Managing Fixed-Income Positions With OTC Derivatives

Managing Fixed-Income
Positions with OTC Derivatives
1
1. Hedging with OTC Derivatives
2. Hedging a Series of Cash FlowsOTC
Caps and Floors
3. Financing Caps and Floors: Collars and
Corridors
4. Other Interest Rate Derivatives
5. Hedging Currency Positions with
Currency Options
2
Hedging with OTC Derivatives
3
Forward Rate Agreements (FRA)
A forward rate agreement, FRA, requires a cash

payment or provides a cash receipt based on the
difference between a realized spot rate such as the
LIBOR and a pre-specified rate.
For example, the contract could be based on a

specified rate of Rk = 6% (annual) and the 3-month
LIBOR (annual) in 5 months and a notional
principal, NP (principal used only for calculation
purposes) of $10,000,000.
4
Forward Contracts and Forward
Rate Agreements (FRA)
In five months the payoff would be
Payoff ($10,000,000)
LIBOR .06 (91 / 365)
1 LIBOR(91 / 365)
If the LIBOR at the end of five months exceeds the

specified rate of 6%, the buyer of the FRA (or long
position holder) receives the payoff from the seller.
If the LIBOR is less than 6%, the seller (or short

position holder) receives the payoff from the buyer.
5
Payoff ($10,000,000)
LIBOR .06 (91 / 365)
1 LIBOR(91 / 365)
If the LIBOR were at 6.5%, the buyer

would be entitled to a payoff of $12,267
from the seller;
If the LIBOR were at 5.5%, the buyer

would be required to pay the seller
$12,297.
6
In general, a FRA that matures in T months and is

written on a M-month LIBOR rate is referred to as a
T x (T+M) agreement.
Thus, in this example the FRA is a 5 x 8 agreement.
At the maturity of the contract (T), the value of the

contract, VT is
VT NP
LIBOR R k (M / 365)
1 LIBOR(M / 365)
7
FRAs originated in 1981 amongst large London
Eurodollar banks that used these forward agreements
to hedge their interest rate exposure.
Today, FRAs are offered by banks and financial

institutions in major financial centers and are often
written for the banks corporate customers.
They are customized contracts designed to meet the

needs of the corporation or financial institution.
8
FRAs are used by corporations and financial institutions to manage
interest rate risk in the same way as financial futures are used.
Different from financial futures, FRAs are contracts between two

parties and therefore are subject to the credit risk of either party
defaulting.
The customized FRAs are also less liquid than standardized futures
contracts.
The banks that write FRAs often takes a position in the futures
market to hedge their position or a long and short position in spot
money market securities to lock in a forward rate.
As a result, in writing the FRA, the specified rate R k is often set equal
to the rate implied on a futures contract.
9
Example:
Suppose Kendall Manufacturing forecast a cash inflow
of $10,000,000 in 2 months that it is considering
investing in a Sun National Bank CD for 90 days.
Sun National Banks jumbo CD pays a rate equal to

the LIBOR.
Currently such rates are yielding 5.5%.
Kendall is concerned that short-term interest rates

could decrease in the next 2 months and would like to
lock in a rate now.
10
Example:
As an alternative to hedging its investment with Eurodollar futures, Sun
National suggests that Kendall hedge with a Forward Rate Agreement with
the following terms:
1. FRA would mature in 2 months (T) and would be written on a 90-day (3-
month) LIBOR (T x (T+M) = 2 x 5 agreement
2. NP = $10,000,000
3. Contract rate = Rk = 5.5%
4. Day count convention = 90/365
5. Cagle would take the short position on the FRA, receiving the payoff
from Sun National if the LIBOR were less than R k = 5.5%
6. Sun National would take the long position on the FRA, receiving the
payoff from Cagle if the LIBOR were greater than R k = 5.5%
11
The exhibit slide shows Kendalls FRA receipts or

payments and cash flows from investing the
$10,000,000 cash inflow plus or minus the FRA
receipts or payments at possible LIBORs of 5%,
5.25%, 5%, 5.75%, and 6%.
As shown, Kendall is able to earn a hedged rate of

return of 5.5% from its $10,000,000 investment.
12
Payoff ($10,000,000)
LIBOR .055(90 / 365)
1 LIBOR(90 / 365)
13
Interest Rate Call
An interest rate call, also called a caplet, gives the buyer a payoff on a
specified payoff date if a designated interest rate, R, such as the
LIBOR, rises above a certain exercise rate, R x.
On the payoff date:

