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You are on page 1of 162

Time

Before you start Money Markets What’s next? Contents

▼

▼

$ $ Instruments

Place Pace

Page i Page 153

▼ ▼

Coupon bearing instruments Discount instruments

Instrument Code page Instrument Code page

Certificate of Deposit (CD) CD 13 Bills of Exchange/Banker’s Acceptance (BA) BA 39

Repurchase Agreement (Repo) REP 23 Commercial Paper (CP) CP 47

▼

Derivatives

Instrument Code page

Interest Rate futures FUT 71

Interest Rate Swap (IRS) IRS 93

Options on Interest Rate futures OPT 115

Options on FRAs – Interest Rate Guarantee (IRGs) IRG 133

Options on IRSs – Swaptions SWP 147

i

Contents

Contents

Instruments Level 3 code Derivatives Level 3 code

Bill of Exchange/Banker’s Acceptance (BA) MMI:BA Options on FRAs – Interest Rate Guarantee (IRGs) MMI:IRG

Spot transactions – Currencies versus USD FXI:SPT Synthetic Agreements for Foreign Exchange (SAFEs) FXI:SAF

ii

Before you start

Time

■ Who is this workbook for? The learning materials for each area of information answer a series of Place Pace

The learning materials for the Know your Markets open Before you start

learning package integrate both traditional workbooks with What do I need to know

materials on the Reuters internal Web site. about my market so I

can do my job?

The package has a modular structure and is split into three

levels and four market sectors.

Market Product

▼

information information

This Level 3 workbook is primarily aimed at sales, client

training and customer sales staff who need an in-depth

understanding of markets and related Reuters products.

This greater understanding will enable them to discuss • What instruments • How are the

their customers’ problems and needs in the context of the are used? instruments used

markets in which they operate. in practice?

• Who uses the

Both the workbook and Web Level 3 learning materials have been instruments? • How is the

designed to answer questions concerning the latter two of the three Reuters product

fundamental areas of information that the Know your Markets package • How do the used?

is intended to address: instruments work

– calculations? • Who are the

❑ Customer information competition?

❑ Market information

Across the market sectors there are also areas of common

information required. For the Know your Markets package these have

❑ Product information

been divided into three workbooks.

❑ Introduction to Derivatives

❑ Competition

There are also underlying techniques used in the financial markets,

for example, Technical Analysis, which you may also need to know

something about. You may find the open learning workbook Technical

Analysis: An Introduction useful for the Reuters 3000 products.

iii

Before you start

Time

Place Pace

This workbook is designed to fit into the following series for the To access the Web site use the address below for the Markets Matrix

Money Markets and Foreign Exchange. page.

Before you start

Customer information

Money M From here you can select the Market or Product information for the

arkets

& Foreig particular market sector you want by making the appropriate screen

n selection.

Exchang

e

ns & tion tion to

Regulati Derivativ

on es

Product information – What do you need to know?

❑ What information is needed?

❑ How to get information

❑ Catalogue of information

Level 3 workbooks

Market and Product ➪ Links to Customer profiles/Customer scenarios on

information Money M Foreign Web or Study Guides

arkets Exchang

Instrume e ➪ Links to instruments on Web or Study Guides

nts Instrume

nts

❑ Level 2

• What it is

The Web site accompanying the workbooks provides you with a set of

• Who uses it

quick reference performance materials which may help you if you

❑ Level 3

need a quick reminder of any of the three areas of information –

• Calculations/charts etc

Customer, Market or Product. The Web site materials contains some

• Reuters products

additional multi-media learning materials such as interviews with and • Endcheck

photographs of market players. These materials are cross-referenced • Customer scenarios

to the workbooks which you should use for more in-depth study.

➪ Links to instruments on Web or Study Guides

➪ Links to Reuters products

iv

Before you start

Time

It is worth noting that although each Level 2 workbook has a section ■ What does this workbook contain? Place Pace

overview and contains the minimum of information. The first two All the workbooks at Level 3 have the same areas of information and Before you start

sections of this Level 3 workbook are suitable for Level 2 use if all that answer the same basic questions. Each area has an icon to identify it

is required is information concerning the following: which is found in the title to the section. The icons and sections are

as follows:

❑ What is the instrument?

What is the instrument?

❑ Who uses the instrument? This always has a definition of the instrument and a

description of what the instrument is used for.

The later sections of the Level 3 workbook deal with calculations and

more complex details about the instrument.

Who uses the instrument?

This describes the market players and their trading

techniques.

7 8 9

This deals with any formulas, calculations and examples

4 5

1 2

6

3

of the way the instrument is used in the markets.

0

This deals with the relevant Reuters 3000 and RT pages,

their contents and how they are used in the markets.

The section may also refer to customer scenarios which

may be relevant.

Endcheck

This section provides an opportunity for you to test your

understanding of the formulas, calculations and

products used.

v

Before you start

Time

Place Pace

Throughout the modules you will find that important terms or ■ How to use this package

concepts are shown in bold, for example, Yield. You will also find that

Before you start at certain points learning activities are included which are designed Before you start using the package you should discuss

to enhance your learning. The various activities use the following with your line manager how he/she will help by giving

icons: time for study and giving you feedback and support.

This means stop and think about the point being made. Although your learning style is unique to you, you will

You may want to jot a few words in the box provided – it find that your learning is much more effective if you

doesn’t matter if you don’t. allocate reasonable sized periods of time for study. The

most effective learning period is about 30 minutes – so

use this as a basis. If you try to fit your learning into odd

This indicates an activity for you to do. It is usually moments in a busy schedule you will not get the best

something written – for example, a calculation. from the materials or yourself. You might like to schedule

learning periods into your day just as you would business

This indicates a reference to an instrument in this or meetings.

MMI:CD another Level 3 workbook. A complete list of the

instruments and their codes is given in the Contents. A Being a successful open learner means more than just reading. Open

cross reference to an instrument will appear like this, learning is interactive – it is designed to enhance your learning by

for example, Certificate of Deposit. getting you to be active. There is an old Chinese saying which may

help:

This indicates that you should use the appropriate

3000 I hear and I forget

Reuters 3000 product or Reuters Terminal (RT) and

I see and I remember

follow the instructions. A screen dump of what you

I do and I understand

should see is usually included as well. It is important to

understand that the activities here assume you have a

RT basic knowledge of the Reuters product software. If The various types of activities and their icons have already been

you do not have this knowledge you may need to start mentioned – even thinking is an activity.

with this first!

Try to make sure your study is uninterrupted. This probably means

that your workplace is not a good environment! You will need to find

This indicates an important item of information worth both the time and place where you can study – you may have access to

i remembering. a quiet room at work, you may have a room at home, you may need to

use a library.

learns at their own rate. Some people find things easy, some not quite

so easy. So don’t rush your learning – make sure you get the most

from the package. You should now have enough information to plan

the use of your workbook and the Web materials – remember it’s your

learning so it’s over to you...

vi

Before you start

Time

Place Pace

■ Discount instruments 29

Commercial Paper (CP)

■ Derivatives

Forward Rate Agreement (FRA) 55

Guarantees (IRGs)

Options on IRSs – Swaptions 147

vii

Before you start

Time

Place Pace

You may find the following chart useful for planning your learning

and to decide the order in which you would like to study the

Before you start instruments

Discount instruments

Derivatives

viii

Money Market Deposits

■ What is it? Before you have a look at the deposit market in more detail you need $ $

to understand some of the terms used for trades in the market place

A Money Market Deposit is an unsecured, fixed rate – some of these have already been introduced. Coupon bearing

investment or loan between financial institutions.

If you are a borrower of funds, you refer to the trade as a taking. The

counterparty to the same trade refers to the deal as a placement.

Within the Money Markets the deposit market is often referred to as The borrower, or taker of the funds pays interest based upon:

the Interbank deposit market. This is because the market operates

essentially between banks. Deposits are fixed-term, non-negotiable ❑ An agreed interest rate

investments or loans which yield interest. The interest rates paid are

used as a basis for other Money Market and FX instruments ❑ A defined amount of loan – the principal

including:

❑ A specified period of the loan – the maturity or tenor

❑ Establishing the price of coupon bearing instruments such

as CDs and Repos, and the price of discount instruments ❑ An end date or maturity date on which the taker pays back

such as CPs and T-Bills the principal and any interest due

❑ Pricing derivative instruments such as FRAs and short A transaction is agreed on its trade date but the start date of the trade

Interest rate futures for the purpose of calculating interest is known as the value or

delivery date. This is the date on which the placer delivers the

❑ Setting the rates on instruments which have a ‘floating’ principal to the taker. The value date is usually taken as spot which is

aspect such as Interest Rate Swaps and Floating Rate Notes usually two working days after the trade date. However, as is described

later, the value date may differ depending on the maturity of the

❑ Pricing Forward FX rates deposit.

Within the Interbank deposit market there are two basic types – fixed At the end date – the maturity date – of the loan the taker pays back

and notice: the principal, plus any owed interest. The lender, or placer of the

deposit, receives the principal and interest from the taker at maturity.

A fixed deposit is one where the rate of interest and the

maturity date are agreed at the time of the transaction. Takers and placers are often referred to as buyers and sellers

respectively, even though the monies are not actually bought or sold.

A notice or call deposit is one where the rate of interest You should note that deposits are generally non-negotiable. This

may be changed or the termination of the deposit means that the deal remains on the books until the maturity date,

requested with effect from a specified number of working even if one of the parties wishes to terminate or ‘break’ the deposit

days. A working day means that the Money Market prior to the maturity date.

financial centre involved with the trade must be open for

business.

1

Money Market Deposits

The maturity or tenor of a loan is important because its duration is In this OTC market, irregular or broken dates will be quoted for

Coupon bearing used to calculate interest payments. There are three common maturities which do not quite match the short or fixed dates

maturities you will encounter: described previously. The rates for broken dates are calculated by

interpolating between the rates for two known dates. For example, a

Short dates 4-month deposit rate can be calculated by interpolating between the

Maturities that are up to, but not including one month. The table 3- and 6-month rates.

below indicates the short date name and day count conventions:

You must be careful when using the term spot for the value date. In

Overnight O/N Deposit today – return tomorrow most cases for fixed dates spot is two working days but in GBP trades

in London, spot is value today.

Tomorrow/next T/N Deposit tomorrow – return next

business day The examples below illustrate the events for an overnight and 2-

month deposit.

Spot/next S/N Deposit on spot date (two days after

trade date) – return day after

Borrower

Spot/week S/W Deposit on spot date – return 7 Overnight: Borrow Return

calendar days later Short date principal principal+

Interest

10th July 10th July 11th July

Trade date Today Next day

Fixed dates

Maturities that run from one to twelve months out of spot. Fixed

dates are often referred to as the periods. The most active periods are

indicated in the table below:

Investor

Period or tenor 1 2 3 6 12

2 month: Deposit Receive

principal+

Fixed date principal

Interest

The value date for most Eurocurrency fixed date transactions is spot.

i Some domestic deposits tarde value date as today.

10th July

Trade date

12th July 12th Sept

Spot 2 Months

year. Because of the credit risks recognised by trading institutions for

deals longer than one year in duration, these maturities are not very

liquid.

2

Money Market Deposits

Components of a trade As in the FX Markets, the Deposit Markets have a bid side – taker, and $ $

The principal particulars of a deposit trade are: an offered side – placer. The table below compares some of the

terminology and components of FX and Deposit deals. Coupon bearing

Trade Date The date on which the trade takes place.

Value Date The start date of a deposit. On this date, the lender Term or component Spot FX contract MM Deposit contract

delivers the principal of the trade to the borrower.

Interest on the deposit begins to accrue on this date. No. of currencies 2 1

Maturity The end date of the deposit. On this date, the Value date Date on which the Date on which the

Date borrower repays the lender the principal of the currencies are placer delivers the

trade, plus all interest due. The last day for interest exchanged principal to the

accrual on a deposit is the day before the maturity taker. This is the start

date. date of the deposit

Rate The agreed upon interest rate expressed as a Maturity date Not applicable Date on which the

percentage on a per annum basis. This may also be taker repays the

called a yield. principal plus

interest to the placer.

Basis The number of days in a year used to calculate This is the end of the

interest. Most of the world uses a 360 day basis, deposit

meaning that a year is said to contain 360 days.

Countries such as Canada, Ireland, Singapore, Hong Price/rate The agreed upon The agreed upon

Kong, Belgium and the U.K. use a 365 day basis. rate expressed as an rate expressed as a

amount of the quote percentage per

Currency The currency of the deposit. currency per single annum

unit of the base

Amount The amount of the deposit. currency

Taking bank The bank that borrows the money. The deposit is Bid means Expression of an Expression of an

recorded as a liability on this bank’s books. intent to buy the intent to borrow the

base currency specified currency

Placing bank The bank that lends the money. The deposit is

recorded as an asset on this bank’s books. Offer means Expression of an Expression of an

intent to sell the intent to lend the

Payment Precise instructions advising each bank as to the base currency specified currency

Instructions appropriate details for the delivery of principal on

the value date to the taking bank, and subsequent Hit the bid means To sell the base To lend the specified

repayment of principal plus interest to the placing currency at the bid currency at the bid

bank on the maturity date. price price

Method/via The method used to transact the trade. (Direct, via a Take the offer means To buy the base To borrow the

broker, etc.) currency at the specified currency

offered price at the offered price

Confirmation Printed verification of all the terms of the trade.

Each counterparty sends the other a confirmation.

3

Money Market Deposits

There are two ways you will see interest rates expressed: The bid/offer rates from this

Coupon bearing bank are quoted in decimals

❑ Fractions. Until the early 1990s, interest rates were

expressed as a combination of a whole number, when

applicable, and a fraction. Fractions are quoted as a

denominator divisible by two or four producing halves,

quarters, eighths, sixteenths, thirty-seconds and, rarely,

sixty-fourths. Quotes between market-makers generally

have a spread of 1/8 % or 1/4 % , for example 6 – 6 1/8 % .

used which allows for narrower spreads. A movement of

1/100 of a percent is referred to as a basis point (BP) so

from 6.03% to 6.04% represents a move of 1 BP. A typical

market-maker quote in decimal form usually has a 10 BP

spread, for example 6.00 - 6.10%.

Before moving on use the RT to have a look at some rates... These are

the maturities

The bid/offer rates from this bank

To see the rates from a typical bank type in BPNC are quoted in fractions

RT and BADD and press Enter after each entry.

the maturities Offer = 53/4% , Bid = 51/2% .

4

Money Market Deposits

The only official benchmark that exists for interest rates is that

provided by a Central Bank for overnight funding. The rates for the Borrowers/Lenders Coupon bearing

other maturities are generated by the market. However, nearly every In the Interbank Deposit markets banks borrow and lend

institution has a slightly different opinion of what the rate is for a in response to their customers’ requirements. The banks

given maturity. To cope with this situation the market needs a also accept and relend deposits on their own account in

mechanism that provides a semi-official benchmark rate for the fixed order to profit from movements in interest rates. If a Money Market

date maturities. transaction involves different currencies on the two sides of the trade,

then the transaction has a FX aspect and gives rise to a deposit swap.

LIBOR London Interbank Offered Rate. This is the rate a bank

offers or charges for lending money. A long position means you have bought a currency.

i A short position means you have sold a currency.

LIBID London Interbank Bid Rate. This is the rate the bank

bids for money or pays for deposited funds.

Banks trading on their own account will also be seeking to maximise

LIMEAN This is the average of the LIBOR and LIBID rates which profits from interest arbitrage. This means the banks are constantly

you may sometimes see used looking for the greatest spread between the rates for accepting and

relending deposits.

The banks in London use a system that has been imitated by other

Brokers

financial centres. Each day, at around 11:00 am London time, a

Brokers are active in the Money Markets where they act as

survey of up to 16 British Banking Association (BBA) selected banks

intermediaries between counterparties – they try to match a

is undertaken for their fixed rate maturity lending (offer) rates to

borrower with a lender. Brokers do not take positions on their own

each other for the major Eurocurrencies. A single rate is established

account but receive fees for arranging transactions.

per currency and maturity which is known as a BBA LIBOR or

LIBOR fixing. These LIBOR fixings are used for setting rates on

The following criteria must be satisfied before a trade can be

loans, FRNs and interest rate derivatives. It is important to note the

completed:

following about LIBOR information:

❑ The two parties must have opposite interests – one must

❑ The term LIBOR is always qualified with a currency and a

be a lender, the other a borrower.

maturity, for example, 3-month Deutschemark LIBOR

❑ LIBOR is a reference rate and a t best can be used to fix rates

❑ They must agree on currency, rate, tenor (which must

for negotiated deals

have the same start and maturity dates for the deposit),

❑ Contributing banks cannot be held to LIBOR prices

amount and that enough credit is available between them.

❑ LIBOR refers only to Eurocurrencies – not domestic markets

It is often the case that the amount is negotiated

downward to reflect the credit availability of one or both

Other countries have a similar fixing procedure to LIBOR, for

parties.

example PIBOR is the Paris Interbank Offered Rate and FIBOR is the

Frankfurt Interbank Offered Rate. However, London LIBOR is used

for most transactions in the Money Markets.

5

Money Market Deposits

The interest due on a three month deposit of 10,000,000 USD at

Coupon bearing Interest (I) is calculated by taking into account the Principal 6 1/2 % that has a tenor of 92 days would be calculated as follows:

7 8 9 amount of the deposit (P), the agreed upon interest Rate (R)

4 5 6

expressed in its decimal form, the year Basis (B) of the 10,000,000 (P) x 6.5 (R) x 92(N)

1 2 3 Interest due (I) =

0

currency, either 360 or 365, and the Amount of days (N) that 360 (B) x 100

the deposit lasts. The formula looks like this:

= 166,111.11 USD

Principal (P) x Rate (R) x Amount of days (N) The Basis for USD is 360. The basis is seen as A/360 which means

Interest due (I) =

Basis (B) x 100 the actual number of days (92) over a 360-day year. Actual days

...Equation 1 include weekends and holidays.

It is important to recognise that the interest paid at the maturity of

Interest on deposits maturing within 12 months is paid at maturity

the deposit is simple interest. Compound interest is interest paid on

only.

accumulated interest which you may encounter in the capital

Coupon bearing instruments have two values: markets.

❑ Present Value (PV) – the fair market value today Suppose now that the deposit had been 10,000,000 GBP. Using the

same tenor and rate the interest due is now:

❑ Future Value (FV) – the total repayment value, including 10,000,000 (P) x 6.5(R) x 92(N)

interest, on maturity Interest due (I) =

365 (B) x 100

= 163,835.62 GBP

( )

= P+ P x R x N

B x 100

The Basis for GBP is 365, seen as A/365. Note the difference in

interest amounts due to the different day bases.

Year day basis conventions Except GBP, CAD, BEF, ECU where:

Future Value

[ ( )]

= P x 1 +

R x N

B x 100

...Equation 3 i

Domestic 360 Domestic

Euro

365

365

Euro 360

interest, Present Values and Future Values, a knowledge and

understanding of Equations 1 – 3 will be useful.

6

Money Market Deposits

The difference in Basis can be important if you are comparing the ■ Summary $ $

Money Market Yields, MMY – interest paid – between different

instruments. To compare rates between instruments you have to Coupon bearing

compare like with like. To do this you need to calculate the true

Money Market Deposits

annual yield for both deposits.

You wish to compare a GBP deposit which uses Actual/365 (A/365) to

calculate interest with a Eurodeposit which uses Actual/360 (A/360) ❑ Domestic and Euro Markets

for interest calculations. To compare like with like you need to add

interest for 5 more days for the Eurodeposit. To do this simply ❑ Maturities or tenors one day to 12 months

multiply the Rate by 365/360.

• Short dates – up to one month

For example, a Euromark deposit for DEM 100 million has a quoted • Fixed dates – 1, 2, 3, 6, and 12 months from spot

rate of 10%. What is the true annual yield for this deposit on a 365 • Broken dates – dates not matching short or fixed dates

day year basis?

❑ Interbank rates

True annual yield = 10 x 365

360 • Bid/Offer

• Offer/Bid – London

= 10.14%

❑ Interest rate quoted as a % per annum

Similarly if you need to compare an A/360 quoted instrument with

one using A/365, the Rate will need to be multiplied by 360/365 –

❑ Simple interest calculations

the interest is less because only 360 days are used to calculate the true

annual yield.

• A/360

• A/365

This means that you must be careful when comparing the data for

instruments onscreen! ❑ LIBOR

7

Money Market Deposits

Coupon bearing The following exercises using Reuters products and the

RT may help your understanding of Money Market

Deposits and how they are used.

Speed Guide. From this page double-click in

<DEPO/1> to display the DEPOSITS Speed Guide.

From here double-click in any currency you require

rates for. You may also find it useful to display LIBOR rates for

Eurocurrencies by typing in ISDA and pressing Enter – for

Eurodollar LIBOR rates from different banks type in LIBO and

press Enter.

8

Money Market Deposits

$ $

3000 Exercise 1. Using the MMMW page in Money 3000 3000 You can also use the MMMW page to calculate Coupon bearing

can be useful as you can display Bid and Ask prices broken dates for deposits. But before you look at

for a number of currencies from different the page try the following:

contributors simultaneously. For example you want

to lend £5 million for 3 months and at the same time you need to

borrow 2 million DEM. You use MMMW to display GBP Bid rates

and DEM Ask rates from different contributors to select who you To calculate broken dates carry out the following:

want to trade with. Assume 3 months is 90 days in both cases.

1. Select maturity rates for either side of the broken date.

2. Calculate the rate change for each day between the maturities

selected.

3. Multiply the result from 2) by the number of days for the broken

date.

4. Add the result from 3) to the rate for the near deposit and this is

the broken date rate.

Exercise 2

It is 30th June 1997 and you need the GBP rate for a broken date of

15th August 1997 using TTKL Bid prices opposite. Value is 2nd July.

The 1 month deposit maturity date is 4th August and the maturity

1) Which GBP contributor would you deposit funds with for the best

date for 2 months is 2nd September. There are 29 days from 4th

rate of return and what interest would you expect to receive?

August until 2nd September, and 11 days to the broken date.

Answer:

Calculate the broken date rate for the bid.

Answer:

2) Which DEM contributor would you borrow funds from and what

interest would you pay?

Answer:

Before you check your answers on page 12, why not complete the following End

check?

9

Money Market Deposits

$ $ ■ End check 5. You are the Treasurer of a large corporation in London and at

times you need to deposit and borrow dollars. There are four

Coupon bearing banks you could deal with quoting the following Eurodollar rates

1. Which of the following Money Market instruments is not for one month (31 days) on a 360-day year basis.

negotiable?

Bank A Bank B Bank C Bank D

❑ a) Cash deposit

6 /16 – 69/16

11

63/4 – 65/8 67/8 – 611/16 613/16 – 63/4

❑ b) Certificate of Deposit

❑ c) Eligible Bill a) From which bank would you borrow Eurodollars and at what

❑ d) Commercial Paper rate?

b) From your answer in a), if you borrowed $5 million what is the

2. Which of the following Eurocurrency deposits is quoted on the total amount payable at maturity?

basis of Actual/365 days? c) With which bank would you deposit funds and at what rate?

❑ a) Euromarks Answer a)

❑ b) Euroyen

❑ c) Eurosterling

❑ d) Eurodollars

quoted at 3.00%?

❑ a) 3.00% Answer b)

❑ b) 3.02%

❑ c) 3.04%

❑ d) 3.05%

53/4 – 515/32% . A market-taker takes $20 millions at 515/32% . Calculate

the interest due for the deposit.

Answer c)

Answer:

10

Money Market Deposits

Your notes $ $

Coupon bearing

11

Money Market Deposits

1) The highest Bid rate is from TTKL at 6.84 %. The interest for 1. a) ❑

90 days is £84328.70.

2. c) ❑

Use Equation 1.

Interest = 5,000,000 x 90 x 6.84 3. c) ❑

365 100

4. $546,875.00 ❑

2) The lowest Ask rate is from TRDL at 3.10%. The interest due

for 90 days is 15500 DEM. Use Equation 1.

Interest = 20,000,000 x 180 x 5.46875

Use Equation 1.

360 100

Interest = 2,000,000 x 90 x 3.10

360 100

1) 1 month rate is 6.5938%, 2 month rate is 6.7500%

2) Number of days between maturities is 29 days. b) $5,028,793.00 ❑

Rate change per day is 6.7500 – 6.5938/29 = 0.1562/29

3) Rate change for broken Use Equation 3.

date period is 11 x

0.1562/29 = 0.0592

4) Broken date rate is

Total amount= 5,000,000 x

[ (

1 + 6.6875 x 31

100 x 360 )]

therefore 6.5938 + = 5,000,000 x (1.0057586)

0.0592 = 6.6530

c) Bank D – This has the highest bid rate of 63/4% . ❑

Calculator things are much

simpler! Make sure you

enter the correct data in

the fields and Money 3000

performs the calculation

for you. Check your answer

How well did you score? You should have managed to get most of

here.

these questions correct.

