the "bad credit (Type II) decisions,
particularly in the banking sector, unscrupulous lending", or the adverse selection of credits is
hedged against the sellers of the same, or the re-structures of the same. Thinking of securitization
(insurance) as a panacea of all ills of a bad credit decision might spell the hedging of the risk in
the form of transfer of the "hot potato", from one issuer to the other Without the actual asset
against which the loan is backed reaching an upswing in the value either By the virtue of demand
supply mismatch being addressed

 The economy productivity or the business cycle being reversed from the downturn to the
upturn (Monetary and fiscal maeasures)
 More buyers than sellers in the market
 A breakthrough innovation.

On a day to day basis the transferring of the loans from the

 Sub-ordinate debt (freshly made and highly collateralized debt) to the

 Sub-ordinate realizable
 Sub-ordinate non-realizable

Senior as well as bad (securitized) debt might be a better way to distinguish between the assets
that might require or be found eligible for re-insurance or write - off or impaired against the
assets of the collaterals or is realized as a trade-off of the loan granted against or the addition of
goods.

This is totally built up in any bank based on the terms of these deposits, and dynamic updation of
the same as regards to the extent of the exposure or bad credit to be faced, as guided by the
accounting standards, and adjudged by the financial and non-market (diversifiable) risks, with a
contingency for the market (non-diversifiable) risks, for the specified types of the accounting
headers as found in the balance sheets or the reporting or recognition (company based
declaration of the standards) of the same as short term, long term as well as medium term debt
and depreciation standards.

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The issuance of the accounting practices and standards as regards to the different holding
patterns, adds to the accountability that is sought, in case the problem increases in magnitude.

 The originators earn fees from originating the loans, as well as from servicing the assets
throughout their life.

The ability to earn substantial fees from originating and securitizing loans, coupled with the
absence of any residual liability, skews the incentives of originators in favor of loan volume
rather than loan quality. This is an intrinsic structural flaw in the loan-securitization market that
was directly responsible for both the credit bubble of the mid-2000s as well as the credit crisis,
and the concomitant banking crisis, of 2008.

"The financial institutions that originate the loans sell a pool of cashflow-producing assets to a
specially created "third party that is called a special-purpose vehicle (SPV)". The SPV
(securitization, credit derivatives, commodity derivative, commercial paper based temporary
capital and funding sought for the running, merger activities of the company, external funding in
the form of venture capitalists, angel investors etc. being a few of them) is "designed to insulate
investors from the credit risk (availability as well as issuance of credit in terms of assessment of
bad loans or hedging of the already available good loans as part of the practice) of the originating
financial institution".

The SPV then sells the pooled loans to a trust, which issues interest bearing securities that can
achieve a credit rating separate from the financial institution that originates the loan. The
typically higher credit rating is given because the securities that are used to fund the
securitization rely solely on the cash flow created by the assets, not on the payment promise of
the issuer.

The monthly payments from the underlying assets—loans or receivables—typically consist of

principal and interest, with principal being scheduled or unscheduled. The cash flows produced
by the underlying assets can be allocated to investors in different ways. Cash flows can be
directly passed through to investors after administrative fees are subtracted, thus creating a

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“pass-through” security; alternatively, cash flows can be carved up according to specified rules
and market demand, thus creating "structured" securities."

This is an organized way of functioning of the credit markets at least in the Developed Primary
non-tradable in the open market, company to company, bank to bank dealings to keep the
markets running, afloat as well as operational and provision of the liquidity by the liquidity
providers in the market, which is very well scrutinized for any "aberration, excessive instrument
based hedging and market manipulation" or "outlier, volumes" based trades or any such
"anomalies, block trades 'company treasury' based decision without proper and posterior/prior
intimation", by the respective regulators as directed by the law and as spotted in the regular hours
of trading in the pre-market/after-hours trading or in the event based specific stocks and
corrected and scrutinized for insider trading in the form of cancellation of the trades, re-issuance
of the amount of the cancelled trades or freezing of the markets (specific securities being taken
off the trading list for the duration of time) in event of a pre-set, defined by the maximum and
minimum fluctuation in the trading in the secondary market that is the over the counter markets.

Generally the Primary markets are more scrutinized by the same commission but this market
comes under the category of institutional and company related trades and underwritings, as well
as guarantees and hence is governed by the broader set of rules as directed in the corporate and
business law and reporting standards governing the business in the specific geography.