If the designated rate is less than Rx, the interest rate call expires
worthless.
If the rate exceeds Rx, the call pays off the difference between the
actual rate and Rx, times a notional principal, NP, times the
fraction of the year specified in the contract, .
Payoff Max[R R x ,0]()( NP)
14
Interest Rate Call
Example:
Given an interest rate call with a designated rate of
LIBOR, Rx = 6%, NP = $1,000,000, time period of
180 days, and day-count convention of actual/360, the
buyer would receive a $5,000 payoff on the payoff
date if the LIBOR were 7%:
Payoff = Max[.07.06, 0](180/360)($1,000,000)
Payoff = $5,000
15
Interest Rate Call
Hedging Use
Interest rate call options are often written by
commercial banks in conjunction with futures
loans they plan to provide to their customers.
The exercise rate on the option usually is set

near the current spot rate, with that rate often
being tied to the LIBOR.
16
Hedging a Future Loan Rate
with an OTC Interest Rate Call
Example:
Suppose a construction company plans to finance one of
its project with a $10,000,000 90-day loan from Sun
Bank, with the loan rate to be set equal to the LIBOR +
100 BP when the project commences 60 day from now.
Furthermore, suppose that the company expects rates to

decrease in the future, but is concerned that they could
increase.
17
Example:
To obtain protection against higher rates, suppose the company
buys an interest rate call option from Sun Bank for $20,000
with the following terms:
1. Exercise rate = 7%
2. Reference rate = LIBOR
3. Time period applied to the payoff = 90/360
4. Notional principal = $10,000,000
5. Payoff made at the maturity date on the loan (90 days after
the options expiration)
6. Interest rate calls expiration = T = 60 days (time of the
loan)
7. Interest rate call premium of $20,000 to be paid at the
options expiration with a 7% interest: Cost = $20,000(1 +
(.07)(60/360)) = $20,233
18
Example:
The exhibit slide shows the company's cash flows
from the call, interest paid on the loan, and effective
interest costs that would result given different
LIBORs at the starting date on the loan and the
expiration date on the option.
As shown in Column 6 of the slide, the company is

able to lock in a maximum interest cost of 8.016% if
the LIBOR is 7% or greater at expiration, and still
benefit with lower rates if the LIBOR is less than 7%.
19
20
Interest Rate Put
An interest rate put, also called a floorlet, gives the
buyer a payoff on a specified payoff date if a designated
interest rate, R, is below the exercise rate, Rx.
On the payoff date:

If the designated rate (or reference rate) is more than R x, the
interest rate put expires worthless.
If the reference rate is less than Rx, the put pays the difference
between Rx and the actual rate times a notional principal, NP,
times the fraction of the year, , specified in the contract.
Payoff Max[R x R ,0]()( NP)
21
Interest Rate Put
Hedging Use
A financial or non-financial corporation that is planning
to make an investment at some future date could hedge
that investment against interest rate decreases by
purchasing an interest rate put from a commercial bank,
investment banking firm, or dealer.
22
Hedging a CD Rate with
an OTC Interest Rate Put
Example:
Suppose the ABC manufacturing company was
expecting a net cash inflow of $10,000,000 in 60 days
from its operations and was planning to invest the
excess funds in a 90-day CD from Sun Bank paying
the LIBOR.
To hedge against interest rate decreases occurring 60