12

Certificate of Deposit (CD)

In order to issue a CD in the US domestic market a bank must have a

A Certificate of Deposit is a negotiable receipt for funds good or acceptable credit rating in the market place. Most US bank Coupon bearing

deposited at a bank or other financial institution for a CDs are issued with maturities of 1 to 6 months, in $1 million units –

specified time period and at a specified interest rate. pieces – at face value. The majority of US domestic CDs are payable

at maturity in New York.

In other words it is an IOU with a fixed coupon. Most CDs issued by

banks are negotiable instruments and are bearer certificates which Many US banks issuing CDs also prefer to place the instruments

means that ownership belongs to whoever possesses the certificate. directly with their clients. This technique has two advantages:

What then is the difference between 1. The bank’s borrowing is less visible which influences their

an interbank deposit and a CD? The credit rating

Certificate of Deposit problem with a simple deposit is that

MegaBank

is for a fixed term and is non- 2. CDs issued through dealers may reappear in competition

$1,000,000 negotiable. By buying a negotiable to any new issue the bank may seek to launch

Maturity 3 months CD for a fixed period, if it becomes

Interest 6.75%

necessary to raise funds before the However, US banks do issue CDs on a commission basis through a

maturity date, then the buyer can sell number of Securities Houses who make a market in CDs. These

the CD in the secondary market. houses have distribution networks for the world-wide retail of new

issues.

The rate of interest paid on a CD depends on factors such as current

market conditions, the denomination of the CD and the standing of

the bank offering the instrument.

This section of

screen is

The depositor can retain the CD until maturity and receive the

taken from

guaranteed interest or if funds are required urgently the CD can be

Money 3000

sold in the money markets. The CD will be sold at the going market

page MMBW

price which reflects the current interest rates. CDs are issued at a

for USD

lower rate than LIBOR because they may not be held to maturity.

Domestic CDs

CDs were first issued in the US in 1961, in the Euromarkets in 1966

and in London in 1968.

USD denominated CDs issued by Foreign banks in the US are often called

i Yankee CDs

13

Certificate of Deposit (CD)

$ $ Euro CDs In addition to the fixed rate coupon CDs, there are also two

A Euro CD is a receipt for a Eurocurrency fixed term deposit typically variations which may be encountered:

Coupon bearing with a London-based bank. Euro CDs are mainly USD denominated

bearer instruments issued in $1 million units. It is common to see ❑ Discount CDs. In this case a CD offered at £1 million face

early and late prices quoted for CDs which reflects whether the CD value and a yield of 10% would be bought for, say, £900,000.

matures in the first or second half of the month respectively. On maturity the loan would be repaid at £1 million earning

£100,000 interest on an investment of £900,000. This

The main issuers of Euro CDs are branches of major US banks, represents a true yield of 11.11%.

British clearing banks, branches of major continental Europe banks

and Japanese banks. There is a secondary market in Euro CDs ❑ Floating Rate CDs. These are based on a benchmark –

although as much as 50% of current issues are lock-ups – the CDs are usually LIBOR and are similar in principal to Floating

bought and held to maturity, often in the safe custody of the issuing Rate Notes, FRNs, used in the debt markets. You may find

bank. it useful to compare these instruments with FRNs in the

Debt Markets section. Although not very common the two

types which may be encountered are 6-month instruments

with a 30-day roll and a 1-year paper with a 3-month roll.

The buyer of a Floating Rate CD has some protection

against rising interest rates but this is offset to some extent

This section of because this type of CD is less liquid than the normal fixed

screen is rate type.

taken from

Money 3000 On each roll date accrued interest is paid and a new coupon is set.

page MMBW i

for USD

Domestic

Euro CDs

14

Certificate of Deposit (CD)

Investors Coupon bearing

The advantage of CDs for investors is that the instruments

are negotiable in the secondary market should they wish

to raise cash quickly. However, this means that issuers of

CDs will pay some 10 - 15 basis points below comparable fixed deposit

rates for such negotiable instruments.

bulk of demand has come from specialist money market funds. These

funds are required to maintain short average maturity on their

portfolios which makes CDs attractive instruments.

As well as buying and selling CDs to clients, dealers create a

secondary market by quoting bid and offer prices to other dealers.

The normal settlement date for CDs denominated in a foreign

currency is 2 business days. Domestic CDs settle the following day –

the same for domestic currency deposits.

anonymous trading facilities between dealers. Typical brokerage is 1

basis point per annum on the amount traded which is paid by the

party initiating the trade.

i

However, these quoted prices are more varied than for instruments

such as government securities as the credit rating of banks issuing

CDs varies which affects the quoted prices.

15

Certificate of Deposit (CD)

$ $ ■ CDs in the market place Year day basis conventions Except GBP, CAD, BEF, ECU etc. where:

i

Coupon bearing Interest on short-term CDs is normally payable at maturity Domestic 360 Domestic 365

Euro 360 Euro 365

7 8 9 which in the US is termed a bullet security. For CDs issued

4 5 6

1 2 3 with maturities of 12 months and greater, interest is typically

0

paid semi-annually. The CD has an original maturity of 366 days – a leap year! The

interest due is simply calculated from the formula:

A bullet security is one where the principal of a loan is paid in whole on

i maturity

Principal (P) x Rate (R) x Amount of days (N)

On maturity the bearer of a CD will receive the instrument’s Interest due (I) =

Basis (B) x 100

principal plus the agreed interest which is due. But supposing the ...Equation 2

bearer requires cash for a project and decides to sell the CD. What is

a fair market value for the CD? What is its Present Value, (PV)? = 1,000,000 x 8.5 x 366

360 x 100

A dollar received in the future is worth less than a dollar today

because there is no opportunity to invest the dollar and earn interest.

The Future Value (FV) – the repayment amount – is the amount of = $86,416.67

money you would have if you invested a sum today, PV, for a period of

time at a given rate of interest. So the Future Value of the CD = $1,086,416.67

Future Value = Principal + Interest due ...Equation 1 You now decide that you must sell the CD for settlement on the 1st

November 1996 when there are only 61 days left to maturity.

The fair value, or settlement amount, of the CD should be that

amount of money (PV) which when placed on deposit today for the Suppose the current 2-month deposit rate is 9.75%. The fair value of

number of days left to maturity would result in the same FV if the CD the CD should be that amount of money, PV, which if placed on

were left to mature. So the return on the CD should equal the return deposit today at 9.75% for 61 days would also result in a FV of

currently available on a deposit for the same maturity. $1,086,416.67.

Consider the following CD:

Future Value = Principal + Interest due

Issue date: 1st January 1996 ( )

= P+ P x R x N

B x 100

Maturity date: 1st January 1997

Coupon:

Year basis:

8.5% pa

360 days

Future Value

[ ( )]

= P x 1 +

R x N

B x 100

...Equation 3

16

Certificate of Deposit (CD)

In this case the Principal is the Present Value: You may or may not be offered a fair price if you want to sell your CD. $ $

What is required is a measure of how good or bad the price you are

Present value = Future value ÷ Interest due offered is. The important factor for the value of a CD in the Coupon bearing

1086416.67 secondary market is its Yield To Maturity, YTM which is also known

= 1 + 9.75 x 61

[ 360 x 100 ] as the Money Market Yield, MMY. The YTM is:

it is held to maturity.

Present Value = $1,068,759.87

So the fair value for this CD, 2-months from maturity, discounted at In order to compare the value of a CD with interest rates on deposits

9.75% is $1,068,759.87. and other instruments, market-makers quote a yield basis rather than

cash values.

The general equation for calculating the Present Value for a CD

CDs are quoted on a YTM (MMY) basis rather than in cash terms.

which has not reached maturity is given in Equation 4. i

Present Value

[ ( )]

= P x 1 +

R x N

B x 100

Future Value

Although YTM is the rate of return if an instrument is held to

maturity, short-term investors often liquidate their position before

maturity. These investors are therefore concerned with the horizon

Interest due

[ ( )]

1 +

r x n

B x 100

return on the instrument which has two components:

...Equation 4

Where P = Principal or the CD face value This means the horizon return is the rate of return achieved on an

R = Quoted coupon rate for the CD investment, from purchase to sale, expressed as a percentage per

N = Number of days to maturity annum taking into account both components.

B = Year basis – 365 or 360

r = Current market interest rate If an investment is held to maturity, then its horizon return equals the YTM.

n = Current number of days to maturity

i

17

Certificate of Deposit (CD)

$ $ Example 2 ■ Summary

Using the CD details from Example 1 you are offered $1,065,000.00

Coupon bearing by a market-maker for its purchase with 61 days left to maturity. What

YTM does this represent? Should you sell to the market-maker?

Certificate of Deposit (CD)

Using Equation 3 and rearranging for R, where P is taken as the PV:

❑ A Certificate of Deposit is an IOU with a fixed coupon

R% = ( B x 100

N

)( x

FV – PV

PV

) ... Equation 5

and which is a negotiable instrument

= 360 x 100 x 1086416.67 – 1065000.00

normally payable at maturity

61 1065000.00

deposit typically with a London-based bank

At the price offered the CD yields over 2% more than the

comparable deposit rate of 9.75% – this is an excellent deal!

❑ CDs are often quoted as early or late prices which reflects

The market-maker is unlikely to quote the price of $1,065,000.00 for whether the instrument matures in the first or second half

the CD, which is the settlement amount. What the market-maker will of the month

quote is a two-way price, for example, 11.92/11.87.

This means that the market-maker will buy a CD from you (bid) for a

cash amount that produces a yield of 11.92% for him, or that the

market-maker will sell you (offer) a CD for a sum that will yield you

11.87%.

Yields and not true annual yields. Using this method of quotes makes

the true value of CDs very transparent and easy to compare with

interest rates on fixed deposits. When trading CDs the yield price is

agreed and then the cash settlement is calculated for the purchase/

sale of the CD.

The higher the quoted price, the lower the value of the asset.

i

If you hold a CD you want broker prices to go down – the lower the price, the

greater the yield.

18

Certificate of Deposit (CD)

The following exercises using Reuters products and the Coupon bearing

RT may help your understanding of CDs and how they

are used.

Money Market field <MMKT/>. You can display the

GBP CD prices from the broker Harlow Butler by

double-clicking in the field <CD=HBEL>. You may

also find it useful to type in US/MMKT and press Enter. If you

double-click in the Certificate of Deposits field <USCD1> you will

see a variety of CD prices from different US Commercial Banks.

19

Certificate of Deposit (CD)

$ $

Coupon bearing 3000 Using Money 3000 CD prices can be displayed for

any currency of your choice using the MMCB page.

In the screen below prices for Domestic CDs from

Garvin Guy Butler are shown. You may find the

Calculator useful if you need to calculate the Horizon return for a

CD for a date before maturity. Simply make sure you have the

correct details for the CD required and change the Horizon Date

and press Enter – the new Horizon Return will be displayed.

Date here and press Enter

here – it has changed from 5.670% to 5.616% by

moving the date forward to 15th August 1997

20

Certificate of Deposit (CD)

■ End check 5. On 19th February you buy a 6-month (180 days) Euro CD at $ $

8.40% with the following details and which has 90 days to

maturity: Coupon bearing

1. When do Eurodollar CDs issued for 12 months generally pay

interest? CD face value: $100,000

Issue date: 20th November

❑ a) On the issue date Maturity date: 20th May

❑ b) At maturity

❑ c) Quarterly Coupon: 9.5% pa

❑ d) Semi-annually Year basis: 360 days

2. XYZ Bank wishes to invest in a very liquid instrument. Which of Calculate the following:

the following are they most likely to do? a) The purchase cost of the CD

b) The interest actually paid

❑ a) Buy a A2/P2 Commercial Paper c) If the CD was sold on 29th February at 8.30% how much profit

❑ b) Buy a CD rated AAA is made and what is the Horizon return?

❑ c) Buy a CD rated BBB

❑ d) Deposit funds in the Money Market Answer a)

instruments? A CD:

❑ b) Can be resold in the secondary market

❑ c) Is the safest form of investment

Answer b)

4. You have bought a Sterling CD in the secondary market with a

nominal value of £1,000,000. There are 87 days left to maturity

and a yield of 6.5%. The CD was issued for 90 days with a coupon

of 6.75%. How much do you receive at maturity?

Answer c)

❑ a) £1,015493.10

❑ b) £1,015,631.65

❑ c) £1,016,643.80

❑ d) £1,018,643.60

21

Certificate of Deposit (CD)

Coupon bearing ✔ or ✖ ✔ or ✖

1. b) ❑ 5. c) Profit = $257.51 ❑

Horizon rate = 9.159% ❑

2. b) ❑

3. b) ❑

Selling cost = 100,000 x

[ (

1+ 9.50 x 181

100 x 360 )]

4. c) ❑

[ (

1+ 8.30 x 80

100 x 360 )]

Use Equation 3.

Sum at maturity = 1,000,000 x

[ (

1+ 6.75 x 90

100 x 365 )] = 1.0477638

1.0184444

= $102,878.84

5. a) Purchase cost = $102,621.33 ❑

Profit = Selling – Purchase price

Use Equation 4.

= 102,878.84 – 102,621.33

Purchase cost = 100,000 x

[ (

1+ 9.50 x 181

100 x 360 )]

[ (

1+ 8.40 x 90

100 x 360 )] Horizon return = 257.51 x 360 x 100 x 365

102,621.33 10 360

= 1.0477638

1.0210

100 x 360

How well did you score? You should have managed to get most of

these questions correct.

22

Repurchase Agreement (Repo)

■ What is it? The following diagrams illustrate the process of using a Repo. $ $

A Repurchase Agreement (Repo) is an agreement for the First leg – the sale Coupon bearing

,,

sale of an instrument with the simultaneous agreement by

the seller to repurchase the instrument at an agreed

,,

future date and agreed price.

,,

Dealer A sells instruments

A Reverse Repurchase Agreement – Reverse Repo – is an

worth $1 million

agreement for the purchase of an instrument with the

▼

simultaneous agreement by the seller to resell the

▼

instrument at an agreed future date and agreed price.

Dealer B pays A $1 million

activities using loans. As in most financial loans, lenders require Dealer A Dealer B

collateral – security – for the loan. A Repo is a sale and repurchase (Seller) (Buyer)

agreement which can use almost any asset as collateral. However,

government issued instruments such as T-Bonds and T-Bills are most Dealer A now has $1 million for delivering the instruments worth $1

often used because of the credit worthiness of the issues. FRNs, CDs million to Dealer B.

and CPs are also used for Repos. Second leg – the repurchase

to repurchase equivalent instruments from B at an agreed future ,,

,,

,,

date. Dealer B now holds the instruments and can use them for Dealer A pays $1 million

whatever purpose but has the obligation to deliver equivalent plus a repo rate of 6.5%

instruments to A at the agreed future date.

▼

▼

The interest rate implied by the difference between the sale and Dealer B sells instruments

purchase price is known as the repo rate. worth $1 million

Dealer A Dealer B

effect the cost of the loan.

(Seller) (Buyer)

them back to Dealer B at an agreed price at an agreed future date.

23

Repurchase Agreement (Repo)

Dealers now run books in Repos and Reverse Repos hoping to match

Coupon bearing Central Banks counterparties and make a profitable spread in the middle. In effect

Repo transactions are often used by Central Banks as a this means the dealer is acting in a similar way to a bank – lending

means of monetary control. For example, in the US the money for instruments on one side and taking deposits on the other

largest Repo market involves trading T-Bills overnight side.

which spans the closing and opening times of the Money Markets.

When the Fed uses a Repo it is initially buying T-Bills to temporarily Counterparties to Repos are typically:

add cash to the Money Markets. A Reverse Repo is where the Fed sells

T-Bills to the Money Markets to drain money from the system. You ❑ Central Banks

may think that these explanations are the wrong way round but if you

consider the Fed as Dealer B in the previous diagrams, then all is ❑ Pension funds

well.

❑ Insurance funds

In the UK the Gilt Repo market is relatively new and the global

Master Repurchase Agreement (GMRA) establishes what type of ❑ Large corporations

interest bearing instrument can be used for Repos and allows dealers

to substitute eligible instruments. In many cases government bonds are used for Repos and Repo

Dealers often use Currency Swaps to eliminate FX exposure which

Corporations may arise on interest rate differentials between bonds denominated

Repos may be used by corporations who are trying to match funds in different currencies.

with their available cash which is needed at a future date. In effect

they buy cash instruments – usually T-Bills – to hedge a future

position. Using a Repo means the T-Bills are immediately sold but

their repurchase is agreed for a future date.

24

Repurchase Agreement (Repo)

Term Description

$ $

The Repo market formalises to some extent the use of Coupon bearing

Margin Where the Repo transaction is covered by a bilateral

7 8 9 interest bearing instruments – particularly Government

4 5 6 (cont.) margining agreement between counterparties, a third

1 2 3 bonds – as collateral for loans. In some cases dealers use the

party such as a Custodian Bank or Clearing House is

0

cash raised on existing bonds to buy more bonds. In other

used to revalue the collateral and manage the transfer

cases dealers may have sold bonds they do not actually

of cash and instruments involved.

possess and use the Repo markets to borrow the bonds they require

for cash. Repos can resemble futures contracts in that dealers can

Haircut This is the margin a Repo dealer puts up and is the

open and close large financial positions without involving too much

amount by which the value of the instruments involved

of their capital. Within the Repo markets it is useful to understand

exceeds the cash invested in the Repo transaction.

the following terms:

Buy/ A simultaneous spot purchase and forward sale of

Term Description sellback instruments with the agreed repo rate being used to

Repo derive the forward purchase price. The buyer receives

Ask The interest rate at which a dealer will pay for a Repo to the accrued interest and any coupon payments during

obtain cash. the Repo period. This type of Repo requires no

collateral monitoring or margining provisions.

Bid The interest rate at which a dealer will pay for a Repo to

obtain instruments.

temporary purchase of instruments.

instruments in the Repo transaction.

been provided by the instrument lender. If the price of

the collateral moves in the markets then this will give

rise to a change in value.

between the counterparties. Revaluation is usually

carried out daily.

25

Repurchase Agreement (Repo)

Coupon bearing

Repurchase Agreement (Repo)

the simultaneous agreement by the seller to repurchase

the instrument at an agreed future date and agreed price

instrument with the simultaneous agreement by the seller

to resell the instrument at an agreed future date and

agreed price

between the sale and purchase prices

are important as the bills and bonds involved are

considered to be the most creditworthy collateral

26

Repurchase Agreement (Repo)

The following exercises using Reuters products and the Coupon bearing

RT may help your understanding of Repos and how they

are used.

REPO and press Enter. This screen displays the

Overnight to 3-month rates for US Treasury Repos.

27

Repurchase Agreement (Repo)

$ $

Coupon bearing 3000 US Treasury repo rates from Garvin Guy Butler can

be displayed from the MMDI page for USD.

28

Treasury Bill (T-Bill)

■ What is it? The results of the auction are published in The Wall Street Journal and $ $

look something like this:

A Treasury Bill is a short-term negotiable Bill of Discount

Exchange issued by a government to help finance 13 week 26 week

national debt.

Applications $55,735,696 $48,878,949

Accepted bills $13,073,966 $13,080,408

T-Bills are short-term government instruments issued in both the US

Accepted non-compet. $1.118,192 $861,519

and UK. Normally T-Bill prices are quoted at a discount which

Average price rate 99.227 98.352

reflects the prevailing short-term interest rate. If you buy T-Bills you

3.06% 3.26%

are effectively lending money to the government and as such there is

little risk attached. However, the main purpose of T-Bills is not to Yield

finance government spending but to help control monetary policy.

Yields on T-Bills are therefore lower than other short-term money UK T-Bills

market instruments because the loan is guaranteed by the On the last business day of each week the Bank of England issues 91-

government – less risk, less reward. As a result of their reliability these day bills usually for amounts £5000 – 250,000. Tenders are invited

instruments are used as benchmarks for other investments to be each Friday with bills being issued the following week.

compared with.

The results of the tenders are published in the Financial Times and

In the US and UK T-Bills are recorded centrally so there are no they look something like this:

physical certificates of ownership.

BANK OF ENGLAND TREASURY BILL TENDER

US T-Bills

In the US the Fed typically auctions 13- and 26-week T-Bills on behalf Friday 2 Friday 1

of the government every Monday for delivery on Thursday. It also

auctions 52-week bills every month. Bids can either be competitive or Bills on offer £700m £700m

non-competitive. Competitive bids state the actual price the investor Total of applications £2900m £2246m

is willing to pay whereas for non-competitive bids the investor is Total allocated £700m £700m

willing to pay the average of all bids accepted. Minimum accepted bid £98.475 £98.495

Allotment at minimum level 59% 83%

29

Treasury Bill (T-Bill)

$ $ ■ Who uses T-Bills? In contrast to the primary market, settlement in the secondary

market takes place on the following business day at the latest – T+1

Discount US T-Bill investors or Trade + 1.

In the primary market, market-players such as primary

dealers, large institutional investors, money-centre banks Bills are traded traditionally by large investors in minimum lots of $5

and non-professional investors buy T-Bills in competitive million. The US T-Bill is a very liquid market and with the easy

bids on a discounted basis. For example, a bill with a face value of availability of Repurchase Agreements (Repos) dealers build up

$100,000 may be bought for $97,000. The discount is $3000 which substantial long or short T-Bill positions running into many $100

represents the interest on the loan to the government if the bill is millions.

held to maturity. The professional market-players bid for the bills in

a competitive auction whereas non-professional investors can make UK T-Bill investors

non-competitive bids with no price. If successful the professional The main holders of UK T-Bills are the Discount Houses who

market-players pay their bid price; non-competitive bids are priced as dominate the secondary market and act as intermediaries between

an average of the professional market-players bid prices. the Bank of England and investors. The Bank of England can also

invite Discount Houses and Clearing banks to absorb surplus Money

Between the auction and settlement of new issues, primary dealers Market supplies on a particular day and issue T-Bills by allotment.

make a market in when issued (W/I) bills. This is attractive for

dealers who want to run positions as there is no immediate delivery Market prices

or costs involved. T-Bills are guaranteed instruments carrying no risk and as such the

yield is lower than on Money Market deposits and CDs. T-Bills are

The US T-Bill secondary market is the most active US Money Market. quoted on a discount to par basis not on a yield basis. The practice of

The Fed will only deal with primary dealers who must have adequate: discounting to par dates back to the issue of Bills of Exchange from

Merchant Banks.

• Capital

• Market turnover In the secondary market traders deal with each other using quoted

• Experience and knowledge of government markets bid and offer discount rates. A broker’s price run might look like

this:

Virtually all secondary T-Bill trading in the US is carried out using

InterDealer Brokers (IDBs). The 40 or so primary dealers use the US T-Bill

IDBs on a no-names basis. This means trades are settled with an IDB 13 week 6.50 – 49 2 x 5

directly rather than between counterparties which makes it difficult 26 week 6.70 – 69+ 10 x 12

to assess who is in the market and the size of their position.

52 week 6.96 – 95 1 x 10

Because T-Bills carry virtually no risk of default, brokers quote price

runs for different maturities. This is possible because all bills

maturing on the same date should have the same price, irrespective But what do these quotes mean?

of their issue date.

30

Treasury Bill (T-Bill)

The Big Figure of 6% is also The relationship between discount rate and yield is Discount

known as the handle and is rarely This means there are important, particularly if you need to compare instruments

7 8 9

referred to in conversations. This 10 million Bid lots 4 5 6

which are quoted in different ways. To illustrate the

1 2 3

quote would be 70 – 69+ and 12 million Offer 0

relationship consider the following simple case. Suppose an

lots available exporter sells a $100 instrument which is discounted by 10%

so receiving $90. What is the equivalent interest rate for this loan? It

Bid Offer is not 10%. If the exporter placed the $90 on deposit for a year at a

rate of 10%, then the interest would be $9. The most the exporter

6.70 – 69+ 10 x 12 could receive in interest and from the sale of the instrument is $99,

not $100. So the effective rate of interest to the exporter for issuing

the instrument is greater than 10%

The bid discount rate The offer discount rate is

is the rate you pay to the rate you receive if you The discount rate quoted is always less than the true yield to maturity on an

buy the bill from the i instrument or the effective rate of interest paid.

sell the bill to the broker–

broker – 6.70%. 6.695%. The 69+ means 69.5

basis points. Within the discount markets, instruments have two values which you

need to understand:

As for CDs once a rate has been agreed the settlement amounts are

❑ Present value (PV) – the settlement amount payable

calculated.

today

payable on maturity

calculated using Equation 1.