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 CHAPTER 7: SWAPTIONS

A swaption is an option granting its owner the right but not the obligation to enter into an
underlying swap. Although options can be traded on a variety of swaps, the term "swaption"
typically refers to options on interest rate swaps.

There are two types of swaption contracts:

 A payer swaption gives the owner of the swaption the right to enter into a swap where
they pay the fixed leg and receive the floating leg.
 A receiver swaption gives the owner of the swaption the right to enter into a swap where
they will receive the fixed leg, and pay the floating leg.

The buyer and seller of the swaption agree on:

 the premium (price) of the swaption

 the strike rate (equal to the fixed rate of the underlying swap)
 length of the option period (which usually ends two business days prior to the start date
of the underlying swap),
 the term of the underlying swap,
 notional amount,
 amortization, if any
 frequency of settlement of payments on the underlying swap

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Swaption styles
There are three styles of Swaptions. Each style reflects a different timeframe in which the option
can be exercised.

 American swaption, in which the owner is allowed to enter the swap on any day that falls
within a range of two dates.
 European swaption, in which the owner is allowed to enter the swap only on the maturity
date.
 Bermudan swaption, in which the owner is allowed to enter the swap only on certain
dates that fall within a range of the start (roll) date and end date.

Valuation

The valuation of swaptions is complicated in that the result depends on several factors: the time
to expiration, the length of underlying swap, and the "moneyness" of the swaption. Here the "at
the money" level is the forward swap rate, the forward rate that would apply between the
maturity of the option (t) and the tenor of the underlying swap (T) such that the swap, at time t,
has an "NPV" of zero; see swap valuation. For an at the money swaption, the strike rate equals
the forward swap rate, and "moneyness" therefore is determined based on whether the strike rate
is higher, lower, or at the same level as the forward swap rate.

Given these complications, quantitative analysts attempt to determine relative value between
different swaptions, in some cases by constructing complex term structure and short rate models
which describe the movement of interest rates over time.

However a standard practice - particularly amongst traders where speed of calculation is more
important - is to value European Swaptions using the Black model, where, for this purpose,
the underlier is treated as a forward contract on a swap.

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Here:

 The forward price is the forward swap rate.

 The volatility is typically "read-off" a two dimensional grid of at-the-money volatilities as
observed from prices in the Interbank swaption market. On this grid, one axis is the time to
expiration and the other is the length of the underlying swap. Adjustments may then be made
for moneyness.
Bermudan swaptions have until recently been valued using only one-factor models such as the
Black-Derman-Toy (BDT) or Black-Karasinski (BK) models. The LIBOR Market (LM) model
which is a more general multi-factor model is becoming increasingly popular as a benchmark
model. Whereas the BDT and BK models can be approximated using a lattice facilitating easy
valuation of Bermudan swaption, the LM model doesn't conform to the lattice framework and as
such the valuation seems very difficult. Monte-Carlo simulation is a popular alternative to the
lattice framework for derivatives valution. In order to facilitate valuation of Bermudan swaptions
the Monte-Carlo simulation technique must be extended. A few methods doing this are presently
available, eg [And98]. A common feature of these methods is that the estimated option premia
are only lower bounds on the true premia. The Stochastic Mesh method proposed by [BG97b] for
valuation of Bermudan (equity) options with applications to equity options provides a lower and
an upper bound. We have applied this method to the LM model and use this to verify the premia
found by Andersen. We will also apply the approach suggested in [LS98] to the LM model and
verify the premia found using that approach. As it turns out this approach is a special case of the
[And98] approach.

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 CONCLUSION

It is thus concluded that though the business face various types of risks, the innovative derivative
products can definitely be used to protect oneself from such risks.the use of simple forwards for
currency hedging and the systematic index traded version of forwards the futures contracts do
take care of the higher order size which pose a difficulty to be tailor made in case of forwards.
The credit default swaps protect against the credit default risk and the enables the protection
buyer to hedge against a probable default from the reference entity.The interest rate options are
further advanced form of hedging tools to hedge against the adverse fluctuations of interest rates.
So overall the project provided an insight to various innovative tools that one can use for smooth
sailing in the normal day to day business.

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 References

1. Quantitative Finance & Risk Management - Jan. W. Dash

2. Risk Management in finance: Six Sigma & Other next generation By Anthony
Tarantino

3. Derivatives-John C Hull

4. www.contingencyanalysis.com

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