days from the now, suppose the company purchases
an interest rate put (corresponding to the bank's CD it
plans to buy) from Sun Bank for $10,000.
23
Example:
Suppose the put has the following terms:
1. Exercise rate = 7%
3. Time period applied to the payoff = = 90/360
4. Day Count Convention = 30/360
5. Notional principal = $10 million
6. Payoff made at the maturity date on the CD (90 days from
the options expiration)
7. Interest rate puts expiration = T = 60 days (time of CD
purchase)
8. Interest rate put premium of $10,000 to be paid at the
options expiration with a 7% interest: Cost = $10,000(1
+ (.07)(60/360)) = $10,117
24
Example:
As shown in the exhibit slide, the purchase of the
interest rate put makes it possible for the ABC
company to earn higher rates if the LIBOR is greater
than 7% and to lock in a minimum rate of 6.993% if
the LIBOR is 7% or less.
25
26
Example:
If 60 days later the LIBOR is at 6.5%, then the company would
receive a payoff (90 day later at the maturity of its CD) on the
interest rate put of $12,500:
$12,500 = ($10,000,000)[.07 .065](90/360)
The $12,500 payoff would offset the lower (than 7%) interest
paid on the companys CD of $162,500:
$162,500 = ($10,000,000)(.065)(90/360)
At the maturity of the CD, the company would therefore receive

CD interest and an interest rate put payoff equal to $175,000:
$175,000 = $162,500 + $12,500
27
Example:
With the interest-rate puts payoffs increasing the
lower the LIBOR, the company would be able to hedge
any lower CD interest and lock in a hedged dollar
return of $175,000.
Based on an investment of $10,000,000 plus the

$10,117 costs of the put, the hedged return equates to
an effective annualized yield of 6.993%:
6.993% = [(4)($175,000)]/[$10,000,000 + $10,117]
On the other hand, if the LIBOR exceeds 7%, the

company benefits from the higher CD rates.
28
Cap
A popular option offered by financial

institutions in the OTC market is the cap.
A plain-vanilla cap is a series of European

interest rate call optionsa portfolio of
caplets.
29
Cap
Example:
A 7%, 2-year cap on a 3-month LIBOR, with a NP of
$100,000,000, provides, for the next 2 years, a payoff
every 3 months of (LIBOR .07)(.25)($100M) if the
LIBOR on the reset date exceeds 7% and nothing if the
LIBOR equals or is less than 7%.
Note: Typically, the payoff does not occur on the reset

date, but rather on the next reset date.
30
Cap
Uses
Caps are often written by financial
institutions in conjunction with a floating-
rate loan and are used by buyers as a hedge
against interest rate risk.
31
Cap
A company with a floating-rate loan tied to the LIBOR
could lock in a maximum rate on the loan by buying a
cap corresponding to its loan.
At each reset date, the company would receive a payoff

from the caplet if the LIBOR exceeded the cap rate,
offsetting the higher interest paid on the floating-rate
loan; on the other hand, if rates decrease, the company
would pay a lower rate on its loan whereas its losses on
the caplet would be limited to the cost of the option.
Thus, with a cap, the company is able to lock in a

maximum rate each quarter, and yet still benefit with
lower interest costs if rates decrease.
32
Floor
A plain-vanilla floor is a series of European
interest rate put optionsa portfolio of
floorlets.
33
Floor
Example:
A 7%, 2-year floor on a 3-month LIBOR, with a NP of
$100,000,000, provides for the next 2 years a payoff
every 3 months of (.07 LIBOR)(.25)($100M) if the
LIBOR on the reset date is less than 7% and nothing if
the LIBOR equals or exceeds 7%.
34
Floor
Uses
Floors are often purchased by investors as a tool to
hedge their floating-rate investment against interest
rate declines.
Thus, with a floor, an investor with a floating-rate

security is able to lock in a minimum rate each
period, and yet still benefit with higher yields if rates
increase.
35
Hedging a Series of Cash Flows:
OTC Caps and Floors
36
OTC Caps and Floors
We have examined how a strip of Eurodollar futures

puts can be used to cap the rate paid on a floating-rate
loan, and how a strip of Eurodollar futures calls can be
used to set a floor on a floating-rate investment.
Using such exchange-traded options to establish

interest rate floors and ceiling on floating rate assets
and liabilities, though, is subject to hedging risk.
As a result, many financial and non-financial

companies looking for such interest rate insurance
prefer to buy OTC caps or floors that can be
customized to meet their specific needs.
37
OTC Caps and Floors
Financial institutions typically provide caps