Settlement amount , S = P x 1 –

[ ( R x N

B x 100 )] ...Equation 1

R = Discount rate as a decimal

N = Number of days to maturity

B = Year basis – 365 or 360

31

Treasury Bill (T-Bill)

$ $ By rearranging Equation 1 the Discount rate can be calculated using Example 2 – A UK T-Bill

Equation 2. Calculate the discount rate for the following UK T-Bill which has 91

Discount days to maturity.

R% =

( P – S

P ) (

x

B x 100

N ) ...Equation 2

T-Bill face value:

Settlement date:

£100,000

9th May

Maturity date: 8th August

Settlement value: £98,485

Example 1 – A US T-Bill Year basis: 365 days

Calculate the settlement amount for the following US T-Bill which

has 50 days to maturity. Using Equation 2:

T-Bill face value: $100,000

Settlement date: 9th May Discount rate = 100,000 – 98,485 x 365 x 100

Maturity date: 28th June 100,000 91

Discount rate: 8.12%

Year basis: 360 days = 6.0766%

Using Equation 1:

S = 100,000 x 1 –

[ ( 8.12 x 50

360 x 100 )]

Therefore the settlement value = $98,872.22. This is also written as

98.87% of face value.

approaches maturity N becomes smaller and the settlement price for

the T-Bill rises to converge with its face value.

32

Treasury Bill (T-Bill)

As in the case of other Money Market instruments, quoting a rate Example 3 – A US T-Bill $ $

may not be that useful if you need to compare rates of return from Using the same information from Example 1 calculate the MMY for

different instruments. Rates of return for instruments held to the US T-Bill which has 50 days to maturity. Discount

maturity are compared by calculating the Money Market Yield, MMY

for each instrument. T-Bill face value: $100,000

Settlement date: 9th May

The MMY for an instrument can be calculated as follows: Maturity date: 28th June

Discount rate: 8.12%

1. Calculate the profit to maturity on the instrument.

This is equal to (P – S). Year basis: 360 days

This is equal to (P – S) ÷ S

8.12/100

3. Express 2. on a percentage annual basis MMY =

Therefore: [ (

1 –

8.12 x 50

360 x 100 )]

MMY =

( P – S

S ) (x

B x 100

N ) ...Equation 3

Therefore the MMY = 8.21%

To convert this yield into a true annual yield you would need to

multiply MMY by 365/360.

Equation 3 is very similar to Equation 2 which can be used to express

MMY in terms of the Discount rate as in Equation 4.

True annual yield = 8.21 x 365

360

R/100

MMY = ...Equation 4 = 8.32%

[ (

1 –

R x N

B x 100 )]

33

Treasury Bill (T-Bill)

$ $ Although the MMY is useful for comparing short-term Money Market ■ Summary

instruments a different yield basis is used for comparisons with

Discount coupon bearing instruments which are nearing maturity.

Treasury Bill (T-Bill)

The Bond Equivalent Yield, BEY allows such a comparison to be

made and is particularly useful for comparing T-Bills with Treasury

Bonds and Notes with only a short time to maturity. ❑ Treasury Bills are short-term, negotiable, government

instruments which are issued at a discount. In the US they

BEY takes into account compounding of interest for coupon are known as T-Bills and in the UK they are commonly

payments and adjusts for a coupon period of 365 days. A complicated called Gilts.

formula is used for calculations which will not be discussed here.

However, a good approximation for US T-Bills with a maturity of 6 ❑ T-Bills are used as benchmarks for other instruments to be

months or less is given by the following equation: compared with

BEY = MMY x 365 competitively or non-competitively on a discount basis

... Equation 5

360

❑ UK Gilts are allocated by invitation to tender from the

Bank of England, mainly to Discount Houses and

In the case of UK T-Bills, as both bills and Gilts are priced on a 365 Clearing banks. The Discount Houses dominate the

basis using Equation 5 means that MMY equals BEY. secondary market by acting as intermediaries between the

Bank of England and investors.

34

Treasury Bill (T-Bill)

The following exercises using Reuters products and the Discount

RT may help your understanding of T-Bills and how they

are used.

to display the US Government Debt Speed Guide.

To see the end of the day prices for T-Bills from

GOVPX double-click in the < 0#USBILLS3PM>

field – the weekly issues for each month are listed here. You can

also obtain chains of GOVPX prices from the GPXINDEX page.

the GPXINDEX page

35

Treasury Bill (T-Bill)

$ $

Discount RT For UK T-Bills you can display the latest T-Bill

tender results by typing in BOE/MONEYOPS5 and

pressing Enter. To see the UK Government Debt

Speed Guide type in GB/GOVT1 and press Enter.

To display OTC prices for Treasury Bills double click in the

<GB/TBIL> field. Then double-click in the fields for prices – in

this case <BASD> and <3CLIVE> for Barclays Bank PLC and

Clive Discount Co Ltd respectively.

Compare T-

Bill prices

36

Treasury Bill (T-Bill)

■ End check $ $

Discount

1. You want to buy a UK T-Bill with a face value of £100,000 maturing 2. You check on the RT and find the latest price for a US T-Bill with

in 3-months (91 days). Barclays Bank is quoting 65/8% whilst Clive a face value of $100,000 with a 3-month maturity (90 days) is

Discount House is quoting 611/16% . 5.05%.

a) Which Bank would you buy the T-Bill from? a) What is the settlement rate for the bill?

37

Treasury Bill (T-Bill)

Discount ✔ or ✖ ✔ or ✖

1. a) Barclays Bank – the lowest discount rate ❑ 2. a) $98,735.50 ❑

Use Equation 1.

Settlement = 100,000 x

[ (

1– 5.05 x 90

100 x 360 )]

Settlement = 100,000 x

[ (

1– 6.625 x 91

100 x 365 )] = 100,000 x [(1 – (0.012625)]

MMY = 5.05/100

Use Equation 4.

[(1 – (0.012625)]

MMY = 6.625/100

[(1 – (0.0165171)]

c) 5.186% ❑

True annual yield = 5.115 x 365

= 0.06625

360

0.98348

How well did you score? You should have managed to get most of

these questions correct.

38

Bill of Exchange/Banker’s Acceptance (BA)

■ What is it? the bank issuing the L/C with the necessary documentation such as $ $

Bill of Lading, invoices, warehouse receipts etc the bank accepts the

A commercial Bill of Exchange, or Trade Bill, is an order draft and stamps it ACCEPTED. The resulting Banker’s Acceptance Discount

to pay a specified amount of money to the holder either means the importer’s bank will pay the full amount at the due date.

at a specified future date – Time draft – or on The actual instrument issued is simply a note specifying:

presentation – Sight draft. It is a short-term IOU in

support of a commercial transaction. ❑ The name of the accepting bank

A Banker’s Acceptance, or Banker’s Bill, is a Bill of ❑ A brief description of the underlying transaction

Exchange drawn or accepted by a commercial bank.

Once accepted the instrument becomes negotiable. The exporter can now keep the BA until maturity or if necessary sell

it in the secondary market to raise cash. The BA is now a negotiable

instrument which carries the bank’s obligation to pay.

These instruments have been used in financing international trade

for hundreds of years. A Bill of Exchange in the UK is essentially the If the exporter does sell the BA in the secondary market, then the

same as a BA in the US. These discount instruments are basically buyer pays less than the face value of the bill. In other words the bill

short-term IOUs issued to support a commercial transaction. trades at a discount which has a value determined by the difference

between purchase and face values. The buyer of the BA is effectively

Originally a Bill of Exchange was where an importer agreed to pay an lending money to the original holder and the discount is the interest.

exporter a specific sum of money at a definite future date for goods

or services. The exporter – the drawer – draws a Bill of Exchange on On maturity, the importer has to pay the accepting bank the face

the importer – the drawee. The bill can be drawn as a Sight draft value of the bill. If the importer fails to pay, then the accepting bank

which means that it must be paid immediately on presentation or it still has the obligation to pay the bearer. In consequence accepting

can be a Time draft which means payment is due a number of days banks need to be assured of the credit worthiness of the importer.

after it has been presented.

Typically the exporter sells the BA to his own bank. The bank can

Once the importer acknowledges his obligation to honour the bill he either hold the BA to maturity or re-discount it in the secondary

writes ACCEPTED across the bill which now becomes an acceptance. market.

If the acceptance is between the importer and exporter directly it is Most BAs are now issued to support international trade and are

known as a Trade Bill. If the bill is accepted by the drawer’s/drawee’s bearer instruments drawn on banks having the best credit ratings.

bank then it is known as a Bank Bill. Once a bill has been accepted BAs are drawn for various maturities and face value amounts reflects

then it must be paid at maturity. the nature of the business transaction. BAs are usually created and

traded in lots of USD 1 million or equivalent in other currencies,

In many cases a Time draft is drawn by an exporter under a Letter of although some accepting banks issue smaller lots to attract smaller

Credit, L/C from the importer’s bank. The L/C is a non-negotiable investors.

order from a bank which is required by the exporter who wishes to

have proof that he or she will be paid. Once the exporter provides

39

Bill of Exchange/Banker’s Acceptance (BA)

$ $ The following diagram summarises the processes described in issuing ■ Who uses BAs?

and trading a typical BA.

Discount Banks

Sight or Time draft In London Bills of Exchange and Banker’s Acceptances

Importer Exporter have been issued by Merchant Banks or Accepting House

▼

Drawee Drawer for centuries. In taking on the credit risk for the original

▼

Accepted/Trade Bill drawee, the bank charges a fee to guarantee payment of the bill’s face

▲ value at maturity. The more credit worthy the accepting bank, the

easier it is to sell the bills in the secondary market.

BA sold

L/C The accepting bank’s fee is derived from the difference between the

at

Accepting Bank discount rate the bank buys the original bill from its customer and

Bill of Lading discount

the lower re-discount rate at which it sells the accepted bill in the

▼ ▼

Accepted/Bank Bill secondary market.

▲

The majority of BAs in the US are created by international

BA re-discounted ▼ subsidiaries of money-centre banks. Originally the US market

Secondary market developed to finance US import and export markets – in much the

Investors same way as Bills of Exchange had developed in the UK. However,

many BAs now issued in the US finance trade in which neither

importer nor exporter are US organisations.

Eligible BAs

On this Bill of Exchange of 1898 you

The type of BA described so far is one created for a commercial

can see that it has been Accepted

transaction involving the supply of goods or services and which is

usually supported by a Letter of Credit. However, BAs are also issued

on the basis of less formal contractual agreements as a means of

satisfying credit demand which avoids Central Bank rules and

penalties.

During the 1960s and 1970s Central Banks in both the US and the

UK attempted to control the growth of money supply through bank

credit rationing rather than by raising interest rates. If banks

exceeded their domestic lending targets, then they were penalised by

their Central Bank.

This photograph is reproduced by kind permission

of the Archives Department, Midland Bank plc

40

Bill of Exchange/Banker’s Acceptance (BA)

To overcome these difficulties banks developed the following tactics: ■ BAs in the market place $ $

❑ Lending was channelled through the Eurocurrency markets Within the discount markets, instruments have two values Discount

which were not subject to the same Central Bank rules and 7 8 9 which you need to understand:

4 5 6

regulations 1 2 3

0

❑ Present value (PV) – the settlement amount payable

❑ Working Capital BAs or Finance Bills were created which today

were then sold in the secondary markets. Finance Bills are a

major source of working capital for organisations which ❑ Future value (FV) – the redemption amount

lack the credit rating to issue a Commercial Paper. payable on maturity

The result was that both the Bank of England and the Fed made The settlement amount payable on a discount instrument is

these bills ineligible for re-discount at the Central Bank and they calculated using Equation 1.

made the sale of such bills subject to reserve requirements.

Settlement amount

[ (

= P x 1 – R x N

B x 100 )] ...Equation 1

In broad terms an eligible bill is an acceptance which has been Where P = Redemption value, FV

created to fund specific types of short-term – usually up to 6 months – R = Discount rate as a decimal

commercial transactions. N = Number of days to maturity

B = Year basis – 365 or 360

Eligible BAs issued in the US tend to track T-Bill rates quite closely.

The distinction between eligible and ineligible BAs is therefore

important and it is normal to see quotes only for eligible BAs.

41

Bill of Exchange/Banker’s Acceptance (BA)

$ $ Example 1 Example 2

You are a Corporate Treasurer who needs to borrow £500,000 for the What would be the settlement amount for the following BA issued by

Discount next 182 days. Your bank offers you the following BA. If you took this Barclays Bank Plc.

BA what would be the redemption value or cost of the instrument at

maturity? Underlying trade: Beet export

Face value: £200,000

Settlement value: £500,000

Days to maturity: 142

Issue date: 5th January

Quoted rate: 6.5% pa

Maturity date: 5th July

Year basis: 365 days

Rate: 615/16% pa

Year basis: 365 days

Using Equation 1:

Using Equation 1:

500,000 = P x 1 –

[ ( 6.9375 x 180

365 x 100 )] Settlement amount

[ (

= 200,000 x 1 –

6.5 x 142

365 x 100 )]

Therefore the redemption or face value, P

Settlement amount = 200,000 x (1 – .02529)

P = 500,000

= £194,942. 46

[ (

1 –

6.9375 x 180

365 x 100 )]

In this case you would expect to pay £194,942.46 if you purchased this

BA with 142 days remaining to maturity. At maturity you would

= 500,000 receive £200,000. The difference between the two values is the

(1 – 0.03421) discount – the amount you receive to lend your money.

= £517,705.52

42

Bill of Exchange/Banker’s Acceptance (BA)

Discount

Bill of Exchange/Banker’s Acceptance (BA)

transaction which is issued at a discount. Once a Bill of

Exchange is accepted there is an obligation by the

accepting party to honour the instrument.

Exchange drawn or accepted by a commercial bank which

is a negotiable instrument

to buy and sell which does not incur a reserve

requirement

43

Bill of Exchange/Banker’s Acceptance (BA)

RT may help your understanding of BAs and how they are

used.

Enter. If you double-click in the <GB/TBIL> field

you will see OTC Prices from contributors for T-Bills

and Eligible Bills. Double-click in the fields for

prices – in this case <ALEX> and <GNDB> for Alexanders

Discount PLC and Gerrard and King Ltd respectively.

Compare T-

Bill prices

44

Bill of Exchange/Banker’s Acceptance (BA)

$ $

3000 US Domestic BA rates from Garvin Guy Butler can Discount

be displayed from the MMDI page for USD.

45

Bill of Exchange/Banker’s Acceptance (BA)

$ $ Your notes

you double-click in the <NYAS> field you will see

Reuters prices for BAs from primary dealers.

46

Commercial Paper (CP)

A Commercial Paper is a short-term unsecured, Corporations and banks Discount

promissory note issued for a specified amount and The Commercial Paper originated in the US in the

maturing on a specified date. It is a negotiable nineteenth century as a way of allowing large

instrument typically issued in bearer form. corporations to access capital across the country. At this

time most US commercial banks were restricted to lending

A CP is an unsecured bearer form, fixed maturity, promissory note operations in the State in which they were located. Banks sponsoring

issued on a discount basis by large corporations with good credit CP issues could thus earn issue fees from corporations without having

ratings. to lend funds.

They are used as an alternative to bank loans where the issuer CPs do not pay interest but are discount instruments issued to raise

promises to pay the buyer a fixed sum at a future date but without working capital. The CP to a corporation is what a Certificate of

being backed by assets. Large corporations often borrow large sums Deposit (CD) is to a bank. Although many large corporations issue

for capital investment using debt instruments and then ‘park’ the CPs, many banks now use short-term CPs to raise money which is

money temporarily in the CP market. used to swap USD into a LIBOR funding basis in other currencies.

Most CPs issued by banks have maturities of 30 days or less so that

Maturities range from a few days to 270 days – the usual period is 30 they do not compete with the CD market.

days. The rates offered are typically higher than for T-Bills of the

same maturity. Issuers of CPs tend to ‘roll-over’ the paper on maturity. This means

they sell a new CP to obtain funds to redeem the maturing paper.

A CP is a bearer instrument and because it is unsecured only the However, there is a risk that the new CP issue will not take place on

credit rating of the borrower is available as security. A CP does not the required day. To avoid this risk most CP issues are backed by a

pay interest and is issued on a discount basis. line of credit from a bank.

Investors

In general the CP market is a wholesale market for large institutional

investors although some large US issuers make some provision for

smaller investors.

A secondary market exists in CPs but most are sold to investors who

hold them to maturity. Dealers will buy back CPs they handle but only

after adding a wide spread to ensure a profit. CPs are not therefore as

liquid as T-Bills and CDs.

47

Commercial Paper (CP)

$ $ The yield differential between A1/P1 and A2/P2 rated CPs can be as ■ CPs in the market place

high as 200 points and as low as 15 points depending on the name of

Discount the issuer and the availability of credit. Within the discount markets, instruments have two values

7 8 9 which you need to understand:

4 5 6

Yields on CPs are usually slightly higher than those on T-Bills which 1 2 3

❑ Present value (PV) – the settlement amount payable

instrument. today

Euro Commercial Paper, Euro CP or ECP ❑ Future value (FV) – the redemption amount

Alcoa, the US corporation, issued the first Euro CP in 1970 at a time payable on maturity

when US corporations were seeking USD funding outside the US.

The settlement amount payable on a discount instrument is

A Euro CP is a commercial paper issued on a Eurocurrency basis. calculated using Equation 1.

This means the regulatory conditions which apply to normal CPs

in their country of issue do not apply to ECPs which are issued

outside the country in which the corporation or bank is located.

Settlement amount , S = P x 1 –

[ ( R x N

B x 100 )] ...Equation 1

Euro CPs are similar in most respect to CPs in that they are usually

issued in bearer form with maturities ranging from 30-270 days.

Where P = Redemption value, FV

However, the main difference between the instruments is as follows:

R = Discount rate as a decimal

N = Number of days to maturity

❑ CPs are quoted on a discount to par or face value basis

B = Year basis – 365 or 360

❑ Euro CPs are quoted on a discount to yield basis. This

means that the quoted rate is the same as the Money By rearranging Equation 1 the Discount rate can be calculated using

Market Yield, MMY Equation 2.

Euro CPs face stiff competition from CPs and the Eurocurrency

deposit and lending markets which tend to be used for short-term

corporate financing. R% =

( P – S

P ) (

x

B x 100

N ) ...Equation 2

48

Commercial Paper (CP)

may not be that useful if you need to compare rates of return from Calculate the settlement amount and the MMY for the following US

different instruments. Rates of return for instruments held to CP issued by Motorola Finance. The quoted rate is on a discount to Discount

maturity are compared by calculating the Money Market Yield, MMY par basis for a normal CP.

for each instrument.

CP face value: $100,000

The MMY for an instrument can be calculated as follows:

Settlement date: 1st April

1. Calculate the profit to maturity on the instrument. Maturity date: 1st May

This is equal to (P – S). Discount rate: 8.83%

Year basis: 360 days

2. Express 1. as a proportion of the amount invested.

This is equal to (P – S) ÷ S

Using Equation 1:

3. Express 2. on a percentage annual basis

Therefore: [ (

S = 100,000 x 1 –

8.83 x 30

360 x 100 )]

MMY =

( P – S

S ) (x

B x 100

N ) ...Equation 3 Therefore the settlement value = $99,264.17

Using Equation 4:

Equation 3 is very similar to Equation 2 which can be used to express

MMY in terms of the Discount rate as in Equation 4. 8.83/100

MMY =

R/100

[ (

1 –

8.83 x 30

360 x 100 )]

MMY = ...Equation 4

[ (

1 –

R x N

B x 100 )] Therefore the MMY = 8.8955%

49

Commercial Paper (CP)

Calculate the settlement amount and the MMY for the following Euro

100,000

Discount CP issued by Eurotunnel. The quoted rate is on a discount to yield Settlement value, S =

basis for a Euro CP. In this case the settlement value is calculated

using an equation similar to that used for CDs. [ (

1 +

7.12 x 31

360 x 100 )]

CP face value: $100,000 Therefore the settlement value = $99,390.63

Settlement date: 1st December

Maturity date: 1st January In the case of a Euro CP the MMY is the same as the Discount rate so

Discount rate: 7.12% no calculation is involved!

Year basis: 360 days

[ ( )]

Settlement value, S = P x 1 +

R x N

B x 100 ...Equation 5

[ ( )]

1 +

r x n

B x 100

R = Quoted coupon rate which is zero for a CP

N = Number of days to maturity

B = Year basis – 365 or 360

r = Current discount rate

n = Current number of days to maturity

Settlement value, S = P ...Equation 6

[ (

1 +

r x n

B x 100 )]

50

Commercial Paper (CP)

Discount

Commercial Paper (CP)

promissory note issued at a discount by organisations with

good credit ratings

Eurocurrency basis which avoids normal regulatory

conditions which may apply to Domestic CPs

Euro CP is quoted on a Money Market Yield basis

51

Commercial Paper (CP)

You are considering buying an A1P1 US CP and you view the GGB

Discount The following exercises using Reuters products and the prices on Money 3000. You are considering a CP with a 60 day

RT may help your understanding of CPs and how they are maturity period and face value of $1,000,000. The prices on screen

used. are as follows:

3000 To see prices for US CPs use the MMDI page for

USD. Select COMM PAPER to view prices from

Garvin Guy Butler. You can also select the rating of

the CP you require by selecting A1P1, A1P2 or

A2P2. Why not select all three and compare the rates?

rate or price be?

b) Calculate the Money Market Yield and the true annual yield for

Remember these the CP.

are discount

prices not the

yields

52

Commercial Paper (CP)

$ $

RT To see prices for US CPs for the primary market Discount

type in US/MMKT and then double-click in the

field < CPAPERA>. This page displays BAs for large

US organisations for 5 – 240 days. You can also

double-click in the <RMFA> field to see a Reuters overview of US

CP, CD and BA rates.

observe – type in BOE/ECP and press Enter.

53

Commercial Paper (CP)

Discount ✔ or ✖

a) $990,650.00 or price 99.065 ❑

Use Equation 1.

Settlement =

[ (

100,000 x 1 –

5.61 x 60

360 x 100 )]

= 100,000 x [(1 – (0.0093500)]

True annual yield = 5.7416% ❑

Use Equation 4.

MMY = 5.61/100

[(1 – (0.009350)]

360

Need you have calculated these values? The answer, as you might

expect is no – Money 3000 displays all these values in the

Instrument details fields.

MMY

depending on face value

How well did you score? You should have managed to get most of

these questions correct.

54

Forward Rate Agreement (FRA)

If a FRA is bought at an agreed rate of 5.00%, but at the start of the

A Forward Rate Agreement is a contract between two agreement LIBOR has been fixed at 6.00%, then cash must be Derivative

parties which fixes the rate of interest that will apply to a borrowed at the higher rate of 6.00%. The buyer receives a cash

notional future loan or deposit for which the following settlement of 1.00% on the notional principal amount to compensate

have been agreed: for the increased borrowing costs.

❑ The amount and its currency The seller of a FRA will be paid in cash by the buyer for any fall in

❑ A future date for the loan/deposit to be drawn/ the reference interest rate, below the agreed contract rate. Depositors

placed wishing to hedge against any future falls in interest rates therefore

❑ The term sell FRAs

from Money Market deposit rates. The instrument is similar to an If a FRA is sold at an agreed rate of 10.00%, but at the start of the

Interest Rate futures contract but involves no margin payments. FRAs agreement LIBOR has been fixed at only 8.00%, then cash is

have developed since 1983 and are the most widely used of the OTC deposited at the lower rate of 8.00%. The seller receives a cash

Money Market derivatives. They are used by market players to lock in settlement of 2.00% on the notional principal amount to compensate

short-term borrowing and lending rates. for the reduced income.

,,

Example

,,

A Corporate Treasurer has a forward borrowing requirement in 3

months time for a 3-month loan, but he believes that interest rates If interest rates rise

,,

will have risen by the time he requires the loan. To hedge the

▼

possibility of future borrowing costs the Treasurer buys a FRA for the

forward period. At the start of the FRA, interest rates have risen and

the Treasurer has to borrow in the cash markets at a higher rate.

▼

However, the Treasurer receives cash compensation from the

If interest rates fall

settlement of the FRA for the difference between LIBOR and the

FRA agreed rate. The Treasurer has in effect locked-in the cost of the

forward borrowing at the FRA rate. Buyer Seller

The buyer of a FRA will be paid in cash by the seller for any rise in It is important to remember that a FRA is an agreement to fix a

the reference interest rate, over and above the agreed contract rate. forward rate – there is no obligation to borrow or lend the notional

Borrowers wishing to hedge against rises in future borrowing costs principal amount involved.

therefore buy FRAs.

55

Forward Rate Agreement (FRA)

FRAs have a number of features which market players need to assess There are a number of terms you need to know if you are to

Derivative before they decide on using the instrument. These features include understand how FRAs work and are used. The table below indicates

the following: the terms and their meanings.

