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**Alternative compounding methods for over-the-counter derivative transactions
**

David Mengle, ISDA Head of Research February 5, 2009 Summary • • • • There are two methods for compounding over-the-counter interest rate derivative cash flows in the 2006 ISDA Definitions, namely, Compounding and Flat Compounding. In addition, there exists a third compounding method that is not at present included in the Definitions. The three methods lead to different results when the Floating Amount includes a Spread component; if Spread is zero, there is no difference between the three methods. The method not included in the ISDA Definitions treats Floating Rate as compound interest but treats Spread as simple interest, and can be expressed as a simple formula as described below. Introduction

1.

Market participants have contacted ISDA regarding disputes over the calculation of interest rate swap cash flows that involve both a floating rate and a spread and are subject to Flat Compounding under the 2006 ISDA Definitions. Apparently there are two different understandings of flat compounding in the market, but only one is reflected in the ISDA Definitions. The following note seeks to explain and clarify the three types of compounding and how market participants use them in practice. 2. Overview of compounding methods

In over-the-counter derivatives transactions, the floating interest rate cash flow (hereafter referred to as the Floating Amount) is a function of two components. One the Floating Rate, Libor or Euribor, for example, which is reset periodically during the life of a transaction. The other is the Spread, which is a margin over the Floating Rate and normally does not change over the life of the transaction. The Spread can be positive, negative, or zero. Both Floating Rate and Spread are adjusted by the relevant Day Count Fractions. The Floating Amount can be calculated in two ways. One is simple interest, which calculates interest in each period on the notional principal only. The other is compound interest, which calculates interest on the sum of notional principal and accumulated interest payments. In the

If Spread is zero. show how they can be calculated and. known in the ISDA Definitions as Flat Compounding. cash flows are calculated using simple interest unless the parties specify that Compounding or Flat Compounding is Applicable. All have in common that they in some way add interest back into the principal. such swaps virtually always involve a Spread. makes no distinction between Floating Rate and Spread. a three-month floating rate versus a semiannual fixed rate. known in the ISDA Definitions as Compounding. not found in the ISDA Definitions. say. Appendix A summarizes the main characteristics of the three conventions. The following section will discuss each of the above in more detail. But all differ according to how they treat the Spread component of interest. A common use of the various compounding conventions is in vanilla interest rate swaps that specify. Current period interest is calculated using Floating Rate plus Spread. A different use of compounding is in overnight indexed swaps. A second form. Floating Rate interest but not spread earned at the end of a period is added back into principal. 2 . to the extent feasible. That is. Some market participants apparently refer to this convention as “compounding flat. all three give the same result.1a). for example—are calculated by means of a compounding formula but are then inserted into a simple interest formula to determine Floating Amount. in which “self-compounding” Floating Rate Options—USD-Federal Funds-H.” although usage varies (Appendix A). Spread is then calculated on the principal for the entire calculation period without compounding. Floating Rate plus Spread earned on the notional amount (hereafter Calculation Amount) at the end of each compounding period is added to the principal for the next compounding period. accumulated interest is compounded using Floating Rate only. The most basic form of compound interest. two of which are in the ISDA Definitions. A third form. but as of this writing it has not been possible to substantiate these claims. There are three known compound interest conventions. a one-month floating rate compounded over three months and a three-month floating rate. In other words. involves compounding the Floating Rate but treating the spread as simple interest. for example.2006 ISDA Definitions (Section 6. the three-month rate can be compounded over a six-month Calculation Period so the Floating Amount can be netted against the Fixed Amount.15-OISCOMPOUND in the 2006 ISDA Definitions. But in subsequent periods. express them as formulas. allowing the instrument to earn interest on both initial principal and accumulated interest. treats Floating Rate and Spread differently in different periods. and so on. Another is in basis swaps between. It has been suggested that this third method has become a new market standard.

is defined by ISDA as “Compounding” in the following excerpted passages from the 2006 ISDA Definitions: Section 6. the Floating Amount payable by a party on a Payment Date will be: (…) (b) if “Compounding” is specified to be applicable to the Swap Transaction or that party and “Flat Compounding” is not specified.1. an amount calculated on a formula basis for that Compounding Period as follows: Compounding Period Amount Adjusted Calculation Amount Floating Rate + Spread Floating Rate Day Count Fraction = × × (d) “Adjusted Calculation Amount” means (i) in respect of the first Compounding Period in any Calculation Period. Subject to the provisions of Section 6. In order to do so.3. the Calculation Amount for that Calculation Period and (ii) in respect of each succeeding Compounding Period in that Calculation Period.4 (Negative Interest Rates). for any Compounding Period.1 Compounding. an amount equal to the sum of the Calculation Amount for that Calculation Period and the Compounding Period Amounts for each of the previous Compounding Periods in that Calculation Period. which treats interest and spread the same. assume the following notation: N FA CPAt ACAt = Notional amount (called Calculation Amount in the ISDA Definitions) = Floating Amount for the relevant Calculation Period = Compounding Period Amount for Compounding Period t = Adjusted Calculation Amount for Compounding Period t (= N in Period 1) 3 . Calculation of a Floating Amount. The most basic form of compounding. Alternative versions of Compounding 3. an amount equal to the sum of the Compounding Period Amounts for each of the Compounding Periods in the related Calculation Period… (…) Section 6. Certain Definitions Relating to Compounding. The above definition can be expressed as a general formula. For purposes of the calculation of a Floating Amount where “Compounding” is specified to be applicable to a Swap Transaction: (…) (c) “Compounding Period Amount” means.3.