and floors with:
1. Terms that range from 1 to 5 years
2. Monthly, quarterly, or semiannual reset dates
3. LIBOR as the reference rate
4. Notional principal and the reset dates that often
match the specific investment or loan
5. Settlement dates that usually come after the reset
dates
38
OTC Caps and Floors
In cases where a floating-rate loan (or investment)

and cap (or floor) come from the same financial
institution, the loan and cap (or investment and
floor) are usually treated as a single instrument so
that when there is a payoff, it occurs at an interest
payment (receipt) date, lowering (increasing) the
payment (receipt).
The exercise rate is often set so that the cap or floor

is initially out of the money, and the payments for
these interest rate products are usually made up
front, although some are amortized.
39
Floating Rate Loan
Hedged with an OTC Cap
Example:
Suppose the Diamond Development Company borrows
$50 million from Commerce Bank to finance a 2-year
construction project.
Suppose:
The loan is for 2 years
The loan starts on March 1 at a known rate of 8%
The loan rate resets every three months6/1, 9/1,
12/1, and 3/1at the prevailing LIBOR plus 150 bp.
40
Floating Rate Loan
In entering this loan agreement, suppose the

company is uncertain of future interest rates and
therefore would like to lock in a maximum rate,
but still benefit from lower rates if the LIBOR
decreases.
41
Floating Rate Loan
To achieve this, suppose the company buys a cap
corresponding to its loan from Commerce Bank for
$150,000, with the following terms:
1. The cap consist of seven caplets with the first expiring on
6/1/Y1 and the others coinciding with the loans reset dates.
2. Exercise rate on each caplet = 8%
3. NP on each caplet = $50,000,000
4. Reference Rate = LIBOR
5. Time period to apply to payoff on each caplet = 90/360.
(Typically the day count convention is defined by the actual
number of days between reset date.)
6. Payment date on each caplet is at the loans interest
payment date, 90 days after the reset date.
7. The cost of the cap = $150,000; it is paid at beginning of
the loan, 3/1/Y1.
42
Floating Rate Loan
On each reset date, the payoff on the corresponding caplet would
be
Payoff = ($50,000,000) (Max[LIBOR .08, 0])(90/360)
With the 8% exercise rate (sometimes called the cap rate), the
Diamond Company would be able to lock in a maximum rate each
quarter equal to the cap rate plus the basis points on the loan,
9.5%, but still benefit with lower interest costs if rates decrease.
This can be seen in the exhibit slide, where the quarterly interests
on the loan, the cap payoffs, and the hedged and unhedged rates
are shown for different assumed LIBORs at each reset date on the
loan.
43
Floating Rate Loan
44
Floating Rate Loan
For the 5 reset dates from 12/1/Y1 to the end of the
loan, the LIBOR is at 8% or higher.
In each of these cases, the higher interest on the loan

is offset by the payoff on the cap, yielding a hedged
rate on the loan of 9.5% (the 9.5% rate excludes the
$150,000 cost of the cap; the rate is 9.53% with the
cost included).
For the first 2 reset dates on the loan, 6/1/Y1 and

9/1/Y1, the LIBOR is less than the cap rate. At these
rates, there is no payoff on the cap, but the rates on
the loan are lower with the lower LIBORs.
45
Floating Rate Asset
Hedged with an OTC Floor
Example:
As noted, floors are purchased to create a minimum
rate on a floating-rate asset.
As an example, suppose the Commerce Bank in the

preceding example wanted to establish a minimum
rate or floor on the rates it was to receive on the 2-
year floating-rate loan it made to the Diamond
Company.
46
Floating Rate Asset
Suppose the bank purchased from another financial
institution a floor for $100,000 with the following
terms corresponding to its floating-rate asset:
1. The floor consist of 7 floorlets with the first expiring on
6/1/Y1 and the others coinciding with the reset dates on the
banks floating-rate loan to the Diamond Company
2. Exercise rate on each floorlet = 8%
3. NP on each floorlet = $50,000,000
5. Time period to apply to payoff on each floorlet = 90/360
Payment date on each floorlet is at the loans interest
payment date, 90 days after the reset date
6. The cost of the floor = $100,000; it is paid at beginning of
the loan, 3/1/Y1
47
Floating Rate Asset
On each reset date, the payoff on the corresponding
floorlet would be
Payoff = ($50,000,000) (Max[.08 LIBOR, 0])(90/360)
With the 8% exercise rate, Commerce Bank would be