❑ Cash settlement. As the loan/deposit is for notional funds Term Which means...

there is no exchange of principal. Cash compensation is

paid at the beginning of the notional loan/deposit period. Contract currency and amount The currency and amount of the

notional loan/deposit

❑ Flexibility. As the loan/deposit is for notional funds there is

no obligation by buyers/sellers in the markets to actually Trade date The date the deal is actually

lend or deposit their funds. Market players can use other made

instruments which offer the best returns for their specific

needs. Fixing date This is two business days before

the start of the FRA. It is the date

❑ Lock-in rate. Like Forward FX contracts, if future interest when the LIBOR, or other,

rates fall the buyer will have to compensate the seller and reference rate is fixed. The

forego any benefit from lower interest rates. Equally, if settlement amount is calculated

interest rates rise the seller has to compensate the buyer. using this rate.

FRAs effectively lock-in future interest rates for market

players. For domestic currency FRAs the

fixing date is usually the same as

❑ Low credit risk. As there is no exchange of principal a FRA the settlement date.

is an off-balance sheet instrument. The credit risk is low

because the main risk is concerned with finding a

replacement counterparty should the original party default. Settlement date This is the date when the

The risk involved is therefore on the settlement amount contract period starts and cash

rather than the notional amount. compensation is paid

❑ Cancellation and assignment. A FRA is a binding contract Maturity date The date the contract ends

and cannot be cancelled or assigned to a third party

without the agreement of both counterparties. As with Contract period This is the term of the notional

other instruments with binding contracts, FRA positions loan/deposit – the period from

can be closed using off-setting contracts. settlement to maturity in days

for the contract period – the

price of the FRA in % per annum

56

Forward Rate Agreement (FRA)

The events of the following 3 month FRA are summarised here: Before moving on use Money 3000 to have a look at BBALIBOR ... $ $

3 month FRA Use the Benchmark Watch page, MMBW for GBP Derivative

3000 and select BBALIBOR from the drop down menu.

Contract LIBOR Contract Contract

agreed rate fixed starts ends You can also use page FRASETT on the RT to see a

10th April 12th June 16th June 15th Sept list of all the fixings.

Trade Fixing Settlement Maturity

You should see pages similar to those shown here.

▼

Contract period – 92 days

Rules

1. The start and end dates are calculated from spot dates.

2. The fixing date is 2 days before the start date.

• Spot is therefore two business days later – 14th April

• The start date of the FRA is two business days from the forward

date – 16th June

• The fixing date is two business days before the start date – 12th

June

• The maturity date is 3 months from 16th June – 15th

September

contract terms and conditions – referred to as FRABBA terms. This

means that most banks deal automatically on FRABBA terms unless

otherwise stated. FRA fixing rates are based on LIBOR which are

available daily to the markets. The fixings are made at 11.00 am

London time and are calculated as an average of 16 banks quoting

LIBOR in the London market.

57

Forward Rate Agreement (FRA)

$ $ Market pricing of FRAs In most financial centres market-makers quote the bid price first

The FRA is quoted as a two-way price with bid/offer prices in the whereas in London it is the offered rate which is quoted first – the

Derivative same way as for Money Market deposit rates. FRA market-makers take rate at which they sell. Either way the market-taker always pays the

on large trades because the credit risk is low as there is no notional higher rate!

exchange of principal. This means that the bid/offer spreads

available are tighter compared with cash deposit rates – typically 3 – 5 New York London

basis points for Eurodollar FRAs. These tighter spreads are available

only for standard minimum deal sizes of USD 5 million or equivalent.

Prices quoted are for standard or fixed dates. The table below gives

examples of the conventions for 3- and 6-month series of FRAs:

Bid/Offer Offer/Bid

Starts Ends Starts Ends

forward forward forward forward

Under the FRABBA system Eurocurrency FRAs involving currencies

1 x 4 1 month 4 months 1 x 7 1 month 7 months not linked to LIBOR cannot be traded. However, provided there are

underlying cash Money Market prices, ‘exotic’ FRAs can be priced

2 x 5 2 months 5 months 2 x 8 2 months 8 months and settled against mutually pre-determined reference rates.

3 x 6 3 months 6months 3 x 9 3 months 9 months

1 x 4 FRA

Contract period

Contract Start – 3 months End

▼

agreements. Broken dates are available but the dealing spread may be

wider. Some FRA market-makers are prepared to quote shorter dates

than 1 month.

58

Forward Rate Agreement (FRA)

How are FRA prices determined? The Zero coupon yield curve, also known as the Spot curve, is a $ $

In most cases today, FRA prices are derived from short-term Interest graphical representation of the theoretical Yield To Maturity (YTM)

Rate futures contracts for the same currency. For example, estimate of the yield which should be paid on non-coupon bearing Derivative

Deutschemark FRAs are typically priced off the EuroDeutschemark instruments of different maturities, given the yields currently

future contracts traded on LIFFE or MATIF. It is for this reason the available for coupon bearing instruments.

FRA market has been referred to as the new Interbank Future

Interest Rate market. Because of the close relationship between FRAs Before moving on use Money 3000 to have a FRA analysis page...

and the futures market, FRAs are often quoted for the same periods

as are traded on Futures Exchanges. Use the Analysis page, FRA for GBP and select

3000 Deposits-MID, Futures curve and Zero curve from

There are a number of ways FRA prices can be calculated including the drop down menus for the same FRAs in the TV

those derived from: fields. You can now compare the rates derived from

the different methods.

❑ Cash deposits

For example, to price a 3 x 6 FRA the 3-month and 6-month

deposit rates are used.

▼

months. However, longer date FRAs are available, for example, 18 x

24. Typically these instruments are priced using the Zero coupon

yield curve.

coupons regularly to maturity. Therefore their actual yields depend

on the reinvestment rates that can be achieved on the earned

interest. A Zero coupon instrument is one that pays no coupon but is

issued at a deep discount. The difference between the issue and

redemption prices compensates for any such reinvestment of

potential interest payments.

59

Forward Rate Agreement (FRA)

As Interest Rate futures contracts could easily be used in place of

Derivative FRAs, it is useful to compare the following aspects of the instruments:

Trading It is an OTC contract between counterparties. In some Contracts are traded in pits or electronically on an

cases the deal may be made via a broker. Exchange.

Contract terms Amount, period and settlement procedures are Amounts, expiry dates and settlement periods are fixed

negotiated between the counterparties. and standardised by the Exchange.

Confidentiality There are no obligations placed on the counterparties Deals are transacted open out cry or using electronic

to divulge the terms of the contract. Different market- systems. Orders and trades are immediately visible and

makers may well quote different bid/offer prices. transparent to all market players. On an exchange there

is only one market price at any one time.

Margin payments No margin payments are required. Usually Initial margin is paid as a % of the trade amount –

compensation payments are made on the settlement marked-to-market. The margin payments are held by

date. the Clearing House. Variation margin is also paid to the

Clearing House on a daily basis depending on the

market price movement.

Credit risk Each side is taking a risk on the counterparty, so each After a trade is made on the Exchange, the Clearing

side accepts a small credit risk. House stands as the counterparty, acting as seller to

every buyer and vice versa. The Clearing House

guarantees the performance of contracts and so there is

no credit risk to the contract parties.

Right of offset A FRA contract is binding and cannot be cancelled or Futures contracts can be off-set.

assigned to a third party without the agreement of both

sides.

60

Forward Rate Agreement (FRA)

The ways FRAs and futures contracts can be used to hedge a rise/fall ■ Who uses FRAs? $ $

in interest rates is summarised in the chart below:

Banks Derivative

To hedge rise in interest Within banks, Money Market desks are regular users of

To hedge fall in interest

rates FRAs. The larger US, UK, European and Australian banks

rates

are active market-makers and use FRAs for a number of

Futures Sell contract reasons including the following:

Buy contract

Loss

rate rises

❑ Matching client FRA positions

Interest Profit Loss

rate falls ❑ Arbitrage opportunities against futures contracts

Sell FRA

Loss

rate rises – forward gaps

Interest Loss Banks make a profit from the bid/offer FRA price spread.

Profit

rate falls

Corporations and non-bank financial institutions

These organisations also use FRAs to manage interest rate risk. The

credit risk to the market-maker is small as it only involves risk to the

potential settlement involved. No premium is paid by clients for FRAs

– the only costs they incur are those for any compensation payments.

movements. As FRAs are binding contracts, if a FRA needs to be

closed out for any reason, this is done by arranging a new FRA which

is opposite to the original instrument.

61

Forward Rate Agreement (FRA)

There are two types of risk to be considered when using FRAs:

Derivative FRA settlement payments

❑ Basis risk. This arises if the instrument being hedged is not 7 8 9 The settlement rate is usually determined two business days

4 5 6

linked to LIBOR, for example, a US CP. In this case the risk 1 2 3 before the period of the notional loan/deposit for the

0

exists because the rate setting process for the underlying specified reference rate, LIBOR. It is important to note that

instrument is independent of the rate setting for the FRA. the settlement payment is made at the beginning of the loan

period rather than at maturity – the usual procedure for Money

❑ Funding risk. This is related to the creditworthiness of the Market deposits. Therefore the settlement payment has to be

parties involved. Can both sides meet any compensation discounted to its present value at the current market interest rate.

payments due on the settlement date?

You will need to know two equations in order to calculate settlement

There are also risks involved from both the bank’s and the client’s payments – both equations are very similar. One caters for the

points of view. If a bank sells a FRA and interest rates rise situation where the settlement rate is greater than the contract rate so

subsequently, then the bank will suffer a loss and have to pay the the FRA seller compensates the buyer. The other equation is for the

client compensation. The risk clients take is that the FRA locks-in a opposite situation where the settlement rate is less than the contract

future interest rate. If interest rates move in favour of the clients then rate so the FRA buyer compensates the seller.

they cannot benefit, if they move against them then they compensate

the bank.

Settlement rate greater than contract rate

(L – R) x D x A ...Equation 1a

Settlement payment =

(B x 100) + (L x D)

(R – L) x D x A ...Equation 1b

Settlement payment =

(B x 100) + (L x D)

R = Contract rate as a number not %

B = Day basis – 360 or 365

D = Contract period in days

A = Contract amount

62

Forward Rate Agreement (FRA)

Example 1 In either case the XYZ loan will be based on the current LIBOR. The $ $

It is the 10th April 1997 and the XYZ Corporate Treasurer foresees a FRA payment acts as a subsidy bringing down the net cost of

forward funding requirement for 3 months (92 days) from 16th June borrowing. Derivative

to 15th September 1997. The Treasurer thinks that there is a possible

rise in interest rates and therefore wants to hedge against any interest But what would have happened if the Treasurer’s fears of an interest

rate rise. The Treasurer buys a 2 x 5 FRA on the 10th April from rate rise were unfounded and on fixing LIBOR was 6.50%? This time

OkiBank with the following terms: XYZ have to compensate OkiBank. The settlement amount can be

calculated using Equation 1b.

FRA contract amt. $10,000,000

Fixing date: 12th June 1997 (6.75 – 6.50) x 92 x 10,000,000

Settlement payment =

Settlement date: 16th June 1997 (360 x 100) + (6.50 x 92)

Maturity date: 15th Sept. 1997

230,000,000

Contract rate: 6.75% pa =

36598

Year basis: 360 days

= $6,284.50

What is the settlement due if the BBALIBOR 3-month fixing rate is

7.25% the 10th June fixing date, and who receives payment?

Even though XYZ have bought a FRA contract they still have to raise

the funds they require for 16th June to 15th September in the Money

Markets at the increased rate of 7.25%. However, as the interest rates

have risen, OkiBank have to compensate XYZ a cash sum. The

settlement amount is therefore calculated using Equation 1a.

Settlement payment =

(360 x 100) + (7.25 x 92)

460,000,000

=

36667

= $12,545.34

At this point the FRA contract ceases to exist and the XYZ Corporate

Treasurer can now either reinvest the FRA settlement payment in the

Money Markets or arrange a loan for $10,000,000 – 12,545.34.

63

Forward Rate Agreement (FRA)

It is possible to calculate forward/forward rates from deposit rates If a dealer wants to buy a 3 x 6 FRA, then he thinks that interest rates

Derivative using the following equation: will rise in the period from 3 to 6 months forward. The 3 x 6 FRA can

be considered to be the result of lending for 3 months and borrowing

for 6 as shown in the diagram below.

(RL x DL) – (RS x DS)

RFWD =

(DL – DS) x

[ (

1 + RS x DS

)] Lend

Fwd/fwd ASK

▼

Spot 3 months 6 months

B x 100

RS = Rate from spot to the near date – short period

DL = Number of days from spot to far date

▼

DS = Number of days from spot to near date Borrow

B = Day basis This means that the Forward/forward Ask rate is calculated in

...Equation 2 Equation 2 using:

Forward/forward bid rate RS = Near deposit Bid

If a dealer wants to sell a 3 x 6 FRA, then he thinks that interest rates

will fall in the period from 3 to 6 months forward. The 3 x 6 FRA can

be considered to be the result of borrowing for 3 months and lending

for 6 as shown in the diagram below.

Fwd/fwd BID

Borrow

▼

▼

Lend

This means that the Forward/forward Bid rate is calculated in

Equation 2 using:

RS = Near deposit Ask

64

Forward Rate Agreement (FRA)

In many cases FRA strips of contracts are used to hedge against If you need to calculate the effective annual interest rate for a strip of $ $

longer term interest rate rises. A strip is simply a number of FRAs the following equation can be used which is based on Equation 3.

consecutive contracts. For example, a strip of four FRA contracts, Derivative

1 x 3, 3 x 6, 6 x 9, 9 x 12 could be used to hedge for a 12 month Effective annual rate, R =

period. However, if a strip of FRAs are used what is the effective rate

over the whole period as different contract rates are used for each

FRA? [[1+

( )] [ ( )] [ ( )] [ ( )]]

L0 x 3

4

x 1+

F3 x 6

4

x 1+

F6 x 9

4

x 1+

F9 x 12

4

–1

Suppose the following strip of two FRAs spans the two period 0 to n

and 0 to N. The rate of return for the time period n to N can be L0 x 3 = Current LIBOR or reference rate

calculated using an equation based on the interest rates due for the

F3 x 6, F6 x 9, F9 x 12 = FRA rates for periods 3 x 6, 6 x 9

time periods.

and 9 x 12 respectively

Rate = Rate = Rate = ...Equation 4

r RN - n RN

FRA1 FRA2

▼

period period period XYZ Corporation now needs to protect interest rates for a six month

0 n N

period beginning in 6 months time – a 6 x 12 forward position. The

XYZ Corporate Treasurer could use a 6 x 12 FRA. However, a strip of

two 3-month FRAs, 6 x 9 and 9 x 12, offers the Treasurer the

Interest due for

time period, N

= ( Interest due for

time period, n )(

x

Interest due for

time period, N – n ) flexibility of reversing the hedge at the 9 month period if necessary.

The strip also provides a market limit for a 6 x 12 FRA quote.

Therefore: XYZ need to borrow $5,000,000 in 6 months time for a loan period of

6 months, but the Treasurer thinks interest rates will rise in this time.

[ (

1+

RN x N

B x 100 )] [ (

= 1+

r x n

B x 100 )] [ (

x 1+ RN - n x N – n

B x 100 )] The Treasurer investigates quotes from a number of banks offering

FRAs indexed on a 3-month LIBOR basis.

RN - n =

[ ( 1+

RN x N

B x 100 )] – 1 x 360 x 100 6 x 9 (91d) 6.21 – 6.15 6.23 – 6.18

[ ( 1+

r x n

B x 100 )] N

...Equation 3

9 x 12 (92d) 6.28 – 6.22 6.30 – 6.25

65

Forward Rate Agreement (FRA)

$ $ The Treasurer accepts the bid FRA prices from Bank A as the ■ Summary

cheaper and buys a strip of two FRAs – 6 x 9 plus 9 x 12. This

Derivative effectively locks in the interest rates for the 6-month borrowing

period.

Forward Rate Agreement (FRA)

6 x 12 month exposure of $5,000,000

▼

❑ FRAs are OTC contracts used to hedge interest rate risk

Buy @ Buy @ Rate = based on a notional future loan or deposit

6.21% 6.28% ?

FRA 6 x 9 FRA 9 x 12 notional loan or deposit period

Time Time Time ❑ Rises and falls in future Money Market interest rates are

period period period

6 mths 9 mths 12 mths compensated by payments/receipts at the settlement date

What is the effective FRA rate?

▼

❑ FRA contracts involve no transfer of principal. The only

The effective FRA rate for the strip is calculated using Equation 3. cash payments made are those associated with settlement

payments

[ (

1+

R6 x 12 x N

B x 100 )] [ (

= 1+

R6 x 9 x n

B x 100 )] [ (

x 1+ R9 x 12 x N – n

B x 100 )] ❑ Most FRA contracts use LIBOR as the reference rate

[ (

= 1+

6.21 x 91

360 x 100)] [ (x 1+ 6.28 x 92

360 x 100 )] (Start month forward) x (End month forward). For

example, 6 x 12 means the contract starts in 6 months

time and ends in 12 months, therefore lasting 12 months

= 1.0157 x 1.01605

= 1.03200

183

66

Forward Rate Agreement (FRA)

The following exercises using Reuters products and the Derivative

RT may help your understanding of FRAs and how they

are used.

type in FRA/1 and press Enter. To display the Major

Currency FRAs double-click in the <TOPFRA>

field.

67

Forward Rate Agreement (FRA)

$ $ From the 3-month and 6-month Bid and Ask deposit rates shown

3000 Exercise. Using the FRMW page in Money 3000 can opposite calculate the forward/forward Bid and Ask rates. Assume 3-

Derivative be useful as you can display Bid and Ask prices for a months is 90 days and 6-months is 180 days.

number of currencies from different contributors

simultaneously. For example, you decide to look at a) Forward/forward Bid rate

3 x 6 rates for DEM FRAs from 3 different contributors in order

to select the best rates for you for buying and selling. You look at

the rates and decide that those from HBEL are best. You now

decide to check these rates and calculate the forward/forward

bid and ask prices from deposit rates you display in the MMMW

page.

68

Forward Rate Agreement (FRA)

■ End check 5. Bank A sells Bank B a 3 x 6 USD FRA at a contract rate of 5.86%. $ $

On the settlement the LIBOR 3-month fixing rate is 5.75%. The

FRA contract details are as follows: Derivative

1. If you as a customer buy a FRA you are:

FRA contract amt.: $50,000,000

❑ a) Protecting against a rise in interest rates Contract period: 90 days

❑ b) Protecting against a fall in interest rates Contract rate: 5.86% pa

❑ c) Taking a cash delivery of principal from the counterparty

Year basis: 360 days

❑ d) Making a cash delivery of principal to the counterparty

a) What is the cash settlement amount involved?

2. Today is the fixing date for a 1x4 FRA which you sold for 5.67%. b) Who receives payment?

LIBOR has been fixed at 6.00%. Which of the following

statements is true? Answer a)

❑ a) You pay the counterparty

❑ b) The counterparty pays you

❑ c) No payment takes place until later

may prefer to use FRAs rather than Interest Rate futures contracts

to hedge?

❑ b) FRA prices are less volatile

❑ c) FRAs are priced more competitively

❑ d) FRAs are OTC and can be tailored Answer b)

❑ b) Prices quoted for exchange traded Interest Rate futures

❑ c) Values derived from existing deposit rates

❑ d) None of the above

69

Forward Rate Agreement (FRA)

Derivative Exercise ✔ or ✖

a) Forward/forward bid rate = 2.976% 1. a) ❑

Use Equation 2 – for Bid use Far depo Bid and Near depo Ask

(3.0625 x 180) – (3.125 x 90) 2. a) ❑

Interest =

(180 – 90) x

270.00

[ (

1 + 3.125 x 90

360 x 100 )] 3. d)

4. c)

❑

=

90.703125

5. a) $13,555.14 ❑

b) Forward/forward bid rate = 3.349%

Use Equation 2 – for Ask use Far depo Ask and Near depo Bid Use Equation 1b.

(5.86 – 5.75) x 90 x 50,000,000

Settlement =

Interest (360 x 100) + (5.75 x 90)

(3.1875 x 180) – (3.00 x 90)

=

0.11 x 90 x 50,000,000

(180 – 90) x

303.75

[ (

1 + 3.00 x 90

360 x 100 )] =

36000 + (517.5)

=

90.6750 b) Bank B pays Bank A ❑

By inputting the correct details in the FRA you require you can

check your calculations using the Model FRM page.

How well did you score? You should have managed to get most of

these questions correct.

Bid = 2.9762

Ask = 3.3493

70

Interest Rate futures

■ What are they? particular currency deposited outside the country of origin. For $ $

example, a 3-month Eurodollar Interest Rate future is settled based

Interest Rate futures are forward transactions with on US Dollars deposited outside the US. Derivative

standard contract sizes and maturity dates which are

traded on a formal exchange. An exchange traded futures contract has the following characteristics:

Short-term Interest Rate futures contracts are almost ❑ A standardised specification in terms of unit of trading,

exclusively based on Eurocurrency deposits and are cash trading cycle of contract months, delivery days, quotation,

settled based on an Exchange Delivery Settlement Price minimum price movement etc

(EDSP) or the last price traded.

❑ The opportunity to trade the instrument and offset the

Long-term Interest Rate futures contracts are settled original contract with an equal and opposite trade. Very few

based on government bonds or notes with a coupon and contracts, less than 2%, reach maturity

maturity period specified by the exchange.

❑ A public market in that prices for contracts are freely

If you need an overview of futures derivatives or you need available. Trading takes place open outcry on an exchange

to remind yourself about derivatives in general, then you Derivatives floor and prices are published on exchange indicator

may find it useful to refer to the Introduction to Derivatives Section 2 boards, in the financial press and by providers such as

workbook, Section 2 at this stage. Reuters.

Interest Rate futures are some of the most common futures contracts ❑ Once a trade has been made a Clearing house acts as the

traded on exchanges. Their growth stems from the mid 1970s after counterparty to both sides of the trade. The contract is not

the breakdown of the Bretton Woods Agreement in 1973. The directly between buyer and seller. The Clearing house takes

resulting floating exchange rates in currencies created much more on the credit risk should a counterparty default. This is

volatility in interest rates and the subsequent need to hedge important because it means anyone can have access to the

investments. markets provided they have the required creditworthiness

by the Clearing house – in this way large organisations have

The Chicago Board of Trade (CBOT) introduced the first futures no advantage over smaller organisations or investors.

,,

contracts to hedge interest rate exposure in 1975 when it introduced

,,

contracts on the US Government National Mortgage Association

certificates – known as Ginnie Maes. These contracts are no longer

,,

traded but by 1977 CBOT has added contracts on T-Bonds and in

▼

1982 LIFFE started trading futures contracts on 3 month Sterling

time deposits.

▼

▼

Interest Rate futures are essentially forward contracts in underlying

fixed coupon instruments such as bank deposits and government Clearing house

bonds, notes and bills. Short-term Interest Rate futures based on

Eurocurrencies are cash settled based on interest rates for the Buyer Seller

71

Interest Rate futures

$ $ Exchange contracts

Short and long-term Interest Rate futures contracts are traded on

Derivative exchanges worldwide. Some of the more important contracts are

summarised in the charts below.

LIFFE CME

Short-term Cash settled based on LIBOR Unit of trading Short-term Cash settled based on interbank rates Unit of trading

Three month Sterling (Short Sterling) GBP 500,000 Three month Eurodollar USD 1,000,000

Three month Eurodeutschemark (Euromark) DEM 1,000,000 One month LIBOR USD 3,000,000

Three month Eurolira ITL 1,000,000,000 One year T-Bills USD 500,000

Three month Euroswiss Franc (Euroswiss) CHF 1,000,000 Three month Euromark DEM 1,000,000

Three month ECU ECU 1,000,000 Three month Euroyen JPY 100,000,000

Three month Eurodollar USD 1,000,000 13-week US T-Bills USD 1,000,000

(This contract is for physical delivery)

Government Bonds range years coupon, %

Long-term Nominal value Maturity Notional

Long Gilt (UK) GBP 50,000 10 - 15 9 Government Bonds range years coupon, %

German – Bund DEM 250,000 8.5 - 10 6

Japanese – JGB JPY 100,000,000 7 - 11 6 US T-Bonds USD 100,000 At least 15 8

Italian – BTP ITL 200,000,000 8 - 10.5 12 10 year US T-Notes USD 100,000 6.5 - 10 8

72

Interest Rate futures

Short-term

Futures contracts specifications vary from type to type and from This Interest Rate futures contract is for a notional amount of Derivative

exchange to exchange. Have a look at the following 3-month LIFFE £500,000 – unit of trading – which is placed on a 3-month deposit

‘Short sterling’ contract details below. commencing on the delivery day (maturity) of the contract, at an

interest rate which is implied in the futures price agreed at the time

of the trade.