According to the above definition. derived in Appendix B: FA = N x [(1 + (R1 + S) × d1) x (1 + (R2 + S) × d2) x (1 + (R3 + S) × d3) – 1] A more generally applicable version for compounding over T periods is: FA = N × ��1 + (R1 + S) × d1 � × �1 + (R2 + S) × d2 � ×⋯× �1+ (RT + S) × dT � – 1� = N × ��(1 + (Rt +S) × dt ) – 1� T t=1 Where the product operator ∏n ai means the product a1 × a2 × … × an i=1 4 .Rt S dt = Floating Rate for Compounding Period t = Spread = Day count fraction for Compounding Period t Assume the Calculation Period contains three Compounding Periods. Compounding Period Amount is: CPA2 = ACA2 x (R2 + S) x d2 = (N + CPA1) × (R2 + S) × d2 And for the third period. the Compounding Period Amount is equal to: CPA1 = ACA1 x (R1 + S) x d1 = N × (R1 + S) × d1 For the second period. CPA3 = ACA3 x (R3 + S) x d3 = (N + CPA1 + CPA2) x (R3 + S) x d3 So Floating Amount for the Calculation Period is FA = CPA1 + CPA2 + CPA3 The above definition can be expressed as the following well-known formula.

2 Flat Compounding in the ISDA Definitions. an amount calculated on a formula basis for that Compounding Period as follows: Additional Compounding Period Amount Flat Compounding Amount Floating Rate Day Count Fraction = × Floating Rate × (g) “Flat Compounding Amount” means (i) in respect of the first Compounding Period in any Calculation Period.3. an amount calculated on a formula basis for that Payment Date or for the related Calculation Period as follows: Floating Amount = Calculation Amount × Floating Rate + Spread × Floating Rate Day Count Fraction (…) (c) if “Flat Compounding” is specified to be applicable to the Swap Transaction or that party. using the formula set forth in Section 6. For purposes of the calculation of a Floating Amount where “Compounding” is specified to be applicable to a Swap Transaction: (…) (e) “Basic Compounding Period Amount” means.1(a). (f) “Additional Compounding Period Amount” means. zero and (ii) in respect of each succeeding Compounding Period in that Calculation Period. for any Compounding Period. Section 6. The ISDA Definition of Flat Compounding is contained in the following passages from the 2006 ISDA Definitions. (…) Section 6.3. Subject to the provisions of Section 6. an amount equal to the sum of the Basic Compounding Period Amounts for each of the Compounding Periods in the related Calculation Period plus the sum of the Additional Compounding Period Amounts for each such Compounding Period. the Floating Amount payable by a party on a Payment Date will be: (a) if Compounding is not specified for the Swap Transaction or that party. an amount equal to the sum of the Basic Compounding Period Amounts and the Additional Compounding Period Amounts for each of the previous Compounding Periods in that Calculation Period.1.4 (Negative Interest Rates). Certain Definitions Relating to Compounding. 5 . Calculation of a Floating Amount. for any Compounding Period. an amount calculated as if a Floating Amount were being calculated for that Compounding Period.

FA = � CPAt t=1 3. be expressed in a more complex manner as a step-wise recursive process.1.3 Compounding treating Spread as simple interest. however. As mentioned above. the above provisions of the ISDA Definitions lead to the following formulation: CPA1 CPA2 CPA3 FA = BCPA1 = N × (R1 + S) × d1 = BCPA2 + ACPA2 = N × (R2 + S) × d2 + (CPA1 × R2 × d2) = BCPA3 + ACPA3 = N × (R3 + S) × d3 + [(CPA1 + CPA2) × R3 × d3] = CPA1 + CPA2 + CPA3 Although ISDA Flat Compounding does not appear to reduce to a single formula. we can generalize the above procedure to the following recursive process for a Calculation Period consisting of T Compounding Periods: For the first Compounding Period (t=1): CPA1 = N × (R1 + S) × d1 And for subsequent Compounding Periods (t>1): CPAt = N × (Rt + S) × dt + �� CPAi � × Rt × dt t-1 i=1 T When Spread is equal to zero. there is a nonISDA compounding convention in the market that treats Floating Rate interest as compound interest but Spread as simple interest. It can. Using the same notation as the previous example but letting SA equal Spread Amount and d (= d1 + d2 + d3) equal total days in the Calculation Period 6 .It is not apparent that the ISDA Definition of Flat Compounding can be expressed as a general formula. Along with previous notation. these formulas collapse to the general formula for Compounding in Section 3. define the following additional terms: BCPAt = Basic Compounding Period Amount for compounding period t ACPAt = Additional Compounding Period Amount for compounding period t Assuming again a Calculation Period consisting of three Compounding Periods.