able to lock in a minimum rate each quarter equal to the
floor rate plus the basis points on the floating-rate asset,
9.5%, but still benefit with higher returns if rates
increase.
48
Floating Rate Asset
In the exhibit slide, Commerce Banks quarterly

interests received on its loan to Diamond, its floor
payoffs, and its hedged and unhedged yields on its
loan are shown for different assumed LIBORs at
each reset date.
49
Floating Rate Asset
50
Floating Rate Asset
For the first two reset dates on the loan, 6/1/Y1 and 9/1/Y1,
the LIBOR is less than the floor rate of 8%. At theses rates,
there is a payoff on the floor that compensates for the lower
interest Commerce receives on the loan; this results in a
hedged rate of return on the banks loan asset of 9.5% (the
rate is 9.52% with the $100,000 cost of the floor included).
For the five reset dates from 12/1/Y1 to the end of the loan,
the LIBOR equals or exceeds the floor rate. At these rates,
there is no payoff on the floor, but the rates the bank earns on
its loan are greater, given the greater LIBORs.
51
Financing Caps and Floors:
Collars and Corridors
52
Collars
A collar is combination of a long position in a cap and a
short position in a floor with different exercise rates.
The sale of the floor is used to defray the cost of the cap.
For example, the Diamond Company in the preceding case

could reduce the cost of the cap it purchased to hedge its
floating rate loan by selling a floor.
By forming a collar to hedge its floating-rate debt, the

Diamond Company, for a lower net hedging cost, would still
have protection against a rate movement against the cap
rate, but it would have to give up potential interest savings
from rate decreases below the floor rate.
53
Collars
Example:
Suppose the Diamond Company decided to defray
the $150,000 cost of its 8% cap by selling a 7%
floor for $70,000, with the floor having similar
terms to the cap:
1. Effective dates on floorlet = reset date on loan
3. NP on floorlets = $50,000,000
4. Time period for rates = .25
54
Collars
By using the collar instead of the cap, the company

reduces its hedging cost from $150,000 to $80,000, and as
shown in the exhibit slide, it still locked in a maximum
rate on its loan of 9.5%.
However, when the LIBOR is less than 7%, the company

has to pay on the 7% floor, offsetting the lower interest
costs it would pay on its loan. For example:
When the LIBOR is at 6% on 6/1/Y1, Diamond has to pay
$125,000 ninety days later on its short floor position.
When the LIBOR is at 6.5% on 9/1/Y1, the company has to pay
$62,500.
These payments, in turn, offset the benefits of the

respective lower interest of 7.5% and 8% (LIBOR + 150
bp) it pays on its floating rate loan.
55
Collars
56
Collars
Thus, for LIBORs less than 7%, Diamond has a floor

in which it pays an effective rate of 8.5% (losing the
benefits of lower interest payments on its loan) and
for rates above 8% it has a cap in which it pays an
effective 9.5% on its loan.
57
Corridor
An alternative financial structure to a collar is

a corridor.
A corridor is a long position in a cap and a

short position in a similar cap with a higher
exercise rate.
The sale of the higher exercise-rate cap is

used to partially offset the cost of purchasing
the cap with the lower strike rate.
58
Corridor
For example, instead of selling a 7% floor for

$70,000 to partially finance the $150,000 cost of its
8% cap, the Diamond company could sell a 9% cap
for say $70,000.
If cap purchasers believe there was a greater chance

of rates increasing than decreasing, they would prefer
the collar to the corridor as a tool for financing the
cap.
59
Reverse Collar
A reverse collar is combination of a long position in a

floor and a short position in a cap with different
exercise rates. The sale of the cap is used to defray the
cost of the floor.
For example, the Commerce Bank in the floor

example could reduce the $100,000 cost of the 8%
floor it purchased to hedge the floating-rate loan it
made to the Diamond company by selling a cap.
By forming a reverse collar to hedge its floating-rate