LIFFE 3-month Sterling

Interest Rate Future Typically for financial futures there are 4 delivery months per year –

Unit of £500,000 This is the standard March, June, September and December. It is also possible to have

Trading contract size maturity dates out to several years but ‘far month’ contracts are much

less liquid than the ‘near months’. This means that it is not always

Delivery Mar, Jun This is the trading cycle of possible to get prices for ‘far months’.

Months Sept, Dec contract months

Short-term futures are not quoted as an interest rate percentage.

Delivery Day First business day Instead they are quoted as:

This is the day contract is

after the last

settled 100 minus the implied forward interest rate

trading day

This is the last day and Example

Last Trading 11.00

time on which trading can A forward implied interest rate for a $1 million deposit is 5.55%.

Day Third Wednesday

take place

of delivery month

The futures contract price would therefore be 100 – 5.55 = 94.45.

The futures price is quoted

Quotation 100 minus rate of

according to the type of This convention for pricing short-term futures is based on the way T-

interest

future Bills are quoted – at a discount from the face value of the bill.

Minimum 0.01

price The price movement of a futures contract is measured in ticks. The

movement minimum price movement for a contract is determined by the

(Tick size (£12.50) This is the smallest amount exchange. Depending on the contract, its value is expressed in terms

and value) a contract can change of basis points – a basis point is one hundredth of one percent,

value and the ‘tick’ size 0.01%. So one tick equals one basis point.

Trading 07.15 – 16.02 Exchange trading hours –

hours London time open outcry

APT Trading 16.27 – 17.57

hours Computer-based trading

system hours

73

Interest Rate futures

$ $ This means that a tick has a specific value determined using the Long-term

following equation: The contract specifications for these Interest Rate futures are very

Derivative similar to those for short-term instruments. The major difference is

Tick = Unit of x Basis points x Proportion of year over that settlement is by physical delivery of bonds or notes with coupon

trading 100 which contract runs rates and maturity dates stipulated by the exchange.

Example Although some long-term futures for bonds have prices and

The tick value for the 3-month LIFFE Short sterling contract is: minimum price movements quoted as hundredths of a basis point,

UK Gilts and US T-Bonds are quoted as thirty-seconds of a percentage

point.

= £500,000 x 0.01 x 1

100 4

Example

= £12.50 A UK Long Gilt futures quoted at 111-23 means a price of 111 23/32.

However there are indications that the market convention for UK

On the last day of trading, if a futures position is still open, most Gilts and US T-Bonds may be changed in the near future to that of

short-term Interest Rate futures are cash settled against the EDSP. using basis points.

The exception is the 13-week US T-Bills contract which involves

physical delivery of the instruments. Tick values are easy to calculate for long-term futures:

The EDSP depends on the exchange but typically involves a Tick = Unit of trading x minimum price movement

calculation of interest rates for the Eurocurrency deposit in question.

For example, LIFFE use the British Banking Association Interest

Settlement Rate (BBAISR) and the CME uses an average of a survey The contract details for CBOT T-Bonds are shown opposite.

of rates of the London interbank rates for Eurodollars, LIBOR and

Euromark.

On the last day of trading the futures contract ceases to exist and the

underlying cash market instrument and futures prices are the same.

It is the difference in contract and settlement prices that is paid in

cash – as the principal of these contracts is notional no delivery can

take place on expiry .

74

Interest Rate futures

Chicago Board of Trade This is easy to calculate using the following method:

US Treasury Bond futures Derivative

Unit of T-Bond with face 1. Determine the number of ticks the price has moved up or down.

This is the standard

Trading value $100,000 The number of ticks is the number of one-hundredths of the

contract size

quotation price.

Delivery Mar, Jun This is the trading cycle of

Months Sept, Dec 2. Multiply the number of ticks by the tick value and the number of

contract months

contracts.

Delivery Day Last business day

of delivery month This is the day contract is Profit/ loss = Number of ticks x Tick value x Number of contracts

settled

Example

Last Trading 7th business day This is the last day and Two 3-month Short-sterling LIFFE contracts are bought when the

Day preceding last time on which trading can interest rate is 6.25%. The contracts are therefore priced at 100 –

business day of month take place 6.25 = 93.75.

Quotation Points and 32nds The futures price is quoted At the delivery date the 3-month LIBOR stands at 6.10% which

of point according to the type of represents a price of 100 – 6.10 = 93.90.

future

Minimum 1/32 of a point The contract has therefore gained in value and the number of ticks

price equals 93.90 – 93.75 = 15.

movement

(Tick size ($31.25) This is the smallest amount The profit on the contract = 15 x £12.50 x 2

and value) a contract can change = £375.00

value and the ‘tick’ size

Trading 07.20 – 14.00

hours Chicago time Exchange trading hours –

open outcry

Project A 14.30 – 16.60

Trading hours 22.30 – 06.00 Computer-based trading

system hours

75

Interest Rate futures

Interest rate futures quotations are available from the financial press

Derivative such as the Financial Times and The Wall Street Journal and from

products such as Reuters 3000. The information appears in formats

similar to those following.

Financial press – Short-term Interest Rate futures Financial press – Long-term Interest Rate futures

LIFFE 3 month Sterling Futures £500,000 points of 100% CBOT Treasury Bonds $100,000 points 32nds of 100%

Mar 93.74 93.76 93.74 93.75 Mar 112-19 112-24 110-25 110-28

Jun 93.55 93.57 93.55 93.56 Jun 112-03 112-13 110-09 110-13

Sep 93.35 93.37 93.33 93.35 Sep 111-24 111-24 109-29 109-31

Dec 93.20 93.21 93.17 93.18 Dec 110-16 110-16 109-17 109-17

Reuters 3000 – LIFFE Short and Long-term Interest Rate futures Reuters 3000 – CBOT Short and Long-term Interest Rate futures

76

Interest Rate futures

■ Who uses Interest Rate futures? As in any futures market place for commodities, hedgers can hold $ $

long or short positions and in order to hedge their positions market

Hedgers and speculators players need to take an opposite position to the ones they hold. Derivative

Originally futures contracts were devised so that holders

of an asset could hedge or insure its price today for It is important to understand that the principle of hedging is to

sometime in the future. Hedgers seek to transfer the risk maintain a neutral position. As prices in the cash market for the asset

of future price fluctuations by selling future contracts which move one way, the move is compensated by an equal and opposite

guarantee them a future price for their asset. If the future cash price move in the futures’ price. You can imagine the situation similar to

of their asset falls then they have protected themselves. However, if the movement of the pans on a pair of scales.

the future cash price rises then they have lost the opportunity to

profit. Hedging offers some degree of certainty for future prices and

therefore allows market players to fix prices, interest rate payments or

receipts etc.

governments, bond dealers and fund managers. Cash Futures

contract for an appropriate price and the potential rewards.

because different market players have different strategies and Going short futures

include: If a market player holds, or intends to hold, an asset in the cash

market, then he has a long position. The opposite position in the

❑ Hedgers with opposite risks futures markets means he must go short or sell futures.

❑ Hedgers already holding positions who need to offset their A borrower, who intends to hold cash, needs to protect against the

positions possibility that spot prices fall with a corresponding rise in interest

rates. A short hedge will therefore lock in a selling price.

❑ Speculators with market views on likely price changes who

provide the futures markets with extra liquidity Going long futures

If a market player is short, or intends to go short, in the cash market,

then the opposite position in the futures markets means he must go

long or buy futures.

possibility that spot prices rise with a corresponding fall in interest

rates. A long hedge will therefore lock in a selling price.

77

Interest Rate futures

$ $ Another way of considering market players using Interest Rate futures Sellers of Interest Rate futures

contracts is to look at whether they are buyers or sellers of the

Derivative contracts. ❑ Agree to deliver the underlying instrument and

therefore go short.

Buyers of Interest Rate futures

❑ Are borrowers and are hedging against any rise in interest

❑ Agree to take delivery of the underlying instrument and rates. If interest rates do rise, then any losses in selling the

therefore go long. underlying in the future are offset by gains from the futures

contracts on delivery.

❑ Are lenders and are hedging against any fall in interest

rates. If interest rates do fall, then any losses in buying the The diagrams below show how the losses in the underlying

underlying in the future are offset by gains from the futures instrument are offset by gains in the futures market.

contracts on delivery.

Underlying market Futures market

The diagrams below show how the losses in the underlying

Profit

Profit

instrument are offset by gains in the futures market. Futures price

Cash price

falling falling

+

rising

Underlying market Futures market rising

–

Profit

Profit

Loss

Loss

Cash price Futures price

falling

+

rising

Net cash loss Net futures gain

falling rising

–

Loss

Loss

In summary:

Net cash loss Net futures gain Short hedge Long hedge

As interest rates So futures prices • Protects against rise • Protects against fall

in interest rates in interest rates

Rise Fall

• Locks in selling price • Locks in buying price

Fall Rise

• Used by borrowers • Used by lenders

78

Interest Rate futures

In order to hedge a position it is necessary to match the futures A short hedge can be used by an investor needing to hedge against

contracts as closely as possible with that for the underlying price falls resulting from rising interest rates. This type of hedge can Derivative

instrument in terms of maturity dates, amounts involved etc. In also be used to hedge a future loan to prevent higher borrowing

practice it is difficult to obtain the conditions for a perfect hedge! costs.

simply calculated from the equation: It is 12th June and a Corporate Treasurer has just borrowed £1

million for a 3-month period at an interest rate of 6.0%. In 3-months

Number of contracts required = time the loan will roll-over and the Treasurer is worried that interest

rates will rise by then. The treasurer decides to hedge his position by

Sum to be hedged Actual number of days Number of futures selling 3-month LIFFE Short sterling futures at 93.50. But how

x x

Unit of trading Day basis x No. contracts/year contracts per year many?

Number of = £1,000,000 = 2

For most short-term Interest Rate futures this equation reduces to: contracts required £500,000

It is 11th September and the loan is rolled over and interest rates

Number of = Sum to be hedged

have risen to 6.75%. What is the result of the Treasurer’s hedge?

contracts required Unit of trading

Money markets Futures market

In the examples that follow the sums to be hedged have been 12th June

selected to match unit of trading amounts to simplify the Fears of interest rate will rise from Sell 2 x Sept contracts at 93.50

calculations. 6% (implied interest rate of 6.5%)

30th April

Roll over loan at 6.75%% Buy 2 x Sept contracts for 92.75

(implied interest rate of 7.25%)

to close position

0.75% on £1m for 3 months = £1875 75 ticks x £12.50 x 2 = £1875

gain is not paid as a single instalment but as daily margin payments

which are described later. Also the extra roll over loan interest would

not be payable until the maturity of the loan in 3 months time.

79

Interest Rate futures

$ $ So by selling the futures contracts the Corporate Treasurer has Suppose the following:

hedged the expected rise in interest rates. He has to borrow at a 1st July 31st July

Derivative more expensive rate in the Money Markets but this is compensated by

the gain in buying the futures cheaper than they were sold originally. 30-Day Fed Funds futures price 94.56 95.16

The hedge would also have worked if rates had fallen. The Corporate Implied 30-Day interest rate 5.44% 4.84%

Treasurer would have borrowed at a lower rate in the Money Markets

thus making a gain which would have been offset by a loss on the

futures because they would have risen in price from the original sale

On 1st July the rates have fallen, as expected by the Treasurer to

price.

4.80%. What is the result of the Treasurer’s hedge?

Long hedge – buying futures

Money markets Futures market

A long hedge is typically used by lenders of cash market funds who

need to fix an interest rate for a future date and are worried that

1st July

interest rates might fall.

Deposits $50 million at 4.80% Buy 10 futures at 94.56

Example

31st July

It is 12th June and a Corporate Treasurer has USD funds to lend in

Receive back $50 million plus Sell 10 futures at 95.16

July. The Treasurer is worried that rates may fall during June thus

interest at 4.80% for 1 month.

affecting the interest he is likely to receive.

Interest = $206,666.66 Gain on long position =

60 ticks x $41.67 x 10 =

The Corporate Treasurer will have $50 million to lend and decides to

$25,002.00

hedge his position using CBOT 30-Day Fed Funds futures. The unit

of trading is $5 million and the tick size is $41.67 per basis point.

Net gain on position = 206,666.66 + 25,002.00 = $231,668.66

Number of contracts required =

Net % return = 231,668.66 x 360

50,000,000 31 50,000,000 31

x x 12 = 10.33

5,000,000 30 x 12

= 0.0538

This means that the Treasurer has to buy 10 contracts – a perfect = 5.38%

hedge is not possible – and hold the futures until maturity or close

out prior to expiration. The perfect hedge requires a 5.44% return, but as only 10 contracts

could be bought, this compares well with a cash market return on

unhedged funds at 4.80%.

80

Interest Rate futures

Speculators attempt to exploit price movements in the markets and An interest rate future contract is in effect an exchange

thus provide additional liquidity for hedging activities. Speculators do traded 3-month Forward Rate Agreement (FRA). It is the MMI:FRA Derivative

not necessarily have a position and use their market knowledge to equivalent of a FRA with margins.

profit.

+ margins Interest

Example

▼

FRA Rate

A trader is expecting that the June balance of trade figures will be futures

better than expected causing short-term interest rates to fall and

therefore futures prices to rise. Based on this view the trader buys one The two instruments are compared in the table below.

3-month June LIFFE Short sterling contract at 93.55. This implies a 3-

month GBP interest rate of 6.45%. FRA Interest rate future

The next day the trader is viewing the news on his RT and is proven • Flexible • Standard contract

correct – interest rates have fallen by 0.5%. The trader therefore sells terms

his contract at the new market price of 94.05 and gains 50 ticks. • OTC market

• Exchange traded

His profit is 50 x £12.50 x 1 = £625.00. • No margin required

• Margin required

Suppose, however, that the trade figures had been worse than • Credit risk between

expected and interest rates had risen by 0.5%? The trader would have counterparties • No credit risk as

closed out the contract at 93.05 and made a loss of 50 ticks which is clearing house stands

£625.00. • No right of offset as counterparty

confidential

The chart below compares the relative ways in which the two

instruments are used to hedge interest rate price movements.

To hedge an

Fall Rise

interest rate ..

81

Interest Rate futures

$ $ ■ Interest Rate futures in the market place The process is illustrated as follows:

On the contract date

Derivative This section deals with a number of important matters

The Seller sells a contract to the Buyer and both deposit initial

concerning Interest Rate futures which you will need to

7 8 9

margin with the Clearing house.

,,

4 5 6

1 2 3

understand.

0

When a futures contract is agreed no payment is made. Instead both

parties are required to deposit a margin with the Clearing house

initial margin

payment

initial margin

payment

,,

,,

▼

▼

which acts as the counterparty to both sides. The initial margin is only

a small percentage of the contract price and it is used to cover daily

price movements of the futures’ price in relation to the agreed price.

Clearing house

Each day the futures’ position is marked-to-market which means it is

revalued at the current market price. Any profits and losses are paid Buyer Seller

over daily. By marking-to-market and settling all positions daily the

Clearing house effectively rewrites all futures contracts at the

prevailing market price. During the contract

The Seller’s and the Buyer’s profit and loss accounts are adjusted

If the initial margin is depleted then extra margin – variation margin daily.

,,

– is required. If a profit is made the account will receive it and it may

,,

be withdrawn. The system of maintaining the correct margin ensures

that the loser can bear any losses and the winner is credited with

,,

gains.

▼

variation variation

Dealing on margin is an example of gearing or leverage. Gearing margin margin

allows investors to make a larger investment than could otherwise be payment payment

▼

afforded. Small investments are used to generate large profits,

however, losses can be correspondingly large! For example, a £1000 Clearing house

investment in a futures contract is equivalent to buying a basic

investment of £10,000 – 20,000. Buyer Seller

As the expiry date of the contract approaches the futures price will

equal the current instrument price and so the differential is not very

large. This is why the vast majority, over 98%, of futures contracts are

closed out before the contract reaches the agreed expiry date.

82

Interest Rate futures

On the delivery date or contract closure Advantages and disadvantages of Interest Rate futures $ $

The Seller’s and the Buyer’s profit and loss accounts are settled for The following chart summarises the advantages and disadvantages of

the last time. Interest Rate futures: Derivative

,,

,,

Advantages Disadvantages

,,

▼ • Markets in the major • Only a limited number of

▼

variation variation contracts for Eurodollars, contracts available

margin margin US T-Bonds and UK Gilts are

payment payment large and very liquid • It can be difficult to hedge

positions exactly – matching

▼

▼

Clearing house • The use of margin payments exact amounts and required

allows highly leveraged dates is not always easy

Buyer Seller positions

• When hedging long-term

• Contracts can be bought and futures, the price/yield

sold without having to own relationship varies

the underlying continuously with time and

therefore the hedge ratio

• Most contracts are offset and varies continuously

only a very small percentage

expire resulting in delivery • The mark-to-market

settlement system can lead

to large cash outflows for

adverse price movements

• Trading is usually

concentrated in near month

contracts

far month contracts

83

Interest Rate futures

$ $ Trading strategies for Interest Rate futures Have a look at the prevailing futures prices that the Treasurer sells

There are a number of strategies that traders adopt in order to hedge the contracts:

Derivative positions which do not have ‘perfect’ matches in the futures markets.

The simplest strategies used are: Sell 10 Sept contracts at 94.29 Implied rate 5.71%

Sell 10 Dec contracts at 94.27 Implied rate 5.73%

❑ Futures strips Sell 10 Mar contracts at 93.95 Implied rate 6.05%

Sell 10 Jun contracts at 93.56 Implied rate 6.44%

❑ Stacking futures

Using a strip of futures has effectively locked in the interest rate for

❑ Spread trading the forward 12 month period but what is the rate. The average of the

four interest rates is 5.98% but unfortunately the calculation is not

Futures strips that simple!

These are used to hedge interest rate exposures which span several

futures expiry dates, or span dates which do not exactly match The general equation to calculate a forward-forward rate is given

futures expiry dates. below:

(La x da) x (Lb x db) 1

effectively commits him or herself to lending a notional £500,000 for F axb = x

3 months commencing on the contract expiry rate of 5.71%. The

seller of the same contract commits him or herself to borrowing the

notional amount.

[ (

1 +

(Lb x db

360 or 365

)

)] (db – da)

Example

F a x b = Forward starting in a days and ending in b days

It is early June and a Corporate Treasurer calls a bank to ask for the

price of a one year deposit loan for £5 million starting in September

La = Long period interest rate as a decimal

– a 3 x 15 forward price. The Treasurer is worried that rates will rise

in the next three months and wishes to hedge the current loan

Lb = Short period interest rate as a decimal

interest rates. The period required for the hedge spans four

consecutive, futures expiry dates and the Treasurer can sell a strip of

da = Long period in days

four futures. The number of contracts required to sell ( borrow

effectively) is 10 per contract – the unit of trading for the contract is

db = Short period in days

£500,000.

Exposure

84

Interest Rate futures

The rate is in fact a compound of the notional quarterly interest rate Stacking futures $ $

payments given by the following equation: Suppose in the previous example that the September futures contract

was the only one available. There is still a risk that interest rate will Derivative

rise over the next year but the Treasurer has only one contract

F = 1 –

[( 1 +

4)(

R1 R

)

x 1 + 2 x...

4 ( 1 +

Rn

4 )] available.

contracts are used – 4 x 10 contracts for the four periods. Using the

F = Forward compound rate

same futures prices for selling and buying 40 September futures with

Rn = Rate for period n a gain of 74 ticks results in a profit of 74 x £12.50 x 40 = £37,000.

n = Number of contracts in strip

Sept Dec Mar June Sept

Exposure

In this example the rate is 6.12%.

Suppose in September, the one year LIBOR is 6.75%. If the Treasurer Futures stack Sell 10

had accepted a quote of 6.12% then the loss covering the cash loan

would have been 5,000,000 x 0.0063 = £31,500. Sell 10

However, if the Treasurer closes out 10 contracts for each period by Sell 10

buying, then the gains are as follows. For each contract subtract the

buy from the previous sell price and to calculate the profit multiply Sell 10

the number of ticks by £12.50 and by 10 for the number of contracts.

Buy 10 Dec contracts at 93.45 +82 ticks profit = £10,250 The effectiveness of using a stack of futures depends on the yield

Buy 10 Mar contracts at 93.35 +60 ticks profit = £7,500 curve of interest rates. If the yield curve retains its shape then the

Buy 10 June contracts at 93.26 +30 ticks profit = £3,750 hedge using a stack is as effective as using a strip of futures. If the

Total gains = £30,750 yield curve is positive and steepens, then the stack produces poorer

results. However, even though the stack may not be as effective as

The net loss to the Treasurer is therefore 31,500 – 30,750 = £750. desired it produces better results than no hedge at all!

The hedge is not perfect but a large loss which could have resulted

from not hedging the deposit has been averted.

The use of strips is restricted to prices for the far months required,

but what happens if this is not the case?

85

Interest Rate futures

A spread trade is also known as a straddle. This method of trading Cash futures basis is a reflection of the net cost of carry for a cash

Derivative involves buying/selling futures contracts for one delivery month and position to expiry date of the futures contract. The relationships are

simultaneously selling/buying the same number of contracts for a shown here:

different month.

Futures price = Cash price + Net cost of carry

If interest rates move, then one position hedges the other. The result

is a less risky position than an outright long or short position. Basis = Cash price – Futures price

difference between the forward price of a gap in the underlying cash

markets, for example, 3 x 15, and the implied forward price in the

relevant futures contract. Basis risk describes how these prices vary or

the extent to which risk changes. The extent of this basis risk

determines the effectiveness of the hedge.

futures contracts, basis risk can be small.

not directly priced against Money Markets, then basis risk can be

considerable.

Market players need to monitor basis and basis risk to hedge futures

to maximise profitability. It is also important to remember that

futures are marked-to-market daily which means that the underlying

Money Market exposure being hedged must be revalued daily.

86

Interest Rate futures

Derivative

transaction with a standard contract size and maturity

dates

and are cash settled against an Exchange Delivery

Settlement Price

underlying government bonds or notes

protect against any fall in interest rates

protect against any rise in interest rates

sellers of a futures contract which is marked-to-market

daily

87

Interest Rate futures

RT may help your understanding of Interest Rate futures

and how they are used.

Options Exchanges type in FUTURES and press

Enter. Select the field for the country you are

interested in – in this case double-click in the

<GB/FUTEX1> field. From the list of exchanges select the

exchange of interest – double-click in the <LIF/FUTEX1> field.

From this page you can now select a chain of prices for a

particular contract and the contract specification if you require

this. The screens below show information for the LIFFE 3-month

Short Sterling contract.

88

Interest Rate futures

$ $

RT You may also find the Exchange Traded Interest 3000 The Futures folder, IR Watch page, IFW, is useful Derivative

Rate Futures Speed Guide useful. These pages list for any particular currency to compare short and

all the contracts and easy access to chains of prices. long-term futures contracts. In the Contract 1 and 2

Type in FUT/IR1 and press Enter. Use the F12 and fields enter the details you require. In the example

F11 keys to page up and down respectively. here LIFFE Short sterling and Long Gilt information is displayed.

89

Interest Rate futures

$ $

Derivative 3000 The IFW page can also be used to display one of the 3000 Finally the IFW page can be used to display details

most important futures contracts – the IMM 3- of similar futures contracts offered by different

month Eurodollar contract. The example here exchanges. In the example here you can compare

shows details for the IMM 3-month Eurodollar prices of Euroyen contracts from LIFFE and SIMEX.

contracts and the long-term CBOT US T-Bonds contracts.

90

Interest Rate futures

■ End check 5. A trader at XYZ Bank thinks that trade figures will be better than $ $

expected resulting in a short-term interest rate fall. He buys 5

June LIFFE 3-month Short sterling contracts at 93.72. The Derivative

1. Which of the following interest rates is implied for a LIFFE 3- contract’s minimum price movement is 0.01 and the tick value is

month Short sterling futures contract with a price of 93.18? £12.50.

❑ a) 5.82% a) What is the implied interest rate for the contract?

❑ b) 6.72% b) If the trader is correct and interest rates fall and he sells the

❑ c) 6.82% contract at 93.17, how much profit does the dealer make?

❑ d) 7.82% c) If the trader is wrong and he has to close the contract at 94.03,

what is his loss?

2. If you place an order for a futures contract, when will you be

required to pay initial margin? Answer a)

❑ a) At expiry of the contract

❑ b) Only if you buy a contract

❑ c) At the time of trading the contract

❑ d) Only if you sell a contract Answer b)

3. When trading in futures, credit risk lies with which of the

following?

