CA Final Strategic Financial Management, Paper 2, Chapter 5

CA .Tarun Mahajan
Swaps basic

Valuation of swap

Swaption

Interest rate forwards

Caps, floors & collars

It is a bunch of forward contracts.

Here cash flows are exchanged periodically according to a

predefined formula.

In an interest rate swap one party agrees to pay fixed interest

and other party pays floating interest on a notional principal.

For example I will pay you 8% p.a. on Rs.100cr. for next 5 years
and you will pay me SBI-PLR.
Generic swap means
• a swap where the floating rate is LIBOR. It is also named
as plain vanilla swap. In a generic swap fixed payment is
based on 30/360 days convention, i.e., assuming 30 days
in a month and 360 days in a year. Floating rate payment
is calculated on actual/360 days.
• Actual/360 days is named as money market convention
while actual/365 is called bond equivalent.

Non generic swap:

• all the swaps other than generic swap. For example: Libor
vs prime rate, deferred swap, swaption etc.
Overnight Index Swap
• is an interest rate swap involving the overnight
rate being exchanged for some fixed interest
rate.

All in cost swap means

• a swap in which rates are quoted in such a
manner that it includes transaction cost and
service charges also. Means no charges are
levied separately.
Suppose a swap dealer quotes an all is swap as Libor vs. 5.9/6.1.

It means that dealer will pay 5.9% p.a. fixed in return for Libor.

And will pay Libor in return for 6.1% p.a. fixed.

6.1% 5.9%
Swap
Dealer
Libor Libor
To make valuation of a swap
we can divide it into two parts:

• A bond paying fixed coupon and

• A Variable rate note.

Now we can calculate present value of

both bonds. Difference in their value will
be the value of swap.

Mostly swaps have zero value at

inception, though there may be non par
swaps also.
 In a swap A will B 6% p.a. fixed, while B will pay
Libor for next three year, at the end of each year.
 If Libor is expected to be 5%, 6% & 8% and YTM
for a 3 years bond is 6% then:
 Value of variable coupon bond =

5 6 8 +100
100.74 = + +
(1.06) (1.06) (1.06)
1 2 2
Value of fixed rate bond is Rs.100 because YTM is equal to coupon.

For a fixed rate payer value of bond = 100.74-100 = Rs.0.74

While for a fixed rate receiver it is -0.74.

 A 3 months into 5 years
It is an option to enter swaption means option
into swap. to enter into 5 years
swap after 3 months.

If the strike rate is 6%

A call option would be
and actual fixed rate
the right to enter into
after 3 months happens
swap as a fixed rate
to be 7% then holder
payer.
will exercise his option.
A put option would be the right to enter into swap as
a fixed rate receiver. If market rate falls then holder
will exercise his option.

If direction of interest rate is predictable then one

can enter into swaps to convert from floating to
fixed or vice versa.

But if direction is uncertain then one can use

swaption for the same.
Rate at which money is lent/borrowed as of today is called
Spot rate.

S3 means the rate of interest for a 3 years loan as of today.

Contract to borrow/lend money in future is called forward

contract and the relevant rate is called forward rate.

1f 2
means rate of interest for a one year loan to be taken 2
years from now.
Spot rate is equal to geometric mean of forward rates.

1f 0 = 10%, 1f1 = 11%, 1f2 = 12%, calculate S3.

S3= [(1+ 1f0) x (1+ 1f1) x (1+ 1f2) ]1/3 - 1

S3= [1.10 x1.11 x1.12 ]1/3 - 1= 11%

A shortcut would be to take arithmetic Mean instead of

geometric mean.
 (1 + S 3 )
3

1f 2 = -1
(1 + S 2 )
2

 S2 = 10.5%, S3 = 11%, Calculate 1f1.

 f = (1.11) 3/(1.105)2 - 1 = 12%
1 2
 A shortcut would be 1f2 = S3x3 – S2x2 = 11x3-
10.5x2 = 12%
YTM is the single rate at which present value of
payment to bondholders becomes equal to current
price of bond.

While spot rate is the rate which can be used to

calculate present value of cash flow of a single
point of time.

If YTM for different maturity bonds is given then we

can calculate spot rates as follows:
 Details of three semiannual coupon bonds
Bond Maturity Coupon YTM Price
A 6 months 8% 8% 1000
B 12 months 10% 10% 1000
C 18 months 12% 12% 1000

6 months Spot rate = 8%

It is same as 6 months YTM because there is only one payment for the 6 month Bond.

1 year Spot Rate:

50/(1.04) + 1050/(1+S/2)2 = 1000; S = 10.05%

18 months Spot Rate:

60/(1.04) + 60/(1.05025)2+ 1060/(1+S/2)3 = 1000; S = 12.17%

Cap: It is a series of interest rate call options.

It is used by floating rate borrowers to hedge the risk of increase in

interest rate.

When interest rate increases. On one hand borrower has to pay higher
interest but on other hand it gain by exercising the call

Each option in cap is called the “caplet”.

 Borrowed amount $1 million @Libor, payable quarterly.
Cap @ 6%.
Quarter Libor Interest Cap Net
1 7% -17500 +2500 -15000
2 5% -12500 - -12500
3 8% -20000 +5000 -15000
4 4% -10000 - -10000
After hedging with cap interest outflow is never more than $15000
Floor: It is a series of interest rate put options.

Used by floating rate lender to hedge the risk of

downfall in interest rate. Or

Floating rate borrowers also use it to defray some of

the cost of a cap by taking a short position in floor.

When interest rate decreases below strike price then

the short floor will have to make a payment

Each option in a floor is called the “floorlet”.

Interest rate Collar is combination of the long cap & short floor.

It is created by floating rate borrower to make cost effective hedging.

Long cap gives protection against rise in interest rate &

Short floor reduces cost of hedging (by sacrificing benefit of lower

interest rate)
Interest rate can also be used as an
underlying for derivatives

IRS can be used to convert fixed to

floating rate and vice versa

Swaption are option on swap

Spot rate is geometric mean of

forward rates

Collar is cost free hedging option

 CA. Tarun Mahajan
tarunmahajanca@gmail.com