asset, the bank would still have protection against
rates decreasing against the floor rate, but it would
have to give up potential higher interest returns if rates
increase above the cap rate.
60
Reverse Collar
Example:
Suppose Commerce sold a 9% cap for $70,000, with
the cap having similar terms to the floor.
By using the reverse collar instead of the floor, the

company would reduce its hedging cost from $100,000
to $30,000,
As shown in the exhibit slide, Commerce would lock in

an effective minimum rate on its a asset of 9.5% and an
effective maximum rate of 10.5%.
61
Reverse Collar
62
Reverse Corridor
Instead of financing a floor with a cap, an

investor could form a reverse corridor by
selling another floor with a lower exercise
rate.
63
Other Interest Rate Products
64
Other Interest Rate Products
Caps and floors are one of the more popular interest

rate products offered by the OTC derivative market.
In addition to these derivatives, a number of other

interest rate products have been created over the last
decade to meet the many different interest rate
hedging needs.
Many of these products are variations of the generic

OTC caps and floorsexotic options; two of these to
note are barrier options and path-dependent options.
65
Barrier Options
Barrier options are options in which the payoff depends
on whether an underlying security price or reference
rate reaches a certain level.
They can be classified as either knock-out or knock-in

options:
1. Knock-out option is one that ceases to exist once
the specified barrier rate or price is reached.
2. Knock-in option is one that comes into existence

when the reference rate or price hits the barrier
level.
66
Barrier Options
Knock-out and knock-in options can be formed
with either a call or put and the barrier level can
be either above or below the current reference
rate or price when the contract is established
Down-and-out or up-and-out knock out
options
Up-and-in or down-and-in knock in options
67
Barrier Options
Barrier caps and floors with termination or

creation features are offered in the OTC
market at a premium above comparable
caps and floors without such features.
68
Barrier Options
Down-and-out caps and floors are options that
ceases to exist once rates hit a certain level.
Example:
A 2-year, 8% cap that ceases when the
LIBOR hits 6.5%
A 2-year, 8% floor that ceases once the
LIBOR hits 9%
69
Barrier Options
Up-and-in cap and florr is one that becomes

effective once rates hit a certain level.
Examples:
A 2-year, 8% cap that that becomes effective when
the LIBOR hits 9%
A 2-year, 8% floor that become effective when
rates hit 6.5%
70
Path-Dependent Options
In the generic cap or floor, the underlying payoff on
the caplet or floorlet depends only on the reference
rate on the effective date.
The payoff does not depend on previous rates; that is,

it is independent of the path the LIBOR has taken.
Some caps and floors, though, are structured so that

their payoff is dependent on the path of the reference
rate.
71
Path-Dependent Options: Average Cap
An average cap is one in which the payoff depends
on the average reference rate for each caplet.
If the average is above the exercise rate, then all
the caplets will provide a payoff.
If the average is equal or below, the whole cap

expires out of the money.
72
Example:
Consider a one-year average cap with an exercise
rate of 7% with four caplets.
If the LIBOR settings turned out to be 7.5%,
7.75%, 7%, and 7.5%, for an average of 7.4375%,
then the average cap would be in the money:
(.074375 .07)(.25)(NP).
If the rates, though, turned out to be 7%, 7.5%,

6.5, and 6%, for an average of 6.75%, then the
cap would be out of the money.
73
Path-Dependent Options: Q-Cap
In a cumulative cap (Q-cap), the cap seller

pays the holder when the periodic interest on
the accompanying floating-rate loan hits or
exceeds a specified level.
74
Example:
Suppose the Diamond Company in the earlier cap
example decided to hedge its 2-year floating rate loan
(paying LIBOR + 150bp) by buying a Q-Cap from
Commerce Bank with the following terms (next 2
slides):
75
Q-Cap Terms:
1. The cap consist of seven caplets with the first
expiring on 6/1/Y1 and the others coinciding with
the loans reset dates
2. Exercise rates on each caplet = 8%
3. NP on each caplet = $50,000,000
5. Time period to apply to payoff on each caplet =

