Fixed Income Derivatives

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 Agenda
Fixed Income Derivatives
Swaps and FRA
Interest rate Futures and Options
Swap Market in India
Valuation of Swaps and FRA
Valuation of Futures and Options

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Swaps

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 Important Concepts

The concept of a swap

Different types of swaps, based on underlying
currency, interest rate, equity, or commodity
Pricing and valuation of swaps
Strategies using swaps

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 Swaps
Definition of a swap
Four types of swaps
Currency
Interest rate
Equity
Commodity
Characteristics of swaps
No cash up front
Notional principal
Settlement date, settlement period
Credit risk
Dealer market
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 Swaps

Swap - Arrangement by two counterparties to

exchange one stream of cash flows for
another.

LIBOR pmt Fixed rate pmt

Company Swap Dealer
LIBOR pmt

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 Swaps
First currency swap engineered in 1981 by Solomon
Brothers - between the World bank and IBM
Formation of ISDA in 1985
First commodity swap - oil swap engineered in 1986
by the Chase Manhattan Bank
Earlier currency swaps were one-off transactions -
necessitated an exactly off-setting counter-party
Increasing competition & homogeneity reduced
reliance on identifiable counter-party
Banks moved from pure brokering to accepting and
hedging financial risk on their own books

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 Motivation behind swaps
Liability swaps
to modify the profile of the firm’s liabilities
Asset swaps
to modify the profile of the firm’s assets
Commodity swaps
to hedge exposure to commodity price risk
based on a notional volume of a commodity
counter-party pays (receives) the market price per unit and receives
(pays) a fixed price per unit
Equity swaps
to hedge exposure to equity price risk
based on a market index or specified quantity of stock
counter-party pays (receives) the price returns in the equity index or
stock and receives (pays) a floating interest rate or price returns in
another index

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 Interest Rate Swaps
An agreement to exchange
floating rate payments for fixed rate payments (or
vice-versa)
at regular intervals over a pre-specified period
on a certain principal amount
Typical features
Payments are netted
Principal is not exchanged
Fixed and floating payments can be at different
payment frequency

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 Currency Swaps
an agreement to exchange
principal and interest payments in one currency
for principal and interest payments in another
currency
at regular intervals over a pre-specified period
on a certain principal amount in each currency.
On start date, both principal amounts are
equal to each other, when converted at the
spot exchange rate

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 Swaps-Applications
Swaps may be used to reduce cost of capital, access
new sources of funding, decouple funding,
duration & currency decisions and manage interest
rate / exchange rate risk
By careful tailoring and timing of swap transactions,
the nature of existing assets and liabilities can be
altered to optimize the risk adjusted cost of capital
Efficiency gains are created when risks are shifted to
those best able to bear them.

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 Example - Interest Rate Swaps
Available Loans Aaa Corp Baa Corp
Fixed Rate Loan 10% 11.5%
Variable Rate Loan 7.25% 7.50%

Swap
Aaa Corp Borrows $1mil fixed loan @ 10%
Baa Corp Borrows $1mil variable loan @ 7.5%
Aaa assumes pmts on variable loan @ 7.5%
Baa assumes pmts on fixed loan @ 10.75%

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 Example - Interest Rate Swaps
Available Loans Aaa Corp Baa Corp
Fixed Rate Loan 10% 11.5%
Variable Rate Loan 7.25% 7.50%

Aaa Benefit
Pay Fix @ -10.00%
Get Fix @ +10.75%
Pay Var @ - 7.50%
Var Sav @ + 7.25%
Net Benefit + .50%

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 Example - Interest Rate Swaps
Available Loans Aaa Corp Baa Corp
Fixed Rate Loan 10% 11.5%
Variable Rate Loan 7.25% 7.50%

Aaa Benefit Baa Benefit

Pay Fix @ -10.00% Pay Var @ - 7.50%
Get Fix @ +10.75% Get Var @ + 7.50%
Pay Var @ - 7.50% Pay Fix @ -10.75%
Var Sav @ + 7.25% Fix Sav @ +11.50%
Net Benefit + .50% Net Benefit + .75%

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 IRS - Cash Flow Example
A firm and Bank decide to enter into a fixed for floating, semi-
annual, five-year swap with swap rate c = 5.46% and notional
amount N = $200 million. The reference floating rate is the six
months LIBOR. In this swap contract, the firm agrees to pay
to the bank every six months (Ti = 0.5, 1, 1.5, ..., 5) the amount

Cash flow from firm to bank at Ti

= $200 m × 0.5 × 5.46% = $5.46 million

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 IRS - Cash Flow Example
In exchange, the bank pays the firm at every Ti an amount that
depends on the 6-month LIBOR r2 (Ti−1 ). It is crucial to note
that the reference rate for the payment at time Ti is not the
LIBOR at Ti , but the one determined six months before, at
Ti−1 = Ti − 0.5. This timing convention is important, as we
shall see, to obtain simple formulas to value swap contracts.