1 + S × d ] where: d = � dt t=1 As with Flat Compounding. 7 .5% 5. the convention would compute compound interest for a Calculation Period consisting of three Compounding Periods as follows: CPA1 CPA2 CPA3 SA = ACA1 × R1 x d1 = N × R1 × d1 = ACA2 × R2 × d2 = (N + CPA1) x R2 x d2 = ACA3 × R3 × d3 = (N + CPA1 + CPA2) × R3 × d3 = (N × S × d1) + (N × S × d2) + (N × S × d3) = N × S × d So Floating Amount for the Calculation Period is FA = CPA1 + CPA2 + CPA3 + SA More generally.0% For simplicity. Finally.divided by the year basis. and that Spread is 0. Assume further that one party agrees to pay one-month Libor compounded over a three-month Calculation Period. Examples Assume an interest rate swap with a notional amount of $10 million. this formula collapses to the formula for Compounding when Spread is zero. let each month consist of 30 days so the Calculation Period is 90 days. for T Compounding Periods in a Calculation Period: = N × ��(1 + Rt × dt ) – 1 + S × d� T t=1 T FA = N × [(1 + R1 × d1 ) × (1 + R2 × d2 ) ×⋯× (1 + RT × dT ) .0% 4. 4. assume that the relevant one-month Libor fixings are: Compounding Period 1 Compounding Period 2 Compounding Period 3 4.10%.

464.67) × 0.67 + $38.1 FA = N × ��(1 + (Rt +S) × dt ) – 1� T t=1 30 Compounding.166.67 30 = 360 = (N + CPA1) × (R2 + S) × d2 = ($10.439.166.045 × 30 ) 360 CPA3 = N × (R3 + S) × d3 + [(CPA1 + CPA2) × R3 × d3] = $10.65 = $10.62 So Floating Amount for the Calculation Period is FA = CPA1 + CPA2 + CPA3 = $34. Using the general formula in Section 3.46) × 0.67 + $38.051 × 30 + 360 ($34.166.003833) ×(1.003417) × (1.6% × � × �1 + 5.62 FA = CPA1 + CPA2 + CPA3 = $34.464.46 ($34.000 × �(1 + 4.000 × �(1.808.67 + $38. ISDA Flat Compounding does not reduce to a single formula so must be calculated period-by-period as follows: CPA1 CPA2 = N × (R1 + S) × d1 = $10.31 + $42.31 = $42.000 + $34. As mentioned above in Section 3.000.1� 360 360 360 30 30 = $115.046 × = $38.000 × 0.2 Flat Compounding (ISDA).000.4.000 × 0.000.46 + $42.050 × 30 = 360 $42.004250) . 4.1� Alternatively.67 × 0. Floating Amount is: = $10.439.166.464.166.802.051 × 30 360 $38.000 × 0. one can calculate each of the Compounding Period Amounts separately as described in Section 3.166.000.1% × � .000.74 8 .802.68 = $115.1.000.000.166.461.2.461.67 30 + 360 = N × (R2 + S) × d2 + (CPA1 × R2 × d2) = $10.67 + $38.041 × 30 = 360 $34.1% × ) × �1 + 4.046 × = (N + CPA1 + CPA2) x (R3 + S) x d3 = ($10.1 and then sum them to obtain the Floating Amount: CPA1 CPA2 CPA3 = N × (R1 + S) × d1 = $10.166.31) × 0.461.000 + $34.041 × 30 = 360 $34.430.802.000 × 0.000.62 = $115.65 which is the same quantity as with the single formula.