❑ b) The broker who takes your order

❑ c) The counterparty with whom the trade is made

❑ d) The pit trader placing your order

Mar 9378 Jun 9374 Sep 9370 Dec 9366

❑ b) The USD yield curve is positive

❑ c) A weak USD on foreign exchanges is expected

❑ d) None of the above

91

Interest Rate futures

Derivative ✔ or ✖

1. c) ❑

2. c) ❑

3. a) ❑

4. b) ❑

5. a) 6.28% ❑

Implied interest rate = 100 – 93.72

= 6.28

b) £3437.50 ❑

Contract moves 93.72 – 93.17 = 0.55 = 55 ticks

Therefore profit = 55 x £12.50 x 5 = £3437.50

c) £1937.50 ❑

Contract moves 94.03 – 93.72 = 0.55 = 31 ticks

Therefore profit = 31 x £12.50 x 5 = £1937.50

How well did you score? You should have managed to get most of

these questions correct.

92

Interest Rate Swap (IRS)

■ What is it? The growth of IRSs can be traced to the early 1980s. But why have $ $

these long term OTC derivatives become so important? IRSs are

An Interest Rate Swap is an agreement between characterised by the following: Derivative

counterparties in which each party agrees to make a

series of payments to the other on agreed future dates ❑ The interest amounts for both sides of the agreement are

until maturity of the agreement. Each party’s interest calculated from the same notional principal amount. This

payments are calculated using different formulas by means that there is no physical exchange of the principal.

applying the agreement terms to the notional principal Therefore the risk involved in the swap is reduced to that of

amount of the swap. assessing the credit risk that the other side may default on

their interest rate payments.

If you need an overview of swap derivatives or you need to

❑ The two rates of interest are calculated for the same

remind yourself about derivatives in general, then you Derivatives

currency.

may find it useful to refer to the Introduction to Derivatives Section 4

workbook, Section 4 at this stage.

❑ The interest payments between both parties are usually

netted so it is only the difference in payments which is paid

IRSs are the most important of the OTC swap derivatives currently

to one side or the other. It is for this reason that IRSs are

traded in the global markets. An IRS is in effect an agreement which

sometimes known as contracts for difference.

allows both parties access to better interest rates than they would

normally receive in the markets.

The OTC nature of IRSs means that their terms and conditions can

be very flexible. However, in practice, most agreements are for plain

In other words Party A and Party B both borrow the same amount, at

vanilla – fixed-for-floating – swaps. One side pays a fixed rate whilst

the best interest rates they can and then swap the interest rate

the other pays a floating rate – the situation illustrated in the original

payments to the benefit of both parties. The cost of borrowing for

diagram opposite.

both parties is reduced without altering the underlying principal

loans. The interest rates bases for the loans are therefore separated

Floating-for-floating swaps are available but terms and conditions

from the underlying instruments.

involved with these can be quite complex.

,,

,,

▼

,,

▼

Party A Party B

93

Interest Rate Swap (IRS)

requirements, both the British Bankers Association (BBA) and the Confirmation

Derivative International Swaps and Derivatives Association (ISDA) issue Date: July 1, 1997

To: OkiBank

standard terms and conditions relating to a range of swap derivatives. Attention: Swaps Group Leader

From: MegaBank

Once an agreement is made, most confirmation notes include the

relevant information. For example, a plain vanilla IRS confirmation We are pleased to confirm our mutually binding agreement to enter into a Rate Swap Transaction with

you in accordance with our telephone conversation with Mr. Deal on July 1, 1997, pursuant to the Master

note typically includes: Interest Rate Exchange Agreement between us dated as of July 1, 1997.

Termination Date:

July 1, 1997

July 1, 2002

This is the date of the swap when interest on both sides Notional Amount $50,000,000

starts to accrue. For plain vanilla swaps this date

Fixed Rate Payor: OkiBank

is taken as spot and LIBOR is fixed on the trade Floating Rate Payor: MegaBank

date. These are the same conventions as used MMI:DEP MegaBank Calculation Periods for Payments:

for Money Market deposits. First period: Effective Date to but excluding January 5, 1998.

Last period and End Dates: Each July 1 and January 1 after the first Period End Date,

subject to the Modified Following Banking Day convention, and

finally the Termination Date.

❑ Termination date OkiBank Calculation Periods for Payments:

This is the end date of the contract – the date of the final First period: Effective Date to but excluding July 1, 1998.

Last period and End Dates: Each July 1 after the first Period End Date, subject to the

difference in interest payments. Modified Following Banking Day convention, and finally the

Termination Date.

Fixed Rate:

Each party date on its own Period End Dates

x percent per annum

This is the amount used for interest rate calculations on Fixed Rate Day Count Fraction: 30/360

Designated maturity: six months

Floating Rate Day Count Fraction: Actual/360

Reset Dates: First day of each MegaBank Calculation Period

❑ Fixed rate payor/receiver

Office or branch through which we are acting: Principal Office in New York

As it could be misleading to refer to buying or selling swaps, Office or branch through which you are acting: Principal Office in New York

it is usual to refer to the party who pays or receives the fixed Arrangement Fee: None

rate. Documentation: The Master Interest Rate Exchange dated as a July 1, 1997 between OkiBank

and MegaBank as modified by this confirmation.

Please confirm to us that the terms set forth herein accurately reflect our Rate Swap Transaction with

If the fixed rate receiver has been specified, then by you by signing a copy of this Confirmation and sending it back promptly by hand or by facsimile

transmission. Please notify us immediately if you believe there is an error in this Confirmation.

implication this side must be also the floating rate payer

Confirmed:

and vice versa. In many cases swap traders only specify what

is happening on the fixed side. MegaBank OkiBank

By By

• Reference interest rate, for example, LIBOR

• Payment periods and dates

• Day count conventions An example of a typical Fixed/Floating Swap Confirmation note based on

Sajitas Das, Swaps, IFR 1987

❑ Arrangement fees

94

Interest Rate Swap (IRS)

IRSs are the most important of the swap derivatives both in terms of The ISDA data also shows that IRSs involving the USD dominate the $ $

the face value of OTC contracts not yet settled – the notional markets. The chart below indicates the top five currencies by

outstanding values, and in terms of the average daily turnover. The percentage market share based on the USD equivalent of notional Derivative

following statistics are taken from the BIS Report 1995: Central Bank principal outstanding.

Survey of Foreign Exchange and Derivatives Market Activity. Currency % Market USD billion

equivalent

Derivative Outstanding notional Average daily turnover

USD billions USD billions USD 34.12 4,371.7

JPY 22.61 2,895.9

Interest Rate Swap 18,283 62 DEM 11.23 1,438.9

FRF 9.52 1,219.9

Currency swap 1,957 7 GBP 6.67 854.0

Other 15.85 2030.6

The latest data from the ISDA Summary of Market Survey Statistics: 1995 Total 100.00 12,811.0

Year End confirm the dominance of the IRS markets as the chart

below shows.

15

12,811

USD Equivalent, Billions

12

9 JPY

Other

6

GBP

3,704

FRF DEM

3

1,197 Source: ISDA

0

Interest Interest Currency

Rate Swaps rate options swaps

Source: ISDA

95

Interest Rate Swap (IRS)

$ $ ■ Who uses IRSs? It is this access to different markets which in effect provides credit

arbitrage in the markets. The difference in organisations‘ credit

Derivative Banks and corporations ratings can result in considerable differences in yield gaps on fixed

The ISDA data below shows that the market players using rate debt such as bonds and floating rates paid on loans. Many bond

IRSs the most are banks and multinational corporations. issues are swap driven because issuers can take advantage

of IRSs to swap the interest payments on the funds raised

Market player % of users based on into a different rate basis. Often these transactions also FXI:CSP

year end outstandings involve a Currency swap which effectively converts a

domestic loan into one for a foreign currency.

Corporations 24

Banks 53 Organisations with good credit ratings usually find it easier to borrow

Institutional investors 7 at fixed rates, whilst those with lower ratings tend to get their best

Government 9 terms on a floating rate basis.

Other 7

Have a look at the following example to see how a plain vanilla IRS

Total 100 works between the XYZ and AYZ Corporations. The original lenders

of the loans on both sides need not even know that the

counterparties have entered into a swap agreement.

IRSs are used increasingly by these market players for two main

reasons:

Example – a plain vanilla IRS

❑ To hedge exposure on interest rates Consider the following situation:

❑ To speculate in the swaps markets in order to make a profit XYZ is a multinational corporation with a credit

from offsetting fixed/floating rate transactions rating of AAA. XYZ needs to borrow $50 millions

for 5 years. XYZ can borrow at a low fixed rate but

IRSs also offer the following benefits to corporations and banks: would prefer to take advantage of a floating rate

basis loan. XYZ would like to take advantage of floating rates in order

❑ Counterparties are able to convert underlying interest rates to maximise any interest rate gaps.

from fixed to floating and vice versa over a long term

period AYZ is a corporation with a lower credit rating of

BBB who also need to raise $50 millions for 5

❑ Usually there are cost savings to both sides years. Because of AYZ‘s lower credit rating

borrowing on a floating rate basis or issuing a

❑ IRSs provide access to markets not normally available to the bond with a high value coupon is easier than obtaining a fixed rate

market players, for example, for reasons relating to credit loan. AYZ would prefer a fixed rate loan in order to predict future

rating interest rate payments.

96

Interest Rate Swap (IRS)

11.75%

Rates XYZ can borrow AYZ can borrow Derivative

LIBOR + 1%

XYZ AYZ

Floating @ LIBOR LIBOR + 1%

Required basis Fixed Floating Pays fixed rate of Pays floating rate

10% to lender of LIBOR + 1% to

lender

In order to obtain the type of loan both corporations require they

enter into a swap agreement. Both corporations need to assess the

risks involved if the other side defaults on payments – if this does

happen then the party who does not receive an interest payment still

has to pay the interest due on the underlying loan.

The chart below shows how both sides benefit from the swap.

❶ XYZ borrows at a fixed rate of 10%

XYZ AYZ

❷ AYZ borrows at a floating rate of LIBOR + 1%

Pays out LIBOR + 1% + 10% 11.75% + LIBOR + 1%

❸ XYZ and AYZ enter into an IRS agreement for a notional

principal amount of $50 millions with interest payments to Receives in 11.75% LIBOR + 1%

be exchanged for a 5 year period where:

Payments = LIBOR + 0.75% 11.75%

• XYZ make floating rate payments of LIBOR + 1% to AYZ

• AYZ make fixed rate payments of 11.75% to XYZ Without swap LIBOR 12.00%

AYZ pays this higher fixed rate to XYZ to compensate this

corporation as it has the higher credit rating Savings 0.75% 0.25%

97

Interest Rate Swap (IRS)

Most IRS agreements now involve a market-maker and two separate

Derivative ❑ Without the swap both XYZ and AYZ pay a total of clients who wish to enter a swap, but not necessarily with each other.

12.00% + LIBOR in interest rate charges For example, it may be that the perceived credit risks involved in a

direct swap agreement are not acceptable to one or both parties. By

❑ With the swap both parties pay a total of 11.00% + LIBOR acting as a two-way market-maker a bank acts as an intermediary

(10.00% + LIBOR + 1%) in charges creating a double swap in which both parties are effectively

guaranteed interest payments will take place.

,,

Thus using the swap there is a net saving of 1.00% which in this case

is split 0.75%/0.25% in favour of XYZ which is the organisation with

the better credit rating.

Fixed rate Fixed rate

,,

,,

▼

Originally swaps were arranged directly between counterparties with

banks merely acting as agents for both sides. Now many banks act as

▼

intermediaries and make a two-way market in swaps by taking one

side of the transaction. Floating rate Floating rate

Market-maker

Party A Party B

Of course, the market-maker does not enter into these swaps for no

reward. The intermediary is paid a fee which is either based on the

principal notional amount involved, a spread between the two-way

prices quoted for swap repayments – the swap rate, or both.

In the US and to a lesser extent in the UK, swap rates are quoted over

the yield on a Treasury note with comparable maturity.

based on a 5-year T-Bond which has a yield of 8.00%. This means the

market-maker pays at a rate of 8.70% and receives at a rate of 8.75%.

works...

98

Interest Rate Swap (IRS)

Consider the following situation: 8.70% 8.75%

Derivative

A US swap market-maker, BigBank, are quoting a

LIBOR LIBOR

fixed rate of 70/75 over for a 5-year period against

a floating rate of LIBOR flat.

XYZ BigBank AYZ

8.70/8.75

XYZ is a Money Markets fund which has invested in

floating rate assets which are yielding, on average,

LIBOR + 0.2%. XYZ believe that LIBOR will fall so

they would prefer fixed rate interest payments.

LIBOR + 0.2% LIBOR + 1%

XYZ enter into a swap with BigBank to receive a

fixed rate of 8.70% against paying a floating rate of LIBOR.

fixed rate of 10% or issue a Floating Rate Note Floating Floating

(FRN) with a floating rate repayment of LIBOR + The chart below shows how both XYZ and AYZ effectively turn their

1%. AYZ would also prefer fixed rate interest interest rate payments/receipts into fixed rates and the savings AYZ

payments for their loan. AYZ also enter into an IRS makes.

with BigBank but AYZ pay 8.75% against receiving LIBOR.

XYZ AYZ

Savings – 0.25%

99

Interest Rate Swap (IRS)

$ $ The convention of quoting a swap rate as described separates the Your notes

credit risk element from the general interest rate in the market.

Derivative However not all currencies have well developed government Treasury

instruments across a range of maturity dates. In these cases swap

dealers will quote all-in prices as a total rate.

answer is yes, but in practice there are a number of issues to be

reconciled if you are trying to compare swap rates. In other words are

you comparing like-with-like?

IRS to a colleague would be able to do it?

100

Interest Rate Swap (IRS)

The instruments used to calculate swap rates for different currencies

This section deals with a number of important matters vary. For example, USD swaps are usually quoted as a spread over the Derivative

7 8 9 concerning IRSs which you will need to understand: appropriate Treasury instrument which have semi-annual coupons;

4 5 6

1 2 3 DEM swaps are quoted on an annual Eurobond basis.

0

❑ Swap differences

The chart below indicates the various instruments used for the major

❑ Swap spreads currencies together with the Day count method used for the interest

payment calculations.

❑ Swap valuations

Currency Quoted as... Coupon Day count

❑ Swap structures

USD Spread over T-Bond Semi-annual Actl/Actl

Swap differences DEM Fixed Eurobond Annual 30/360

The four main types of difference were mentioned at the end of the CHF Fixed Eurobond Annual 30/360

last section. FRF Fixed Eurobond Annual 30/360

GBP Spread over Gilt Semi-annual Actl/365

Quotation terms JPY Fixed Government Bond Semi-annual Actl/365

Within the US markets in particular there are a number of different

ways interest payments can be calculated for fixed and floating rates

together with a number of different ways payment schedules can be Frequency of interest payments

stipulated. Different swaps may use a combination of any of the In order to compare swap rates fairly you may need to convert annual

following terms payments into semi-annual or vice versa.

Terms Fixed rate Floating rate

swap rates as appropriate.

Rate quotation • Absolute level • Any LIBOR

• Spread over • Prime rate From ➟ To ➟ Use ➟

Treasury instrument • CD, CP or T-Bill

[( )]

2

2

schedule • Semi-annually • Irregular

• Annually

Annual Semi-annual RS = 2 x

[ (1 + RA ) – 1

]

• T-Bond • Money Market RA = Annual rate % ÷ 100

• Money Market Instrument RS = Semi-annual rate % ÷ 100

Instrument

101

Interest Rate Swap (IRS)

You may also need to convert swap rates depending on the day count Interest rate trends cause variations in swap spreads over the yield

Derivative basis used to calculate interest payments in order to compare like- curves for Government benchmark instruments.

with-like or value swaps.

When interest rates are expected to fall there are many fixed rate

The chart below gives the various methods of converting different issuers wanting to swap into paying floating and receiving fixed, so

day counts. spreads narrow.

From ➟ To ➟ Use ➟

borrowers wanting to swap into fixed but not many willing to receive

it, so spreads widen.

30/360 or Actual/360 Yield x 360

Actual/365 365 Another factor affecting swap spreads is credit risk. In a swap the

market player and the market-maker take on each other’s risk. If

Actual/360 30/360 or Yield x 365

either party fail to honour payment commitments, then the other

Actual/365 360 party has an unwanted interest rate exposure.

Actual/365 30/360 No adjustment

For IRSs the net difference in fixed/floating payments is made, so

the risk of loss is based to some extent on an estimate of the

30/360 Actual/365 No adjustment

volatility of the future floating rate basis, for example, LIBOR.

102

Interest Rate Swap (IRS)

Swap valuation The interest payments are netted between XYZ and AYZ based on the $ $

Consider a plain vanilla IRS in which XYZ Corporation borrow $100 following calculation:

millions for 5 years at a floating rate but enter into an IRS agreement Derivative

with AYZ Bank to make fixed rate payments at 9.00% every 6 months. LIBOR – 9 x $100 millions x No. of days in 6 month period

In return the swap dealer, AYZ, will pay a floating rate of LIBOR every 360 x 100

6 months.

9.00% Fixed Depending on the value, either XYZ or AYZ receive the net payment.

At the start of the plain vanilla swap the derivative has no value to

either party. The interest rates that have been agreed for both sides

are determined so that the present value – the value the swap will

LIBOR Floating have at a future date – of the fixed side equals the present value of

XYZ AYZ

Both payments are the floating side taking into account the conditions of the agreement.

made every 6 months

If the terms of the agreement remain constant then neither side gain

The spot rate for the transaction is 1st June so the first payment is or lose at the expense of the other.

due on 1st December. The amount of interest due on the 1st

December is already known on the 1st June. How can this be the However, suppose interest rates rise and LIBOR increases. In this case

case? The answer is that LIBOR for the first payment is fixed on the XYZ will gain at the expense of AYZ because XYZ pays a fixed rate

1st June as the floating rate to be paid in 6 months time. In a similar and receives a floating rate which has just increased. So the swap now

manner the 1st December LIBOR fixing determines the rate to be has a positive value to XYZ which can be considered to be an asset.

paid for the second payment on the following 1st June and so on The actual value of the asset can be calculated from the difference in

until the final payment in 5 years. present values. Unfortunately in the case of AYZ the swap has a

negative value and is considered to be a liability.

1st June 1st Dec. 1st June

There are two basic ways that swaps can be valued:

1st June Use LIBOR Use LIBOR

from from

1st June 1st Dec. ❑ Pricing from swap curve

LIBOR Net LIBOR Net LIBOR Using the spot curve method produces a more accurate figure than

➝ ➝

➝ ➝

fixed fixed fixed

payment payment the swap curve method, but the calculations involved can be quite

made made complex. Both methods of pricing involve calculations for bonds

which are dealt with in more detail in the Debt Instruments workbook.

Why Debt Market instruments? Read on...

103

Interest Rate Swap (IRS)

$ $ Pricing from the swap curve Example – Fixed side – Straight bond: Floating side – FRN

Yield curves are an essential part of valuing future cash flows and Suppose a plain vanilla swap has been arranged between XYZ

Derivative calculating forward interest rates. Plain vanilla swap rates are priced Corporation and AYZ Bank for a $100 millions notional principal

from benchmark bond yield prices as has already been mentioned. amount for a 3 year period. On the fixed side the payments are

The benchmark Yield To Maturity (YTM) curves are used for pricing 9.30% on an annual basis; on the floating side the payments are 12

over a range of maturities. months LIBOR.

The cash flows over the 3 year period would look something like

those shown in the chart below.

This is taken from page SMWM

for a DEM swap Payment 1 Payment 1 Payment 2 Payment 3

Floating LIBOR? LIBOR? LIBOR?

thought of as a series of coupon payments from an imaginary straight

bond on the fixed side netted against a series of payments from an

imaginary or synthetic Floating Rate Note (FRN) on the floating side. Payments equivalent to those from a Floating Rate Note

Can you see how this works?

Notional straight bond – Notional floating instrument

present value present value

104

Interest Rate Swap (IRS)

XYZ and AYZ enter into the swap on the stated conditions. On the The present value for the floating side can be calculated using the $ $

spot date LIBOR is fixed at 7.50% for the first payment. As has been more direct relationship between the present and future value of an

mentioned the swap has no value at the start of the agreement. On instrument, Equation 2. Derivative

the first payment date the 3 year swap rate is now quoted at 9.00% on

the fixed side and 12 months LIBOR is fixed at 7.79%. What is the

Future Value

value of the swap now? Is the swap an asset or a liability to the receiver PV =

of the fixed side? (1 + R)

Principal + Interest due

What is the value now of the swap that matures in the future? The =

present value of the fixed side can be calculated using the general (1 + R)

straight bond valuation equation. For a bond with an annual coupon

this is Equation 1. Where: R = Discount or LIBOR rate

as a decimal ...Equation 2

C C (C + 100)

Present Value (PV) = + + ...+

1 + R (1 + R)2 (1 + R)n

In this example then: Principal = 100 millions; Interest = 7.50;

R = 0.0779. Because the floating rate is based on Actual/360 the

Where: C = Coupon rate values used need to be adjusted to a 365 day year.

R = Discount or swap rate as a decimal

n = Number of years to maturity

...Equation 1

[ 100 +

( 7.50 x 365

360 )]

PV =

In this example then: C = 9.30%; R = 0.090; n = 3

1+

( 0.0779 x 365

360 )

PV = + +

1.09 (1.09)2 (1.09)3 = $99.7257 millions

= $100.7594 million The net value of the swap is therefore $1.03 millions in favour of the

fixed side. This is because the swap rate quoted by the bank at the

end of the first payment is less than the coupon rate of 9.30% on the

position. The floating side has lost value because LIBOR has

increased.

105

Interest Rate Swap (IRS)

$ $ Treating the value of a swap as the difference between a straight bond Pricing from the spot curve

and a floating rate instrument gives rise to market-makers hedging or The Yield To Maturity (YTM) curve is simply a graph of YTM values

Derivative warehousing a swap position by temporarily buying or selling the of bonds against maturity period. Unfortunately this is a simplistic

underlying bond. view of yields and it is better to use a graph of spot rate against

maturity period. The spot rate is a measure of the YTM on an

The payer of the fixed side buys the underlying which can then be instrument at any moment in time which takes into account a variety

sold to offset the position if the swap rates fall. of market factors. A graph of spot rate against maturity is known as a

spot curve. It is also known as a Zero Coupon yield curve because the

The receiver of the fixed side sells the underlying to offset any losses spot rate for an instrument is equivalent to the yield on an

if swap rates rise. instrument which has no coupon repayment – zero coupon. This

means that spot rates for a series of instruments with zero coupons

The calculations here are quite complicated and time consuming to for a range of maturity periods can be compared directly.

perform. In practice, traders will often use a graphical representation

to assess the relationship of the swap with a benchmark instrument of The curves represent the perceived relationship between the return

the same maturity. The graphical representation used is the spot on an instrument and its maturity – usually measured in years.

curve or Zero Coupon yield curve. Depending on the shape of the curve it is described as either:

❑ Positive

❑ Negative or inverse

In this case the shorter term interest rates are lower than the longer

term rates. This is usually the case – the longer the period of the

investment the higher the yield paid. If an interest rate rise is

expected, then investors will move their assets into long term

instruments which produces a fall in short term rates and an increase

in long term rates.

When short term rates fall investors move their investments into

longer term instruments to lock in a higher rate of return. This

increase in supply of long term funds causes the long term rates to

fall.

106

Interest Rate Swap (IRS)

The shapes of ‘theoretical’ yield curves are shown below – in practice How does the spot curve help in pricing a swap? A more accurate way $ $

they may not appear so clear! of considering an IRS is to consider the instrument as a series of fixed

cash flows on one side combined with a series of notional Derivative

Positive yield curve floating cash flows on the other which are considered as a

MMI:FRA

strip of FRAs or futures contracts.

Yield

interest payment date. MMI:FUT

Maturity FRAs or futures contracts.

Negative or inverse yield curve the swap were valued using this more accurate method, then the net

value in favour of the fixed side is $1.043 millions.

Yield

Maturity

similar credit standing, for example, an IRS and a T-Bond of similar

maturity.

when compared to its spot curve.

107

Interest Rate Swap (IRS)

Plain vanilla swaps usually have very narrow spreads – typically only 5 These are all IRSs which involve variable notional principal amounts

Derivative to 10 basis points. This means that the profit margins for dealers are in the agreement.

small. In order to widen their profit margins and to cater for more

complicated client requirements, dealers can structure more Accreting and amortising swaps consist of strips of swaps with

complex IRSs based on the following basic types: different start or end dates.

