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Didier Faivre
Didier.faivre@calyon.com
February 2006
Zero-coupon Deposit Libor, Euribor FRA Vanilla Swaps Swaps Forwards Caplet/Floorlet Caps/Floors Swaptions Volatity Cube CMS
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Zero-coupon
o Price at date t of one 1 (or any currency) at date T :
o r(t,T) is called the zero-coupon rate at date t for maturity T o In the right side of above equation T-t is a year fraction calculated using ACT/365 convention (or sometimes ACT/ACT if one wants to take into account the leap years).
Deposit
o Loan on a period from 1 week to 12 months between two banks o Interest calculated using monetary interest rate, e.g. linear interest rates
Deposit
o Interest Calculated as :
If bank lends 1M on a period of 3months, in 3 months banks receives :
1M 1 Euribor 3M number of days 360
Number of days is exact number of days between start and end of the loan We speak about Libor1M, Libor3M.. For USD, LiborUSD1M, LiborUSD3M.. For EURO, Euribor1M, Euribor3M
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Deposit
o For some currencies (GBP, AUD), replace 360 by 365
Deposit
o Example for a 3Month deposit o 30 january 2006,offered 3 months rate by BBVA is 2.56% o 3month loan is from 30 january 2006 + 2 business days to (30 january +2 business days)+3months business days o So from 2/2/2006 to 2/5/2006, so 89 days period of interest rates o For a 100M notional loan, redemption is 100*(1+2.56%*89/360)=100.6329M
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LIBOR, EURIBOR
o LIBOR : London Interbank Offered Rate o Every day, fixing at 11am London Time on most currencies : USD, JPY, GBP o For EURO, fixing at FRANCFORT Euribor o Definition :
Average of offered rates for a given maturity, on a basket of banks, for deposits operations
Offered rate : means rate at which Bank wants to lend money, not to borrow (Bid/Ask spread) For various maturities from 1 week to 12 months : Using Monetary interest rates as previously explained
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o On the previous slide, we see that the fixing of Euribor 3M on the 30/1/2006 is 2.542% o The period of interest for a 3M deposit on the 30/1/2006 is from 2/2/2006 to 2/5/2006
30/1/2006 is called the Fixing date 2/2/2006 is called the Start date 2/5/2006 is called the End date
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FRA
o Definition of FRA (Forward rate agreement)
A forward Euribor of maturity T is a forward contract on Euribor beginning at date T (fixing at date T-2D) and ending at date T+ . The maturity T is calculated taking account business days conventions, including various end of month rules. The value of the forward at date t is :
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FRA
o Warning ! : on the the above equation, is a number of days when added to the date T, for example the numbers of days for a given standard reference period (3M, 6M) and otherwise on the right side of equation its a year fraction calculated using the monetary basis convention of the currency (ACT/360 or ACT/365)
This is usual rule for quants documents notations
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Vanilla Swaps
o In a vanilla swap, two counterparties exchange variable cash flows based on Euribor (or Libor for other currencies) against cash-flow based on a fixed rate, in the same currency o Example : 2 years fixed rate against Euribor6M
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o Theoritically, all combinations of period and basis are possible for the two legs o In practice a standard is set for every-market, used by default
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Money markets swaps because ACT/360 is the basis for LiborUSD Bond Basis swaps because 30/360 is the basis for USD corporate bonds
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o The and are called coverage, calculated as year fractions between cash-flows dates for both leg, using each basis.