00 + $41.33 + $37.962. Assuming the same Floating Rates as in the preceding examples but that spread is zero.00025] = $115.625.33 + $37.5% × � × �1 + 5.000.000 × [(1.000.962.0% × ) × �1 + 4.00 30 360 = (N + CPA1 + CPA2) × R3 × d3 = ($10.625.000.33) × 0.000 × 0.004167) – 1] = $112.000 × [(1.000.003333) × (1.040 × 30 = 360 $33.420.500.4.01% × = $2.66 = $10.0% × � – 1 + 0.33 30 = 360 = (N + CPA1) x R2 x d2 = ($10.66 which is the same result as with the single formula.01% × � 360 360 360 360 30 30 90 Again. one can calculate each of the Compounding Period Amounts separately as described in Section 3.66 = $10.5% × � × �1 + 5.33 90 360 SA FA = N × S × d = $10.333.333.4 Zero Spread.000 × 0.00 = CPA1 + CPA2 + CPA3 + SA = $33.000 + $33.0% × � – 1� 360 360 360 30 30 30 9 .045 × $37.00 = $115.420.050 × = $41.000 × �(1 + 4.000 × �(1 + 4.003750) ×(1.333.00) × 0.3 Compounding treating Spread as simple interest. The non-ISDA compounding convention and formula described in Section 3. All three of the above methods yield the same result when Spread is zero.000. Compounding with no spread will lead to the following: FA = N × ��(1 + Rt × dt ) – 1� T t=1 = $10.0% × ) × �1 + 4.003750) ×(1.000 + $33. 4.000.3 leads to the following result: FA = N × ��(1 + Rt × dt ) – 1 + (S × d)� T t=1 30 = $10.004167) – 1 + 0.920.625.3 and then sum them to obtain the Floating Amount: CPA1 CPA2 CPA3 = N × R1 × d1 = $10.333.33 + $2.003333) × (1.000.000.500.

1.045 × 30 360 = $37.00 + $41.050 × = $41.040 × = $10.33 × 0.3 (compounding treating Spread as simple interest) leads immediately to the simple Compounding formula from Section 3.00) × 0.333.000 × 0.000 × 0.33 + $37.920.66 which is the same result as with the other two methods. so the result is the same as with Compounding.050 × 30 = 360 30 + 360 $33.625.962.33 = CPA1 + CPA2 + CPA3 = $33.962.000.045 × = $10.Second.625.000. setting Spread to zero in ISDA Flat Compounding leads to the following changes to Section 4.3: CPA1 CPA2 CPA3 FA = $10.33 = $112.333. inserting a zero spread into the non-ISDA compounding formula described in Section 3.333.33 + $37. Finally.33 $33.000.625.000 × 0.00 30 360 30 + 360 ($33. 10 .333.

Spread on profile (RBS). New formula (TD) Other names (source) Compounding Flat Compounding Compounding with simple spread Yes Yes No 11 . Basic (RBS) Flat compounding (ISDA method) (Summit). Index flat (RBS) Compounding flat (not verified). Compounding with spread excluded (Summit).Appendix A: Comparison of compounding conventions Type Defined by ISDA? Treatment of interest: Floating Rate Compound Compound Compound Spread Compound Mixed Simple Compounding with spread included (Summit). Spread exclusive compounding (CS).

CPA3 = ACA3(R3 + S)d3 = (N + CPA1 + CPA2)X3 = [N + NX1 + N(1 + X1)X2]X3 = N[1 + X1 + (1 + X1)X2]X3 So Floating Amount for this period is FA = CPA1 + CPA2 + CPA3 = NX1 + N(1 + X1)X2 + N[1 + X1 + (1 + X1)X2]X3 = N{X1 + (1+X1)X2 + [(1+X1) + (1+X1)X2]}X3 = N{1 + X1 + (1+X1)X2 + [(1+X1) + (1+X1)X2]X3 – 1} = N{(1+X1) + (1+X1)X2 + [(1+X1) + (1+X1)X2]X3 – 1} = N[(1+X1)(1+X2) + (1+X1)(1+X2)X3 – 1] = N[(1+X1)(1+X2)(1+X3) – 1] More generally. Following Sections 6. Compounding Period Amount is: CPA2 = ACA2(R2 + S)d2 = (N + CPA1)X2 = (N + NX1)X2 = N(1 + X1)X2 And for the third period. the three Compounding Period Amounts are: CPA1 = ACA1(R1 + S)d1 = NX1 For the second period.Appendix B: Derivation of general formula for Compounding in 2006 ISDA Definitions Assume the following notation: N FA CPAt ACAt Rt S dt = Notional amount (called Calculation Amount in the Definitions) = Floating Amount for the relevant Calculation Period = Compounding Period Amount for Compounding Period t = Adjusted Calculation Amount for Compounding Period t (= N in Period 1) = Floating Rate for period t = Spread = Day count fraction for period t Let Xt = (Rt + S)dt and assume that the Calculation Period contains three Compounding Periods.1(b) and 6. the above definition can be expressed as the following formula for any Calculation Period consisting of T Compounding Periods: FA = N ��(1+Xt ) – 1� = N ��(1 + (Rt +S)dt ) – 1� T T t=1 t=1 12 .3(a-d) of the 2006 ISDA Definitions.

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