Cash flow from bank to firm at Ti

= $200 m × 0.5 × r2 (Ti−1)%

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 IRS - Cash Flow Example
Cash flows from the swap for 5 years. Note, there is a lag of one
period

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 FRAs
A FRA is a financial contract between two parties to
exchange interest payments based on a ‘notional
principal’ for a specified future period
on the settlement date, the contract rate is compared
to an agreed benchmark/reference rate as reset on
the fixing date
It is similar to an interest rate swap except that
in a typical IRS the benchmark rate can be reset
more than once, a FRA involves only one interest
rate setting
in a typical IRS the settlement happens at maturity
whereas in a FRA the net settlement amount is
discounted to the FRA start date
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 Example of FRA
A Corporate has an expected requirement for funds
after 3 months but is concerned that interest rates
will head higher from current levels.
The corporate can enter into a FRA to hedge or fix
her borrowing cost today for the loan to be raised
after 3 months.
The rate agreed via the FRA has to be compared to a
benchmark rate to determine the settlement
Therefore, today the Corporate buys a 3 X 6 FRA
from a Bank at say 10.75% with the benchmark
rate being the 3 month CP Issuance rate of the
Corporate 3 months later.

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 Terms for the FRA deal
The Corporate buys from the Bank a 3 X 6 FRA at 10.75%
against the 3 month CP issuance rate for the Corporate.
Notional principal Rs10 cr
the notation 3X6 refers to the start date and the maturity
date respectively for the FRA
Corporate pays 3X6 FRA rate (10.75%) for a 3 month
period starting 3 months from trade date
Corporate receives benchmark rate from the Bank for the
same period. The benchmark rate may be the 3 month
CP rate as decided upon, to be determined on the fixing
date
net amount is due on maturity (6 months from trade date)
but settlement is done on the start date (3 months from
trade date)
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 Terms of the FRA deal
Bank & Corporate enter into a 3 X 6 FRA.
Corporate pays FRA rate at 10.75%. Bank
pays benchmark rate based on 3 month CP
issuance rate of the above corporate 3 months
later. Additional details

Notional principal INR 10 Crore

FRA trade date 27th July 2022
FRA start/settlement date 27th October 2022
FRA maturity date 27th January 2023

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 Interest Rate Swaptions and
Forward Swaps
Definition of a swaption: an option to enter
into a swap at a fixed rate.
Payer swaption: an option to enter into a swap as
a fixed-rate payer
Receiver swaption: an option to enter into a swap
as a fixed-rate receiver
Forward Swaps
Definition: a forward contract to enter into a
swap; a forward swap commits the parties to
entering into a swap at a later date at a rate
agreed on today.
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Interest rate swaps in India

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 Swaps-Benchmark Rates
Swap Rate
Rate quoted by market participants for the specific
tenor of swap
Remains fixed for the tenor of the swap
Corresponds to floating benchmark
In India there are 2 swap rate curves corresponding to
following benchmark rates
MIBOR
MIFOR
MITOR and INBMK discontinued

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 MIBOR swap curve
Swap curve commonly knows as OIS curve
Floating Rate Benchmark
Call Money Rate (MIBOR)
Daily Reset
Tenor can vary from 1 month - 10 years
Most liquid segment is 1year
Net settlement at the termination of the swap

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 MITOR swap curve

Floating Rate Benchmark

Overnight rate based on Cash-TOM Rate
Synthetic Rupee interest rate derived from FX
market
Daily Reset
Tenor can vary from 1month-1 year
Most liquid segment is 1year

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 MIFOR Swap Curve
Floating rate benchmark
Synthetic Rupee interest rate derived from FX
market
MIFOR (Implied Rupee Rate) = LIBOR + Fwd
premium
6-month MIFOR and 3- month MIFOR
commonly serve as the floating leg benchmarks
Semi-annual resets
Settlement of net amount at each reset
Tenor can vary from 2-10 year

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 Basis Swaps

MIBOR-MIFOR swap
Pay MIBOR , Receive MIFOR
Daily Reset
Settlement at the termination of the swap
MIFOR tenor swap
Pay 6-month MIFOR, Receive 3-month MIFOR
Settlement after 6 months

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 Why different Swap Curves…..
Hedging exposure in different floating rates
Liabilities on the balance sheet
Funding their exposure by borrowing in floating
rate, for e.g. call rate
Trading based on views on different rates in
different curves
Illiquid term money market in India and
absence of benchmark rates like 3m/6m
LIBOR in India