❑ Plain vanilla swap ❑ Accreting swaps have notional amounts that increase in

steps over the life of the swap

❑ Forward start swap

This is a fixed-for-floating IRS in which the accrual date of ❑ Amortising swaps have notional amounts that decrease in

the swap for the first interest period starts sometime after steps over the life of the swap

the spot date. This type of swap can still be considered as a

strip of FRAs on the floating side except the near FRAs have These types of swaps are used in real estate markets where developers

been removed. Forward start swaps are often used to hedge seek to lock in the interest cost of future floating rate borrowings

against forward interest rate movements. which either diminish or expand over time. The following charts

illustrate these swaps.

❑ Swaption

This is similar to a forward start swap to which has been Accreting swaps

added the option whether or not to start the swap on the

Notional amount

accrual date. Hence the name is derived from the fact it is

an option on a swap. One counterparty buys the option,

whilst the other writes or sells the option.

options then you may need to refer to the Derivatives

Introduction to Derivatives workbook Section 3. Section 3 Maturity

Swaptions are also dealt with in more detail in

this workbook – Options on IRSs - Swaptions.

Amortising swaps

MMI:SWP

Notional amount

There are many types of structured swaps available now – some of the

more common types are briefly discussed next.

Maturity

108

Interest Rate Swap (IRS)

accreting and amortising swaps and is illustrated in the chart below. Whereas most IRS are plain vanilla swaps, basis swaps cater for

floating interest payments on both sides. The interest rates for both Derivative

Rollercoaster swaps floating sides are calculated on different bases. Typical basis swaps

include the following:

Notional amount

Maturity

In all other respects basis swaps are used, priced etc in the same way

as described previously.

floating rates in different currencies are exchanged, for example,

USD LIBOR against DEM LIBOR.

is arranged in one currency and combined with a cross- FXI:CSP

currency basis swap, then the result is a Currency swap.

A market-maker enters into a plain vanilla DEM swap for fixed DEM

and floating DEM LIBOR. This swap is then combined with a cross-

currency basis swap for USD LIBOR and DEM LIBOR. In effect the

DEM LIBOR payments cancel out leaving a swap of fixed DEM for

floating USD LIBOR – a Currency swap.

Market-maker

109

Interest Rate Swap (IRS)

Derivative

calculated according to different formulas on the same

notional principal amount

are lent or borrowed between the counterparties as part of

the swap

difference is paid to one party or the other

– the swap is a separate transaction

110

Interest Rate Swap (IRS)

The following exercises using Reuters products and the Derivative

RT may help your understanding of IRSs and how they

are used.

Rate Swaps type in SWAP/1 and press Enter.

Double-click in the <TOPIRS> field to see the Fixed/floating basis for

Interest Rate Swap rates for the major currencies. swap

The fixed/floating basis for each currency is indicated. If you

need to find out more about a particular price, double-click on it

and the latest prices from different contributors will be displayed.

Double-clicking on this

price displays this screen

111

Interest Rate Swap (IRS)

$ $

Derivative 3000 Use the Multiple Watch page, SWMW, in the Swaps

folder to view up to three different contributor

quotes for the same currency. Different contributors Fixed/floating terms

may use different swap terms so you may need to

check this in the Basis fields. You can also compare up to three

different currency swap rates in this page.

You may also find it useful to use the Model page, SWM. Enter

the details of the swap you are interested in and the fixed/

floating payments are calculated and displayed in the Cash Flow

Analysis fields.

Fixed/floating

cash flows

112

Interest Rate Swap (IRS)

Derivative

1. In an IRS, the principal amounts involved are usually:

❑ b) Exchanged at the start date

❑ c) Not exchanged

❑ d) Exchanged at an interim date

❑ b) On a gross basis at the end of each interest period

❑ c) At the start of each interest period, as with a FRA

❑ d) On a cumulative basis at maturity

3. A client asks you to quote for a 2 year GBP IRS. You quote

7.43 – 7.39. The client deals at 7.39. What have you done?

❑ b) Transacted a basis swap

❑ c) Agreed to pay fixed/receive floating

❑ d) Transacted a fixed/fixed swap

his interest repayments using an IRS. He receives a quote of

6.75 – 80 using the same interest basis and decides to fix. What

will be the net cost of his borrowing?

❑ a) 6.750%

❑ b) 6.800%

❑ c) 7.375%

❑ d) 7.425%

113

Interest Rate Swap (IRS)

Derivative ✔ or ✖

1. c) ❑

2. a) ❑

3. c) ❑

4. d) ❑

How well did you score? You should have managed to get most of

these questions correct.

114

Options on Interest Rate futures

■ What is it? The relationship between the rights and obligations for the different $ $

types of options is summarised in the following diagram – you may

An Interest Rate option is an agreement by which the find it useful to refer to when considering some of the examples Derivative

buyer of the option pays the seller a premium for the which follow.

right, but not the obligation –

Options

to buy a call option

Call Put

of a specific instrument the underlying instrument

is a short or long-term

Interest Rate futures contract

the style of the option – Buyer/holder Seller/writer Buyer/holder Seller/writer

American or European Long Call Short Call Long Put Short Put

at an agreed price Strike price for the Right but not Obligation to: Right but not Obligation to:

interest rate obligation to: obligation to:

• Buy underlying • Sell underlying • Sell underlying • Buy underlying

instrument instrument instrument instrument

If you need an overview of options or you need to remind • At the strike • At the strike • At the strike • At the strike

yourself about derivatives in general, then you may find it Derivatives price price price price

useful to refer to the Introduction to Derivatives workbook, Section 3 • If the call is • If the holder • If the put is • If the holder

Section 3 at this stage. exercised decides to buy exercised decides to sell

115

Options on Interest Rate futures

$ $ Interest Rate options are financial derivatives first introduced in the Exchange traded Interest Rate options

1980s to hedge interest rate exposure. The underlying instrument for Interest Rate options on an exchange

Derivative can either be for cash or for Government bonds. Exchange traded

If the option is Exchange traded, then it is settled using the same options are standardised in terms of :

conditions as for the underlying futures contracts. There are two

types of Exchange traded options on futures contracts: ❑ Underlying instrument and its trading amount

❑ Options on short-term Interest Rate futures contracts which ❑ Strike prices – in general exchanges try to have a range of

are cash settled if the option expires In-The-Money, At-The-Money and Out-of-The-Money strike

prices

❑ Options on long-term Interest Rate futures contracts which

are settled on Government bonds if the option expires ❑ Expiry dates

OTC Interest Rate options are used to control maximum ❑ Style – most exchange options are American

and minimum levels of borrowing and lending money

and are in effect options on Forward Rate Agreements MMI:IRG ❑ Premium quotations – these are percentage rates expressed

(FRAs). These options are described in greater detail in in decimal points for short-term contracts and as fractions

the section Options on FRAs – Interest Rate Guarantees. for long-term contracts

The diagram below indicates the availability of Interest Rate options. ❑ Margin payments are required to be paid to the Clearing

house

Interest Rate options In effect Interest Rate options on futures give the buyer or the seller

of the instrument the right to lend or borrow money. The following

chart indicates these rights from the buyer’s perspective – sellers

would have the opposite views.

Option Buyer Used to hedge

money at a

IRGs Short-term Long-term predetermined rate

Caps Settled for Settled for Put Gives right to borrow Rising interest rates

Floors cash Government money at a

bonds predetermined rate

116

Options on Interest Rate futures

Exchange contracts $ $

Options on both short-term and long-term Interest Rates are

available on a number of exchanges worldwide. The charts below Derivative

indicate a selection of the Interest Rate options on futures available.

LIFFE CME

Short-term Cash settled based on LIBOR Unit of trading Short-term Cash settled based on interbank rates Unit of trading

Three month Sterling (Short Sterling) GBP 500,000 Three month Eurodollar USD 1,000,000

Three month Eurodeutschemark (Euromark) DEM 1,000,000 One month LIBOR USD 3,000,000

Three month Eurolira ITL 1,000,000,000 One year T-Bills USD 500,000

Three month Euroswiss Franc (Euroswiss) CHF 1,000,000 Three month Euromark DEM 1,000,000

13-week US T-Bills USD 1,000,000

Government Bonds range years coupon, %

Long-term Nominal value Maturity Notional

Government Bonds range years coupon, %

Long Gilt (UK) GBP 50,000 10 - 15 9

German – Bund DEM 250,000 8.5 - 10 6 US T-Bonds USD 100,000 At least 15 8

Italian – BTP ITL 200,000,000 8 - 10.5 12 10 year US T-Notes USD 100,000 6.5 - 10 8

117

Options on Interest Rate futures

Options contracts details vary from type to type and from exchange

Derivative to exchange but the following examples taken from a LIFFE contract

and a CBOT contract are typical specifications.

Option on 3 month Sterling Interest Rate future Options on US Treasury Bond futures

Underlying contract One 3-month Sterling futures This is the standard contract size. Underlying contract One US Treasury Bond

contract – GBP 500,000 futures contract – $100,000

Quotes as either decimals or

Premium quotations Multiples of 0.01 ( 0.01%) fractions of rate Premium quotations Multiples of 1/64th of a point

Minimum Price 0.01 This is the smallest amount a Minimum Price 1/64

Fluctuation (Tick) (£12.50) contract can change value and Fluctuation (Tick) ( $15.625)

the ‘tick’ size.

Contract expiry March, June, September, Contract expiry March, June, September,

December Option contracts are referred to December

by the trading cycle of the futures

Exercise procedure American contract months. Exercise procedure American

exercised on or before expiry

date – American

118

Options on Interest Rate futures

■ Who uses Options on Interest Rate futures? If the treasurer had been in the position of a lender of funds and $ $

wanted to guarantee a minimum rate of interest on a deposit then

Buyers/sellers she would have used a put option. Derivative

Interest Rate options are used to hedge interest rate

exposure. The chart below indicates the buyers and Originally these types of option were written on real loans/deposits.

sellers of options and the rights to the respective Now they are settled on a cash compensation basis where the writer

underlying instruments if the options are exercised. or the holder, pays or receives the difference between the interest

rate on the underlying loan or deposit and the strike price of the

Option on futures Buyer/holder has On exercise Seller/ option. This means that options are traded independently and

contract right to: writer has obligation to: separately from the actual instruments.

Call Buy a futures contract Sell a futures contract Another way of looking at the use of Interest Rate options on futures

– – is summarised in the chart below:

Go long Go short

Market player who is a ... wants to...

Put Sell a futures contract Buy a futures contract

– – Money Market buyer of a Call guarantee minimum

Go short Go long fund manager deposit rates on future

deposits – a floor

Example

Corporate seller of a Put guarantee maximum

A Corporate Treasurer has a loan of $1 million with an interest rate

Treasurer borrowing rates on

of LIBOR, reset every 3 months. The current interest rate is 6.25%

future loans – a cap

but she feels that interest rates may rise. If she buys an Interest Rate

futures contract she effectively locks in her borrowing at the futures

contract rate and cannot take advantage of any interest rate falls.

Using the futures contract limits her losses but does not give her the

opportunity to profit. The solution is to use an option contract. In

this case she buys an interest rate call option with a strike price of

93.75 (6.25%) and a maturity to suit the roll-over date of the loan.

On maturity:

and allows the option to right to buy the option and pays

expire. the strike price of 93.75.

119

Options on Interest Rate futures

$ $ ■ Options on Interest Rate futures in the market place The information in the chart allows you to calculate the premium

cost of any option which is quoted.

Derivative This section deals with typical contract quotations and how

7 8 9 options are traded and premiums are calculated for Interest Example

4 5 6

1 2 3

Rate options which are derived from exchange traded futures Suppose you need to hedge a 6.25% interest rate on a 3-month

0

contracts based on: Eurodollar investment starting at the end of September. To hedge

the return on this investment you decide to use an option. You will

❑ Short-term interest rate instruments need to buy a Sep Call option but what strike price should you use?

❑ Long-term interest rate instruments The strike price for 6.25% is simply determined by subtracting 6.25

from 100. So the strike price is 100 – 6.25 = 93.75. Buying a Sep Call

Typical exchange contract quotations

option gives you the right, but not obligation, to buy a 3-month

Interest Rate option quotations are available from the financial press

Eurodollars futures contract on or before the September expiry date

such as the Financial Times and The Wall Street Journal and from

at an interest rate of 6.25%. But how much will you have to pay the

products such as Reuters Money 3000. The information appears in a

seller for this right?

similar style to those in the following examples.

Contract premium price

Financial press – Option on short-term Interest Rate futures contract

This is calculated using the following simple equation:

3-month Eurodollar = 0.01: Tick price = $25

contract

Eurodollar (CME) $ million; pts of 100% From the chart opposite the premium for a Sep9375 Call is 0.11. So

the premium cost is therefore:

Strike Calls Puts

price Mar Jun Sep Mar Jun Sep Expiry

= 0.11 (quote) x $25 (tick size)

dates of

futures 0.01 (tick size)

9325 0.50 0.30 0.29 0.00 0.15 0.42

9350 0.26 0.16 0.18 0.01 0.26 0.55 contracts

= 11 x $25 = $275.00

9375 0.05 0.07 0.11 0.05 0.42 0.73

prices are calculated by deducting the

quoted strike price from 100.

rate interest of 100 – 93.50 = 6.50%

120

Options on Interest Rate futures

Reuters Money 3000 – Options on short-term Interest Rate futures Financial press – Option on long-term Interest Rate futures contract $ $

Options on short-term Interest Rate futures can be found using the

IR Options folder, Futures Option Watch page IFOW for any Minimum price movement Derivative

US Treasury Bond future = 1/64: Tick price = $15.625

particular currency. The following is a section of a screen dump

showing Bid/Ask prices for the IMM 3-month Eurodollars futures

Call and Put options on the Index and Option Market (IOM) of the T-Bonds (CBOT) $ 100,000; 64ths of 100%

CME.

Strike Calls Puts

price Apr Jun Sep Apr Jun Sep Expiry

dates of

110 1-23 2-15 2-61 0-61 1-53 2-63 futures

111 0-55 - - 1-29 - - contracts

112 0-32 1-21 2-04 2-06 2-58 4-03

futures contract. This means that the a premium of

underlying T-Bond futures contract has a

43/64%

market value of $112,000

This is calculated as before. The premium cost for a Sep110 Put

which gives you the right to sell US Treasury Bond futures at the

strike price at any time to expiry is quoted at 263/64% in the chart

above. So the premium cost is therefore:

63

= 2 /64 x $15.625

1

/64

121

Options on Interest Rate futures

$ $ Reuters Money 3000 – Options on futures contracts How an Exchange traded Interest Rate option contract works

Options on long-term Interest Rate futures can be found also using Exchange traded Interest Rate options on futures are traded in a

Derivative the IFOW page for any particular currency. The following is a section similar way to exchange traded futures contracts in that margin

of a screen dump showing Bid/Ask prices for US T-Bond futures Call payments are required by the Clearing house. Initial margin is

and Put options on CBOT. payable by the appropriate party at the time of the trade.

is open and the resulting profits/losses are credited/debited to both

counterparty margin accounts.

,,

,,

,,

▼

Profits and Profits and

losses losses

▼

Clearing house

Buyer Seller

to expire, then expiry takes place on the same date as the underlying

futures contract. Also, as for the underlying futures contract, the

option is cash settled.

between the Exchange Delivery Settlement Price (EDSP) and the

strike price using the following equation:

122

Options on Interest Rate futures

A buyer of a LIFFE Short sterling Jun9300 Call allows the option to There are many strategies available in the options markets – some are

expire. This gives the buyer the right to receive interest at a rate of quite complex and have colourful names. Derivative

7.00% on the underlying futures contract. At the time of expiry the

EDSP is 9375 – an interest rate of 6.25%. Therefore the buyer The various strategies are usually represented diagrammatically as

receives a cash settlement: break-even graphs which show the potential for making a profit. The

diagrams use the break-even point as the basis for the diagram where

= (9375 – 9300) x £12.50

Break-even point = Strike price ± premium

= 75 x £12.50 = £937.50

The option premium was 0.30. This means that the premium cost The most basic buy /sell strategies for puts and calls are

was: illustrated using profit/loss charts in the following Derivatives

examples. You may find it useful to refer to option Section 3

= 30 x £12.50 = £375.00 strategies in general by referring to the Introduction to

derivatives workbook.

The net profit on the option is therefore £937.50 – 375.00 = £562.50.

Depending on whether the market player is a buyer or seller of a call

A simpler way of calculating the option profit is to use the following or put, gains or losses either have ceiling values or are limitless.

equation:

= 45 x £12.50 = £562.50

123

Options on Interest Rate futures

$ $ Buying a Call option – Long Call At expiry the profit/loss chart for the Long Call looks like this:

A fund manager has investments that mature in the future which he

Derivative will need to re-invest. The manager believes that interest rates will be

lower in the future and needs to protect his position. He buys Call

options on futures contracts that correspond to the fund Strike price = 93.00

investments. In other words he buys the right, but not obligation to Profit

make a future Money Market loan at a pre-determined interest rate.

If interest rates decline, then gains made on the options should help

offset the lower interest rate return. However, if interest rates rise,

then the fund manager can still take advantage of the higher rates Futures

and not exercise the options. 9225 9250 9275 9300 9325 price

Break-even point

options on a LIFFE 3-month Short sterling futures contract having a

= 93.00 + 0.04 = 93.04

strike price corresponding to an interest rate of 7.00%. He buys Loss

9300Sept Calls with a premium of 0.04.

Maximum loss = premium price

Remember that short-term futures contracts have strike prices = 0.04

determined from 100 – interest rate. So as strike price increase, the

interest rate falls.

(interest rates fall) and are unlimited

falls ( interest rates rise)

premium price

124

Options on Interest Rate futures

Buying a Put option – Long Put At expiry the profit/loss chart for the Long Put looks like this: $ $

The Treasurer of XYZ Corporation may or may not need to borrow

funds at a specified time in the future depending on the outcome of Derivative

a tender bid but he is worried that interest rates will rise. By buying Strike price = 93.00

Put options the Treasurer can lock in the maximum interest cost in

the event he needs to borrow. In other words the Treasurer buys the Profit

right to sell the underlying futures contract and therefore he is

entitled to borrow money at a future date at a fixed interest rate.

This protects him against a future rise in interest rates.

If interest rates rise, then the option can be exercised at a profit to Futures

offset the increased borrowing costs. If interest rates fall, then the 9275 9300 9325 9350 9375 price

Treasurer can take advantage of lower interest rates and not exercise

the option. If the tender is unsuccessful and no borrowing is

required, then the Treasurer can exercise or sell the option for

whatever value it has but his loss is limited to the option premium Loss

cost.

Maximum loss = premium price

The Treasurer decides to buy Put options on a LIFFE 3-month Short Break-even point = 0.21

sterling futures contract having a strike price corresponding to an = 93.00 – 0.21 = 92.79

interest rate of 7.00%. He buys 9300Sept Puts with a premium of

0.21.

(interest rates rise)

(interest rates rise) and is unlimited

125

Options on Interest Rate futures

$ $ Selling a Call option – Short Call Selling a Put option – Short Put

A fund manager expects interest rates to remain relatively steady for This is more or less the same scenario as for a Short Call except that

Derivative the next few months or possibly fall slightly. The manager would like this time the fund manager believes that interest rates will remain

to earn extra income on his portfolio and decides to sell Call steady or rise slightly.

options on long-term futures contracts.

At expiry the profit/loss chart for the Short Call looks like this:

If interest rates remain steady and the options are not exercised,

then they expire worthless and the fund manager has earned extra

Maximum profit = premium received

income equal to the value of the premium received.

The risk the fund manager takes is that prices on the underlying Profit

bond contracts rise. If the options are exercised then he has the

obligation to deliver the bonds.

appropriate if the Treasurer firmly believes the underlying bond 100 111 112 113 114 price

prices are unlikely to rise. By writing Out-of-The-Money Calls, less

premium is received but the options are less likely to be exercised.

At expiry the profit/loss chart for the Short Call looks like this:

Loss

If bond prices decrease

Maximum profit = premium received then the option may be

exercised

Profit

Futures

100 111 112 113 114 price

Loss

If bond prices increase

then the option may be

exercised

126

Options on Interest Rate futures

Derivative

short and long-term futures contracts. On expiry options

on short-term futures are cash settled, options on long-

term futures are settled by physical delivery of the bonds.

sell the underlying futures contract if the option is

exercised

sell/buy the underlying futures contract if the option is

exercised

short-term underlying futures and fractional percentage

values for long-term underlying contracts

127

Options on Interest Rate futures

RT may help your understanding of options on Interest

Rate futures and how they are used.

Speed Guide type in OPS/IR1 and press Enter.

From this page there are a limited number of

contracts to view – mainly those from CBOE and

EOE. Double-click in a field of interest – the screen here shows

the CBOE 10 Year Treasury Yield Calls and Puts for a number of

strike prices for different months.

128

Options on Interest Rate futures

$ $

3000 To see premium prices for Interest Rate options Derivative

select the FuOpt Watch page, IFOW, for IR Options

for any particular currency you need. In the screens

shown here LIFFE 3-month Short sterling and IOM

3-month Eurodollar Call and Put premiums are displayed for

various strike prices for the underlying September and December

futures contracts respectively. If it is more convenient, you can

view the information by name rather than the contract RIC.

129

Options on Interest Rate futures

$ $

Derivative 3000 You may also find it useful to use the Interest Rate

History page, IOIR, and FuOpt Model, IFOM page.

The IOIR page displays the deposit rates you select

for up to three currencies simultaneously – you can

choose any combination of currencies and deposit periods as

required from the drop down menus. The IFOM page can be

useful if you need to know the option delta values and whether

an option premium is In-The-Money, At-The-Money or Out-of-

The-Money.

Using this IFOM page you can see that the Call for this 9275 strike

for the September contract which has an underlying value of 92.85

has a delta value of 0.6281 which means it is ITM

Using this IFOM page you can see that the Call for this 9300 strike

for the September contract which has an underlying value of 92.85

has a delta value of 0.2965 which means it is OTM

130

Options on Interest Rate futures

■ End check 3. What is the maximum interest rate that the buyer of a 9375Sept $ $

Put is guaranteed on a future loan?

Derivative

Using the chart of premium prices for options on Eurodollars answer Answer:

the following:

Eurodollar (CME) $ million; pts of 100%

price Mar Jun Sep Mar Jun Sep

9325 0.50 0.30 0.29 0.00 0.15 0.42 4. What is the premium cost for a 9350Jun Call?

9350 0.26 0.16 0.18 0.01 0.26 0.55

9375 0.05 0.07 0.11 0.05 0.42 0.73 Answer:

Tick size for this contract is 0.01 and the tick value is $25

1. Why are the Calls with higher strikes cheaper than those with

lower strikes, and why are the Puts with higher strikes more

expensive than those with lower strikes?

Answer:

5. You buy an option on LIFFE which can exercised at any time.

Which of the following describes this type of option?

❑ a) European

❑ b) American

❑ c) Asian

❑ d) Average

expiry?

Answer:

131

Options on Interest Rate futures

Derivative ✔ or ✖

1. The higher the strike the lower the Call prices ❑

because they are further Out-of-The -Money.

The higher the Put prices because they are further

In-The-Money.

= 93.25 – 0.15

= 93.10

borrower is given by 100 – (Strike – Premium)

= 100 – 93.02

= 6.98%

0.01 and the tick value is $25

= 16 x 25

= $400

5. b) ❑

How well did you score? You should have managed to get most of

these questions correct.

132

Options on FRAs – Interest Rate Guarantees (IRGs)

■ What is it? Interest Rate caps and floors thus provide insurance against interest $ $

rate movements over a consecutive number of roll-over loan dates

An Interest Rate Guarantee is a financial derivative which which are subject to floating rate payments. They can be used by Derivative

can be considered to be an option on a series of Forward borrowers and lenders for the protection they need.

Rate Agreements (FRAs).

Caps and floors are a series of OTC options which coincide with the

An Interest Rate Cap is an agreement between roll-over dates on floating rate loans which can be considered to be a

counterparties in which one party agrees to make series of Forward Rate Agreements (FRAs) with the same strike prices

payments to the other if floating rates exceed an agreed for the loan maturity period.

strike rate.

series of

▼

An Interest Rate Floor is an agreement between FRA IRGs

options

counterparties in which one party agrees to make

payments to the other if floating rates fall below an

agreed strike rate. An OTC call is an option to buy a FRA and is known as a borrower’s

option.

yourself about derivatives in general, then you may find it Derivatives A borrower has a loan which has floating rate LIBOR interest rate

useful to refer to the Introduction to Derivatives workbook, Section 3 payments. The borrower fears that interest rates could rise. The

Section 3 at this stage. borrower could buy a FRA which would fix payments but what

happens if interest rates fall? The borrower would not be able to take

Caps and floors are OTC options which in effect ‘guarantee’ buyers a advantage of the fall. If the borrower buys an OTC call option on

hedge on rising and falling interest rates respectively. Hence these LIBOR to match the roll-over dates of the loan, then the borrower

options are also known as Interest Rate Guarantees (IRGs). has the right to buy a FRA at each roll-over date.