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SWAP 3Y Fix Leg Frequency Basis 3M ACT360 Float Leg Frequency Basis 3M ACT360
Lib start Lib end coverage pay dates fix dates 17/02/06 17/05/06 0.247222 17/05/06 15/02/06 17/05/06 17/08/06 0.255556 17/08/06 15/05/06 17/08/06 17/11/06 0.255556 17/11/06 15/08/06 17/11/06 19/02/07 0.261111 19/02/07 15/11/06 19/02/07 21/05/07 0.241667 17/05/07 15/02/07 17/05/07 17/08/07 0.255556 17/08/07 15/05/07 17/08/07 19/11/07 0.261111 19/11/07 15/08/07 19/11/07 19/02/08 0.252778 18/02/08 15/11/07 18/02/08 19/05/08 0.252778 19/05/08 14/02/08 19/05/08 19/08/08 0.252778 18/08/08 15/05/08 18/08/08 18/11/08 0.252778 17/11/08 14/08/08 17/11/08 17/02/09 0.255556 17/02/09 13/11/08
Lib start Lib end coverage pay dates fix dates 17/02/06 17/05/06 0.247222 17/05/06 15/02/06 17/05/06 17/08/06 0.255556 17/08/06 15/05/06 17/08/06 17/11/06 0.255556 17/11/06 15/08/06 17/11/06 19/02/07 0.261111 19/02/07 15/11/06 19/02/07 21/05/07 0.241667 17/05/07 15/02/07 17/05/07 17/08/07 0.255556 17/08/07 15/05/07 17/08/07 19/11/07 0.261111 19/11/07 15/08/07 19/11/07 19/02/08 0.252778 18/02/08 15/11/07 18/02/08 19/05/08 0.252778 19/05/08 14/02/08 19/05/08 19/08/08 0.252778 18/08/08 15/05/08 18/08/08 18/11/08 0.252778 17/11/08 14/08/08 17/11/08 17/02/09 0.255556 17/02/09 13/11/08
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SWAP 3Y Fix Leg Frequency 6 M Basis 30360 Float Leg Frequency 3 M Basis ACT360 Lib start Lib end coverage pay dates fix dates 17/02/06 17/05/06 0.247222 17/05/06 15/02/06 17/05/06 17/08/06 0.255556 17/08/06 15/05/06 17/08/06 17/11/06 0.255556 17/11/06 15/08/06 17/11/06 19/02/07 0.261111 19/02/07 15/11/06 19/02/07 21/05/07 0.241667 17/05/07 15/02/07 17/05/07 17/08/07 0.255556 17/08/07 15/05/07 17/08/07 19/11/07 0.261111 19/11/07 15/08/07 19/11/07 19/02/08 0.252778 18/02/08 15/11/07 18/02/08 19/05/08 0.252778 19/05/08 14/02/08 19/05/08 19/08/08 0.252778 18/08/08 15/05/08 18/08/08 18/11/08 0.252778 17/11/08 14/08/08 17/11/08 17/02/09 0.255556 17/02/09 13/11/08
Lib start Lib end coverage pay dates fix dates 17/02/06 17/05/06 0.5 17/08/06 15/02/06 17/08/06 17/11/06 0.505556 19/02/07 15/08/06 19/02/07 21/05/07 0.494444 17/08/07 15/02/07 17/08/07 19/11/07 0.502778 18/02/08 15/08/07 18/02/08 19/05/08 0.5 18/08/08 14/02/08 18/08/08 18/11/08 0.497222 17/02/09 14/08/08
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SWAP 3Y Fix Leg Frequency 1 Y Basis 30360 Float Leg Frequency 3 M Basis ACT360 Lib start Lib end cov pay dates fix dates 17/02/06 17/05/06 0.247222 17/05/06 15/02/06 17/05/06 17/08/06 0.255556 17/08/06 15/05/06 17/08/06 17/11/06 0.255556 17/11/06 15/08/06 17/11/06 19/02/07 0.261111 19/02/07 15/11/06 19/02/07 21/05/07 0.241667 17/05/07 15/02/07 17/05/07 17/08/07 0.255556 17/08/07 15/05/07 17/08/07 19/11/07 0.261111 19/11/07 15/08/07 19/11/07 19/02/08 0.252778 18/02/08 15/11/07 18/02/08 19/05/08 0.252778 19/05/08 14/02/08 19/05/08 19/08/08 0.252778 18/08/08 15/05/08 18/08/08 18/11/08 0.252778 17/11/08 14/08/08 17/11/08 17/02/09 0.255556 17/02/09 13/11/08
Lib start Lib end cov pay dates fix dates 17/02/06 17/05/06 1.005556 19/02/07 15/02/06 19/02/07 21/05/07 0.997222 18/02/08 15/02/07 18/02/08 19/05/08 0.997222 17/02/09 14/02/08
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is the schedule of the floating leg of the swap (for a 4 years with a 6Months period on floating leg, m = 8, for example). o The value of the floating leg is :
o It can be shown that it is also : o is the end date of the swap and schedule of fixed leg.
the
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o The term is called the Level of the swap, its value is close to the sensitivity or duration of a standard bond of same maturity, period and with coupon rate of .