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Pricing and valuation

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 General principle of valuation
Discount the future cash flows using “relevant yield” curve
A method of projecting future cash flows
Deciding about the discounting curve
Swaps involve floating rates – do we need to project the future
resets to value swaps?
Depends upon the “discounting curve”
If discounting curve is same as the swap curve then floating
leg will value to par on reset date
Hence need to know the current floating rate till next reset
What if the discounting curve is different from swap curve
Need to project the future floating rates
Calculate zero rates using swap curve
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 Valuation and hedging
Swaps can be hedged using cash market instruments
Example - Pay fixed OIS can be hedged by buying 1
year AAA rated paper and funding the position
through call
Hedging activity ensures that there is no-arbitrage in
the market
Valuation of the swap is nothing but pricing of the
hedges
Valuations can differ if there are market arbitrages
and different players use different instruments to
hedge

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Pricing and Valuation of Interest
Rate Swaps
How is the fixed rate determined?
A digression on floating-rate securities. The price
of a LIBOR zero coupon bond for maturity of ti
days is
1
B0 (t i ) =
1 + L 0 (t i )(ti /360)
Starting at the maturity date and working back,
we see that the price is par on each coupon
date.

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Pricing and Valuation of Interest
Rate Swaps (continued)
By adding the notional principals at the end, we
can separate the cash flow streams of an interest
rate swap into those of a fixed-rate bond and a
floating-rate bond.
The value of a fixed-rate bond (q = days/360):
n
VFXRB =  RqB (t ) + B (t )
i =1
0 i 0 n

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 Pricing and Valuation of Interest
Rate Swaps (continued)
The value of a floating-rate bond
VFLRB = 1 (at time 0 or a payment date)

At time t, between 0 and 1,

1 + L 0 (t1 )q
VFLRB = (between payment dates 0 and 1)
1 + L t (t1 )(t1 − t)/360
The value of the swap (pay fixed, receive floating)
is, therefore,
VS = VFLRB − VFXRB

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 Pricing and Valuation of Interest
Rate Swaps (continued)
To price the swap at the start, set this value to zero and
solve for R  
 
 1  1 − B 0 (t n ) 
R =   n 
 q  
 
 i =1
B (t
0 i )

Note how dealers quote as a spread over Treasury rate.
To value a swap during its life, simply find the
difference between the present values of the two
streams of payments. Market value reflects the
economic value, is necessary for accounting, and
gives an indication of the credit risk.
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 Swap Valuation Example
Today is t = 0 = March 1, 2001. Consider a firm that sold a piece of
equipment to a highly rated corporation, and it is then due to
receive payments in 10 equal installments of $5.5 million each
over 5 years. The firm would like to use these $5.5 million semi-
annual cash flows to hedge against the coupon payments the firm
must make to service a $200 million, floating rate bond that it
issued some time in the past, and also expiring in 5 years.
Suppose that the floating rate on the corporate bond is tied to the
LIBOR, at LIBOR + 4 bps. The 6-month LIBOR on March 1,
2001 is currently at 4.95% and so the next interest rate payment
the firm must make is (4.95+0.04)%/2×200 million= $4.99
million. So, the next floating rate coupon payment is covered.
However, if the LIBOR were to increase by more than 0.51% in
the next 5 years, the cash flows from the installments would not
be sufficient to service the debt.
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 Swap Valuation Example
A solution is to enter into a fixed-for-floating swap with an
investment bank, in which the firm pays the fixed semi-annual
swap rate c, over a notional of $200 million, and the bank pays
the 6-month LIBOR to the firm. On March 1, 2001, the swap rate
for a 5-year fixed-for-floating swap was quoted at c = 5.46%. So,
in this case, the net cash flow to the firm from the swap contract
is

Net cash flow to the firm at Ti

= $200 million × (1/2) × [r2 (Ti−1 ) − 5.46%]
where r2 (t) is the six month LIBOR at time t.

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 Swap Valuation Example
Why does this swap resolve the problem?
Consider the net position of the firm:

At every Ti the firm

1. receives 5.5 million;
2. pays (r2 (Ti − 0.5) + 4bps)/2 × 200 million on its outstanding
floating rate debt;
3. receives r2 (Ti − 0.5)/2 × 200 million from the bank as part of the
swap;
and at time Ti
4. pays 5.46% × 0.5 × 200 million to the bank as part of the swap.