Caps and floors are based on a floating rate such as LIBOR, Prime If floating rates rise, then the option is exercised and the borrower

rates and CPs and are sold for a one-off premium. The most receives a cash settlement. If floating rates fall, then the option is not

commonly quoted caps and floors use 3-month or 6-month LIBOR. exercised but the borrower can take advantage of lower cash market

rates. The borrower pays a premium for this insurance protection to

Exercise for both caps and floors occurs automatically on set dates the option writer or seller.

during the maturity period of the option if this is to the holder’s

advantage.

133

Options on FRAs – Interest Rate Guarantees (IRGs)

option. A cap is a series of options that gives the buyer the right to pay the

Derivative lower of the market rate or strike rate.

Example

An investor is due to receive floating rate LIBOR payments 3 monthly A cap offers the buyer the protection against rising interest rates by

for the next 15 months. The investor fears that interest rates will fall setting a maximum limit for payments whilst the buyer retains the

and in this case buys an OTC put option on LIBOR to match the roll- right to benefit from falling prices. The use of Interest Rate Swaps or

over dates of the payments. The investor now has the right to sell a Interest Rate futures locks in borrowing rates to a fixed rate for the

FRA at each roll-over date. whole transaction.

If interest rates fall, then the option is exercised and the investor The cost to the buyer is limited to the premium which is paid to the

receives a cash settlement from the option seller. If floating rates rise, seller – the buyer has no further obligations.

then the option is not exercised but the investor can take advantage

of the higher cash market rates. Most caps are based on LIBOR and the following example illustrates

how a cap works.

Some of the advantages offered by these OTC options include:

Example

❑ Flexibility covering a wide range of maturity periods, A Corporate Treasurer has borrowed $10 million on a floating rate

amounts and strike prices basis for 15 months using 3-month LIBOR roll-over dates. The

Treasurer believes that interest rates will rise and wants to cap the

❑ The one-off cost of the option premium is known at the loan at 6.00%. The Treasurer buys a cap option and pays a premium

beginning of the transaction to the seller.

❑ A single agreement may cover a maturity period of several The Treasurer’s loan can therefore be considered to be a series of

years and is therefore less costly in fees FRAs starting in 3 months from the first loan period – 3 x 6, 6 x 9, 9 x

12, 12 x 15.

If on any roll over date LIBOR exceeds the cap rate agreed, the seller

of the option has to pay the Treasurer the difference between LIBOR

and the cap rate as a cash settlement.

and the various payments made to the buyer of the cap.

134

Options on FRAs – Interest Rate Guarantees (IRGs)

cap rate is paid to the buyer These are the opposite type of options to caps in as much as they

provide the buyer with a guaranteed minimum interest rate. They can Derivative

be considered to be a series of put options on FRAs all with the same

Cap rate

strike price.

LIBOR

setting a minimum limit for the rate of return whilst the buyer retains

the right to benefit from rising rates.

A Corporate Treasurer has invested $10 million in FRNs with an

interest rate linked to 3-month LIBOR. The Treasurer is concerned

Maturity that interest rates might fall and needs to protect against interest

rates below 6.00%. The Treasurer buys a 6.00% floor for 15 months

3x6 6x9 9 x 12 12 x 15 based on 3-month LIBOR and pays a premium to the seller.

FRA FRA FRA FRA

The chart below indicates the LIBOR fluctuations over 15 months

If LIBOR is above the cap rate then the Corporate Treasurer can take and the various payments made to the buyer of the floor.

out a loan at LIBOR knowing that the extra cost above the agreed cap

rate is guaranteed by the option. In other words the Corporate Seller has to pay the buyer the

Treasurer’s interest payments have been limited to the cap level set. difference between LIBOR and

floor rate

If LIBOR is below the cap rate, then the seller makes no payments to

Floor rate

the buyer. However, the Corporate Treasurer now pays interest at a

lower rate than the cap level which is within the interest rate

maximum set.

LIBOR

The overall effect is that the Corporate Treasurer protects his interest

rate payments from rises above a cap level whilst simultaneously

taking advantage of any falls in interest rates. No payment No payment

Maturity

3x6 6x9 9 x 12 12 x 15

FRA FRA FRA FRA

135

Options on FRAs – Interest Rate Guarantees (IRGs)

$ $ If the interest rate falls below the floor rate agreed, then the buyer

receives the difference between LIBOR and the floor rate as a cash Summary

Derivative payment.

Caps Floors

If the interest rate is above the floor level, then the buyer receives no

• Protect buyers from rising • Protect buyers from falling

payment. The option is not exercised and the Treasurer receives a

interest rates above an interest rates below an

higher rate of return from the underlying.

agreed level whilst agreed level whilst

allowing the opportunity allowing the opportunity

The overall effect is that the Corporate Treasurer protects the rate of

to benefit from any fall in to benefit from any rise in

return on the investment from falls below a floor level whilst

rates rates

simultaneously taking advantage of any rises in interest rates.

• Establish a maximum • Establish a minimum rate

Collars borrowing cost for buyers of return for buyers over

The collar is the natural combination of a cap and a floor where a over the maturity period the maturity period of the

market player wants to restrict interest rates between guaranteed of the option option

maximum and minimum limits and reduce overall premium costs.

• Do not affect the • Do not affect the

This can be achieved by buying a cap to place a maximum interest underlying loan underlying deposit or

rate limit whilst simultaneously selling a floor to earn premium investment

income or vice versa.

• Provide a flexible • Provide a flexible

alternative to fixed rate alternative to fixed rate

borrowing lending

on FRAs all with the same on FRAs all with the same

strike price strike price

136

Options on FRAs – Interest Rate Guarantees (IRGs)

Buyers/sellers of caps and floors Derivative

The various buyers and sellers of caps and floors are

summarised in the charts below:

Caps Floors

floating rate debt who fixed rate debt who floating rate debt who floating rate debt who

anticipate rising interest anticipate interest rates anticipate falling interest take the view that interest

rates will fall or remain stable rates rates will not fall below a

minimum value

• Investors with fixed rate • Financial institutions who • Investors wishing to set a

assets who want to protect have issued capped minimum return for

the net interest margins floating rate liabilities sell interest rates on their

on their investments a cap to hedge the value investments

of the liability

• Organisations wanting to • Organisations who take

• Organisations wanting to • Organisations who take hedge the risk of falling the risk that interest rates

hedge the risk of rising the risk that interest rates interest rates whilst at the will fall and have to make

interest rates whilst at the will rise and have to make same time taking a payment to the buyer.

same time taking a payment to the buyer. advantage of rises in This risk is taken in

advantage of any falls in This risk is taken in interest rates. The cost of return for a premium

interest rates. The cost of return for a premium the option is limited to payment.

the option is limited to payment. the premium payment.

the premium payment.

137

Options on FRAs – Interest Rate Guarantees (IRGs)

In this case a market player has the view that market rates will rise so Example

Derivative a cap is required. However buying a cap requires a premium In a similar way to the previous example a Corporate Treasurer

payment. By selling a floor, premium is received which the market wishes to hedge an investment by setting the minimum rate of return

player uses to offset the cap premium. The market player’s view is he expects. This is therefore the Treasurer’s floor. At the same time

that interest rates will not fall and therefore the floor will not be the Treasurer sells a cap which will earn premium income. If the

exercised – this is a risk. floor is bought at 5.0% and the cap sold at 7.0%, then the collar is

indicated in the chart below.

Example

A Corporate Treasurer borrowing money decides to limit borrowing

costs to 6.0% because the current interest rates are only slightly Seller of cap pays the buyer the

higher than this. This is therefore the Treasurer’s cap. At the same difference between LIBOR and

time the Treasurer sells a floor at 4.0% thus placing a collar on cap rate

interest rate payments and earns premium income. The collar is Cap rate 7.0%

indicated in the chart below.

LIBOR

Collar – margin 2.0%

Buyer of cap receives the

difference between LIBOR and

cap rate

Cap rate 6.0%

Floor rate 5.0%

Buyer of floor receives the

LIBOR

floor rate Maturity

Seller of floor pays the buyer Floor rate 4.0%

from the floor option. If LIBOR rises above 7.0% then the Treasurer

the difference between

will have to make a payment to the cap buyer. However, the

LIBOR and floor rate

Maturity Treasurer’s view is that interest rates will not rise and that the cap

option will not be exercised.

The option guarantees that if LIBOR rises above 6.0%, then the For collars in general, because the option involves a simultaneous

Treasurer receives payment from the seller. If LIBOR falls below purchase and sale, the premium charges involved are partially or fully

4.0%, then the Treasurer will have to make a payment to the floor eliminated. One premium is received whilst the other is paid.

buyer.

138

Options on FRAs – Interest Rate Guarantees (IRGs)

For the cap bought by the Treasurer in the previous example, on the

This section deals with premiums and OTC caps and floors first LIBOR roll-over date, the floating rate is 7.00%. Derivative

7 8 9 quotations with particular reference to the importance of

4 5 6

1 2 3

implied volatilities in pricing these options. The Treasurer therefore receives a cash payment which equals:

0

Premium payments and settlements 100 360

The purchase of caps and floors involve the payments of premiums.

Usually market-players requiring quotations from banks for IRGs are

quoted premiums in terms of basis points.

Typical OTC contract quotations

Interbank quotations for IRGs are not made using basis points.

The value of the premium is then calculated by multiplying the basis

Instead professional options market-makers use complex analytical

points by the notional principal amount of the loan.

models to calculate option prices based on the following factors.

Example

1. Strike price

A Corporate Treasurer wishes to buy a 3 year 6.5% USD 3-month

LIBOR cap for a $20 million notional principal amount. The

2. Time to expiry

premium is quoted at 115 basis points – one basis point is one

hundredth of a percentage point.

3. Interest rates

The cash premium required to be paid by the Treasurer to the cap

4. Volatility

seller is:

Of the factors, volatility is the only one for which the market-maker

20,000,000 x 0.0115 = $230,000

does not have a precise value. But what is this volatility? In the case of

Interest Rate options, the volatility is a measure of the rate of

Any cash settlements due on the roll-over LIBOR dates are calculated

fluctuation in interest rates. How is a volatility value derived?

using the simple equation:

The volatility implied in an option price is calculated using statistical

Notional standard deviations of historic underlying price movements over a

(LIBOR% – cap/floor rate %) x principal x Actual no. of days given period, expressed as a percentage per annum.

100 amount 360

139

Options on FRAs – Interest Rate Guarantees (IRGs)

$ $ The implied volatilities are therefore forecasts of the proportional Cap and floor volatilities are available from individual market-makers

percentage range, up or down, within which the underlying interest on the RT.

Derivative rate is expected to finish at the expiry date of the option.

The confidence level of the various currency Caps and Floors double-click in a

volatility forecast being field of interest, for example, <GBPCAP=ICAP>.

correct for one standard You will now see the cap Bid and Ask volatility prices

deviation either side of the as percentages from International Brokers Ltd. If you need to see

mean in a statistical normal more information about the contributor just double-click on the

distribution is 68%. For two figure to display a page of information. Why not try? You should

68% standard deviations the see screens similar to those shown here.

confidence level of

forecasting the correct

volatility range is 95%.

95%

Example

DEM one year forward interest rates are 4.00% and the one year

volatility is forecast at 10%. So the standard deviation is ±0.04 and two

standard deviations is ±0.08.

The price ranges for the two confidence levels are shown in the table

below:

not the implied forward interest rates.

140

Options on FRAs – Interest Rate Guarantees (IRGs)

A market-maker might quote 11.50 – 13.50 % volatility for a 3 month for options based on the movement of four of the pricing factors. You

LIBOR GBP At-The-Money Cap. may find it useful in looking at historic option prices. Derivative

This two-way Bid/Ask price quotation means:

➞

➞

Strike price

On Bid side The market-maker will buy Puts or Calls at 11.50%

➞

➞ ➞ ➞

Underlying forward price

per annum

➞ ➞

Expiry date

On Ask side The market-maker will sell Puts or Calls at 13.50%

per annum Volatility

spread in the option premium.

The prices are for At-The-Money options – the strike price is at the

current underlying forward rate. Why not test the summary above by using the RT?

Once the counterparties want to trade, all the factors, including the

volatilities, are entered into each side’s pricing models to calculate

the premium to be paid. If both sides agree then the transaction

proceeds.

Strike price

▼

Expiry date

▼

Premium

▼

Interest rate

▼

Volatility

▼

Pricing model

Each

counterparty

141

Options on FRAs – Interest Rate Guarantees (IRGs)

Derivative

be an option on a series of Forward Rate Agreements

(FRAs)

interest rate payments and floors which fix a minimum

rate of return

confines interest rate commitments between

predetermined maximum and minimum limits

implied volatilities for caps and floors

142

Options on FRAs – Interest Rate Guarantees (IRGs)

The following exercises using Reuters products and the Derivative

RT may help your understanding of IRGs and how they

are used.

implied volatilities type in VOL/1 and press Enter

to see the Implied Volatilities Speed Guide. In the

Interest Rate Volatilities field double-click in the

<IRGS/1> field. Now double-click in the field for the cap or floor

for the currency you require, from the contributor you require.

Try double-clicking in <GBPCAP=ICAP> to see the At-The-Money

volatilities for GBP from Intercapital Brokers Ltd.

To see more

information from the

contributor, double-

click on the quote

143

Options on FRAs – Interest Rate Guarantees (IRGs)

$ $ Your notes

information use F12 to page forward from IRGS/1.

Double-click in the <USDIRG=TKFX> field. You

should now see IRG caps and floors volatility quotes

together with other options and swaps quotes from Tokyo Forex.

144

Options on FRAs – Interest Rate Guarantees (IRGs)

■ End check $ $

Derivative

1. Your company obtained a 3-year rollover credit for $10 million on 2. Your organisation wishes to speculate by placing $10 million in

the basis of 6-month LIBOR from XYZ Bank one year ago. As FRNs for 2 years based on 6-month LIBOR. Although you are

Treasurer you are of the opinion that interest rates are likely to convinced that interest rates will rise from their current rate of

rise in the future. Therefore you want to hedge against an interest 5.00% and you would like to benefit from any rise, you would still

rise of 0.25% above the prevailing interest level of 5.00%. like to protect yourself against an adverse movement of 1% in

interest rates.

a) Do you buy a Cap or Floor?

Answer: a) Do you buy a Cap or Floor?

Answer:

b) Note the terms of the contract here:

Underlying index

Term Underlying index

Reset period Term

Strike Reset period

Notional amount Strike

Notional amount

c) If the premium costs 120 basis points, how much does the

option cost you? c) If the premium costs 50 basis points, how much does the

Answer: option cost you?

Answer:

exercise the option? Calculate any settlement amount involved. d) At the first settlement date 6-month LIBOR is at 3.50%. Do you

Answer: exercise the option? Calculate any settlement amount involved.

Answer:

exercise this option? e) At the third settlement date the rate is 6.00%. Do you

Answer: exercise this option?

Answer:

145

Options on FRAs – Interest Rate Guarantees (IRGs)

Derivative ✔ or ✖ ✔ or ✖

1. a) Buy a Cap ❑ 2. a) Buy a Floor ❑

b) ❑ b) ❑

Underlying index 6 month LIBOR Underlying index 6 month LIBOR

Term 2 years Term 2 years

Reset period Every 6 months Reset period Every 6 months

Strike 5.00 + 0.25 = 5.25 Strike 5.00 – 1.00 = 4.00

Notional amount $10,000,000 Notional amount $10,000,000

d) You exercise the option because you have to d) You exercise the option because you have to

borrow at 6.00%. ❑ lend at 3.50%. ❑

You receive compensation You receive compensation

= 10,000,000 x 0.75 x 180 = 10,000,000 x 0.50 x 180

100 x 360 100 x 360

= $37,500 ❑ = $25,000 ❑

e) You do not exercise the option because you can ❑ e) You do not exercise the option because you can ❑

borrow in the market at 5.00% lend in the market at 6.00%

How well did you score? You should have managed to get most of

these questions correct.

146

Options on IRSs – Swaptions

A Swaption is a financial derivative which grants the Banks and corporations Derivative

right, but not the obligation, to buy or sell an Interest Swaptions are used by the same market players who use

Rate Swap (IRS) on agreed terms of interest rate, IRSs – banks and multinational corporations.

maturity, fixed or floating rate payer, on or by an agreed

date. In return for this right the buyer of a swaption pays Swaptions are used increasingly by these market players for two main

the seller a premium. reasons:

If you need an overview of options and swaps derivatives

❑ To hedge exposure on interest rates

or you need to remind yourself about the types of Derivatives

derivatives available, then you may find it useful to refer Section 3/4

❑ To speculate in the swaps markets in order to make a profit

to the Introduction to Derivatives workbook, Sections 3 & 4 at

from offsetting fixed/floating rate transactions

this stage.

Swaptions offer similar benefits to corporations and banks as IRSs:

Swaptions are OTC contracts used by market players who seek the

advantages of an IRS but who also would like to benefit from any

❑ Counterparties are able to convert underlying interest rates

favourable interest rate movements.

from fixed to floating and vice versa over a long term

period

Swaptions, in common with other options, use the terms Call and

Put. However, their meanings are not quite as obvious as before. The

❑ Usually there are cost savings to both sides

meanings and uses of Swaptions Calls and Puts are described in the

chart below.

❑ IRSs provide access to markets not normally available to the

market players, for example, for reasons relating to credit

Call Swaption Put Swaption rating

Right-to-pay Swaption Right-to-receive Swaption

• The buyer has the right to • The buyer has the right to

pay the fixed side to and receive the fixed side

receive the floating side from and pay the floating

from the holder of the side to the holder of the

underlying IRS underlying IRS

against falling interest against rising interest

rates rates

147

Options on IRSs – Swaptions

Derivative This section deals with examples of how Call and Put

6.50% ,,

,,

6.00%

7 8

4 5

1 2

0

9

6

3

Swaptions work in the market place.

,,

LIBOR LIBOR

Call Swaptions

Example Swaption Swaption Underlying

XYZ Corporation decides to hedge against falling interest rates using seller buyer IRS

a 1 plus 4 Call Swaption. This means they buy an instrument which

grants the right to exercise the option in one year for an underlying 4

year Fixed pay/Floating receive (Current interest rate/LIBOR) IRS

for a Swaption rate of Fixed pay/Floating receive, 6.5%/LIBOR. Payments XYZ receive XYZ pay Net % position

This means that if XYZ, the Swaption holder, exercises their right in a Fixed 6.50% 6.00% + 0.50

year, they will pay the IRS holder a fixed rate and receive LIBOR, and

at the same time receive 6.5% fixed interest from the option seller Floating LIBOR LIBOR Cancel out

and pay LIBOR.

instrument must be less than the Swaption rates.

IRS is 6.0%/LIBOR. XYZ exercise their right on the Swaption and

make a net gain of 0.5% in interest rate payments, so hedging against

falling interest rates.

148

Options on IRSs – Swaptions

$ $

,,

Put Swaptions

,,

Example 6.50% 6.00%

XYZ Corporation needs to hedge against rising interest rates using a Derivative

1 plus 4 Put Swaption. This means they buy an instrument which

grants the right to exercise the option in one year for an underlying 4 ,,

year Fixed receive/Floating pay (Current interest rate/LIBOR) IRS

for a Swaption rate of Fixed receive/Floating pay, 6.5%/LIBOR. LIBOR LIBOR

This means that if XYZ, the Swaption holder, exercises their right in a Swaption Swaption Underlying

year, they will pay the IRS holder LIBOR and receive a fixed rate, and seller buyer IRS

at the same time receive LIBOR from the option seller and pay a

fixed rate of 6.5%.

To justify exercising the swaption, the interest rates of the underlying Payments XYZ receive XYZ pay Net % position

instrument must be greater than the Swaption rates.

Fixed 7.00% 6.00% + 0.50

At expiration the current rate for a 4 year Fixed receive/Floating pay

IRS is 7.0%/LIBOR. XYZ exercise their right on the Swaption and Floating LIBOR LIBOR Cancel out

make a net gain of 0.5% in interest rate payments, so hedging against

rising interest rates.

149

Options on IRSs – Swaptions

Derivative

but not obligation, to buy or sell an Interest Rate Swap at

agreed terms on or by an agreed date

swaption – gives the buyer the right to pay the fixed side/

receive the floating side from the holder of the

underlying IRS

receive swaption – gives the buyer the right to receive the

fixed side/pay the floating side from the holder of the

underlying IRS

150

Options on IRSs – Swaptions

The following exercises using Reuters products and the Derivative

RT may help your understanding of Swaptions and how

they are used.

SWAPTION/1 and press Enter. As with other OTC

option prices the Bid and Ask quotes from the

various contributors are as volatilities. If you double-

click in the <USDSTN=TXFX> field you will see Swaption

volatilities for the USD from the Tokyo Forex Co Ltd. If you

double-click in the <DEMSWPTNS=TTKL> field you will see the

volatilities from Tullets on DEM – these are mid-quotes.

151

Options on IRSs – Swaptions

$ $ Your notes

Derivative

152

What’s next?

You have now completed this Level 3 workbook which has Books What’s next?

been designed to give you a better understanding of the The Penguin International Dictionary of Finance

market and product information you may need for your Graham Bannock & William Manser, Penguin, 2nd Edition 1995

job. ISBN 0 14 051279 9

You may have all the knowledge and understanding you Investments

require or you may still need to study further workbooks William F. Sharpe, Gordon J. Alexander & Jeffrey V. Bailey, Prentice

and /or Web materials in the Know your Markets series. Hall, 5th Edition 1995

ISBN 0 13 18 3344 8

In particular you may need to study the Level 3 workbook:

Foreign Exchange Instruments – the companion workbook to A–Z of International Finance

this one. Stephen Mahony, FT/Pitman Publishing, 1997

ISBN 0 273 62552 7

The remaining workbooks in the Know your Markets package cover the

following markets at both Level 2 and Level 3: Financial Derivatives

David Winstone, Chapman & Hall, 1st Edition 1995

❑ Debt ISBN 0 412 62770 1

❑ Equities Booklets

Chicago Mercantile Exchange

❑ Commodities, Energy and Shipping • An Introduction to Futures and Options: Interest Rates

You may also find the Further resources useful for further reference. Swiss Bank Corporation

The order of the materials/information has no significance and • Financial Futures and Options

covers many of the sources used in the preparation of this workbook. • Options: The fundamentals

ISBN 0 9641112 0 9

If you have access to the Internet, then you may find the Web

addresses listed useful.

Chicago Board of Trade

• Financial Instruments Guide

The decision to study further workbooks or use the Web site is yours –

• An Introduction to Options on Financial Futures

Good luck! • Trading in Futures

• An Introduction

• Options: a guide to trading strategies

153

What’s next?

Further resources

What’s next? Reuters Money 3000 – Training Programme Futures - Hedging with Short-term Interest Rate Futures

1. Foreign Exchange & Money Markets • Item code: UKCA0349

2. Futures & Forward Rate Agreements

3. Bonds & Swaps FRAs - Fundamentals

4. Options • Item code: UKCA0306

FRAs - Applications

Intuition Plus: CAT

• Item code: UKCA0364

Call & Fixed Deposits - Fundamentals

• Item code: UKCA0290 Swaps - Interest Rate Swaps - Fundamentals

• Item code: UKCA0385

Fixed Deposits - Dealing

• Item code: UKCA0320 Swaps - Interest Rate Swaps - Applications

• Item code: UKCA0386

Treasury Bills - Fundamentals

• Item code: UKCA0291 Options - Fundamentals

• Item code: UKCA0308

Treasury Bills - Dealing

• Item code: UKCA0323 Options - Transactions

• Item code: UKCA0309

Certificates of Deposit - Fundamentals

• Item code: UKCA0292 Options - OTC Options - Fundamentals

• Item code: UKCA0403

Certificates of Deposit - Dealing

• Item code: UKCA0322 Repurchase Agreements - Fundamentals

• Item code: UKCA0314

Bills of Exchange - Fundamentals

• Item code: UKCA0293 Internet Web sites

Applied Derivatives Trading

Commercial Paper - Fundamentals • http://www.adtrading.com/

• Item code: UKCA0294 Have a look at the ADT Guide

Futures - Fundamentals Derivatives Research Unincorporated

• Item code: UKCA0301 • http://fbox.vt.edu:10021/business/finance/dmc/DRU/contents.html

A good collection of well explained articles

Futures - Hedging with Long-term Interest Rate Futures

• Item code: UKCA0348 AIB: Derivatives in plain English

• http://cgi-bin.iol.ie/aib/derivs-pe/

Futures - Hedging with Long-term Interest Rate Futures

• Item code: UKCA0348

154

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