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5/4/03 is a saturday
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Caplet, floorlet
o A caplet is a call option on a Euribor (or Libor..) forward o The caplet of strike K pays at date T+d the difference, if positive, between Euribor on the period starting T ending T+d :
pay-off of caplet at date T+d is :
Max(Euribor(T, T+d)-K;0)
The fixing of the Euribor is at T-2D, taking into account non business days.
Caplet, floorlet
o The market practice to value a caplet at date t is :
B t ,T BSprice FRA t ,T ,T , K ,T t , , Lognormal,call
Caplet, floorlet
o After having defined the swaptions, we will also explain what is a volatility cube.
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FT
F0 e
N 0, T
o Then o Then
is defined as :
is defined as :
FT
EMax K
FT ,0
E K
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E FT
F0 N d1
K N d2
K N d2
F0 N d1
E K FT
F K 1 2 T
ln d1
d2
d1
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' N 0, T
E FT K
o Then o Then
EMax FT
is defined as : is defined as :
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E FT
F0
K N d
' Tn d
E K FT
d F0 K
K F0 N d
' Tn d
' T
o This formula shows that the price of an ATM option (caplet/swaption) depends in fact only on the standard deviation, not on F and on the volatility o We remind that a very good approximation of the relation between s (the standard deviation) and s (the volatility) for ATM is :
0
'
F0
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o If the buyer of the options pays the option at date 0 (and get the pay-off at maturity):
call put F0 K B 0 ,T
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Cap, floor
o A cap is a sum of caplets, a floor a sum of floorlets o Value of cap is the value of all the caplets included, same thing for floor o Example : 1 Year Cap on Euribor3M
Remark : most of the time, the first caplet is not included as the value today of the first Euribor is Known. So most of the times, only 3 caplets in the above example
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~ ~ ~ ~ B 0 ,T j i FRA 0 ,T j 1 ,T j
~ ~ B 0 ,T j i K
o So Cap-Floor = Value of floatLeg Minus Value of Fixed Leg (strike K) o The strike K such that Cap = Floor can be seen as a swap rate corresponding to the schedule of the Cap and floor, so using frequency and basis of this schedule.
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o The ATM rule (p 37) shows that the cheapness of ATM caplet/floorlet depends only of the standard deviation, so cheapness can be evaluated using the formula : ' F
0
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1 1 S T ,Tn
Max K
S T ,T ,Tn ,0
o For a payer cash settlement swaption, the buyer of the option receives at date T :
n i 1
1 1 S T ,Tn
Max S T ,T ,Tn
K ,0
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1 S T ,Tn
1/ 2 1 S T ,Tn
By :
n i 1
i/ 2
n i 1
1
i n
1 S T ,T The number is called the level cash of the swap ; at maturity, the level cash is just calculated by replacing the zero-coupon rates by the swap rate to discount (and also replacing all coverages by 1).
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B t ,T
i 1
1 1 S t ,T ,Tn
B t ,T
i 1
1 1 S t ,T ,Tn
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B t ,Ti S t ,T ,Tn
B t ,T
i 1
1 1 S t ,T ,Tn
S t ,T ,Tn
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Volatility cubes
o First lets define a volatility surface for a given reference rate, let say the Euribor3M o We need to be able to price a caplet on Euribor6M for any strike and any maturity o A volatility surface for this reference rate will be as following :
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Volatility cubes
o If we define these surfaces for all reference rates (Euribor1M, Euribor2M, 3M, 12M) and all swap (1Y, 2Y, 10Y, 30Y) we can price any vanilla cap or swaption o The set of vol surfaces is called a volatility cube o In practice, more complex models are used and calibrated on previous sufaces and used to get the volatilies for any caplet/floorlet/swaption o The purpose of these models is to avoid numerical problem due to non proper interpolation methods.
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CMS 0 ,T ,Tn
o The pricing of CMS and CMS options is not straightforward derivation of swap forward and swaptions o but follows the call/put parity formula (p 39)
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