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Swap Valuation Example

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 Swap Valuation Example
Summing up, the firm’s net cash flow position from the receivable,
debt, and swap is

Total cash flow at Ti = 5.5 million (Receivable)

− (r2 (Ti − 0.5) + 4bps)/2 × 200 million (Debt)
+0.5 × [(r2 (Ti − 0.5) − 5.46%] × 200 million (Swap)
= 5.5 − 0.04% × 100 − 5.46% × 100
=0
That is, the firm is perfectly hedged: The risk in the fluctuations of
the LIBOR stemming from its liabilities has been eliminated by
the swap (the firm receives the LIBOR from the bank, and pays
the LIBOR + .04% to bond holders). The remaining fixed
components sum up to zero.
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 Swap Valuation Example
Value of swap = Value of floating rate bond − Value of fixed rate
bond
i,.e.,
V swap (t; c, T) = PFR(t, T) − Pc (t, T)
Value of a floating rate bond:
Let T1 , T2 , ... Tn be the floating rate reset dates and let the current
date t be between time Ti and Ti+1: Ti < t < Ti+1. The general
formula for a semi-annual floating rate bond with zero spread s
is
PFR(Ti , T) = Z(t, Ti+1) × 100 × [1 + r2 (Ti)/2]
where Z(t, Ti+1) is the discount factor from t to Ti+1.
At reset dates, Z(Ti , Ti+1) = 1/(1 + r2 (Ti)/2), which implies
PFR(Ti , T) = 100
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 Swap Valuation Example
At payment dates Ti , the value of the floating rate bond is PFR(t, T) =
100. Also, using the price of the fixed rate bond Pc (Ti, T) we then
obtain

Using the discount factor in the next slide, we obtain

V swap (t; c, T) = 100 – ((0.0546/2) x 100 x 8.69 + 0.7628 x 100)
= 100 – (23.7237 + 76.28)
= 100 – 100.0037
0
This means that the swap doesn’t cost anything
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 Swap Valuation Example
LIBOR Discounts and Swap Curve from Federal Reserve

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 Swap Valuation Example
The swap rate c is given by that number that makes V swap (0; c, T)
equal to zero. Rewriting the equation generically for any
payment frequency n and payment dates T1 , ... TM , we have

Solving this, we get

From the table, one can observe that the swap rate is 5.46%, which
is exactly the rate given by the bank.
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 Pricing and Valuation of Interest
Rate Swaps (continued)
A basis swap is equivalent to the difference
between two plain vanilla swaps based on
different rates:
A swap to pay T-bill, receive fixed, plus
A swap to pay fixed, receive LIBOR, equals
A swap to pay T-bill, receive LIBOR, plus pay
the difference between the LIBOR and T-bill
fixed rates

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Overnight Index Swaps

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 Overnight index swap - an
example

Bank A enters into a 7 day OIS with Bank B,

where Bank A pays a 7 day fixed rate @
6.50% and receives Overnight MIBOR. The
notional amount is Rs 10 cr.

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 Calculating Cash flows
Let us say MIBOR rates are as follows
Day 1 6.61%
Day 2 6.40%
Day 3 6.60%
Day 4 6.50%
Day 5 6.62%
Day 6 6.70%
Day 7 6.68%
The interest on the principal amount of Rs 10 cr on the
floating leg gets compounded on a daily basis. In the case of
a holiday, interest is computed on a simple interest basis for
the holiday and the preceding Mumbai business day.

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 Calculating Cash flows

Day 1 6.4 100000000 17534

Day 2 6.6 100017534 18085
Day 3 6.5 100035620 17815
Day 4, 5 &
6.62 100053434 54440
6 (Sat, Sun)
Day 7 6.7 100107874 18376 100126250

Total accrual on a floating leg = Rs 126250

Total accrual on fixed leg = 100000000*6.50% *7/365
= Rs 124657

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 Settlement

Net interest payment

= 126250 - 124657
= Rs 1,593
This amount will be paid by party B to party A
at maturity

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 MIFOR Swap-an example
Bank A enters into a 2 year MIFOR swap with Bank
B, where Bank A receives a 5 year fixed rate @
6.65% and pays 6-month MIFOR. The notional
amount is Rs 100 cr on 20 August 2020.

6-month MIFOR is reset semi-annually

Net amounts are exchanged semi-annually

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 Cash Flows
Settlement Fixed Rate 6- Differenc Settlement
Dates month e Rate Amount
MIFOR (Rs. Cr)
20 Feb 21 6.65% 5.90% 0.75% 0.75
20 Aug 21 6.65% 5.75% 0.90% 0.90
20 Feb 22 6.65% 6.25% 0.40% 0.40
20 Aug 22 6.65% 6.50% 0.15% 0.15
Bank A will receive the the settlement amount from Bank B
at each of the settlement dates

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