90/360
76
Q-Cap Terms:
6. For the period 3/1/Y1 to 12/1/Y1, the caplet will payoff
when the cumulative interest starting from loan date
3/1/Y1 on the companys loan hits $3 million.
7. For the period 3/1/Y2 to 12/1/Y2, the caplet will payoff

when the cumulative interest starting from date 3/1/Y2 on
the companys loan hits $3 million.
8. Payment date on each caplet is at the loans interest

payment date, 90 days after the reset date.
9. The cost of the cap = $125,000; it is paid at beginning of

the loan, 3/1/Y1.
77
The exhibit slide shows the quarterly interest, cumulative
interests, Q-cap payments, and effective interests for assumed
LIBORs.
In the Q-caps first protection period, 3/1/Y1 to 12/1/Y1,

Commerce Bank will pay the Diamond Company on its 8%
caplet when the cumulative interest hits $3 million.
The cumulative interest hits the $3 million limit on reset date

9/1/Y1, but on that date the 9/1/Y1 caplet is not in the money.
On the following reset date, though, the caplet is in the money

at the LIBOR of 8.5%. Commerce would, in turn, have to pay
Diamond $62,500 (90 days later) on the caplet, locking in a
hedged rate of 9.5% on Diamonds loan.
78
In the second protection period, 3/1/Y2 to 12/1/Y2,

the assumed LIBOR rates are higher.
The cumulative interest hits the $3 million limit on

reset date 9/1/Y1. The caplet on that date and the
caplet on the next reset date (12/1/Y1) are in the
money.
As a result, with the caplet payoffs, Diamond is

able to obtained a hedged rate of 9.5% for the last 2
payment periods on its loan.
79
80
When compared to a standard cap, the Q-cap provides protection

for the 1-year protection periods, whereas the standard cap
provides protection for each period (quarter).
As shown in the next exhibit slide, a standard 8% cap provides

more protection than the Q-cap, capping the loan at 9.5% from
date 12/1/Y1 to the end of the loan and providing a payoff on 5
of the 7 caplets for a total payoff of $687,500.
In contrast, the Q-cap pays on only 3 of the 7 caplets for a total

payoff of only $500,000.
Because of its lower protection limits, a Q-cap cost less than a

standard cap.
81
82
Exotic Options
Q-caps, average caps, knock-in options, and

knock-out options are sometimes referred to
as exotic options.
Exotic option products are nongeneric

products that are created by financial
engineers to meet specific hedging needs and
return-risk profiles.
83
Exotic Options
Chooser Option: Option that gives the holder the right to choose
whether the option is a call or a put after a specified period of time.
Bermudan Option: An option in which early exercise is restricted to

certain dates.
Forward Start Option: An option that will start at some time in the
future.
Trigger Option: An option that depends on another index; that is,

whether the option is in the money depends on value of another
index.
84
Exotic Options
Asian Option: An option in which the payoff depends on the average
price of the underlying asset during some part of the options life:
Call: IV = Max[Sav X,0]; put: IV = Max[X - Sav,0].
Lookback Option: An option in which the payoff depends on the

minimum or maximum price reached during the life of the option.
Binary Option: An option with a discontinuous payoff such as a

payoff or nothing. For example: If the price is equal or less than X,
the option pays nothing; if the price exceeds X, the option pays a
fixed amount.
Compound Option is an option on an option: Call on a call, call on

put, put on put, and put on call.
85
Exotic Options
Caption: An option on a cap.
Floortion: An option on a floor.
Yield Curve Option: An option between two points on a yield curve.

For example, a yield curve with a exercise equal to 200 basis point on
the difference between the yields on two-year and 10-year notes:
Payoff = Max[(YTM10 YTM2) .02, 0]NP.
86

Managing Fixed-Income Positions With OTC Derivatives

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Managing Fixed-Income Positions With OTC Derivatives

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Managing Fixed-Income

Positions with OTC Derivatives

A forward rate agreement, FRA, requires a cash

For example, the contract could be based on a

If the LIBOR at the end of five months exceeds the

If the LIBOR is less than 6%, the seller (or short

If the LIBOR were at 6.5%, the buyer

If the LIBOR were at 5.5%, the buyer

In general, a FRA that matures in T months and is

Thus, in this example the FRA is a 5 x 8 agreement.

At the maturity of the contract (T), the value of the

Today, FRAs are offered by banks and financial

They are customized contracts designed to meet the

Different from financial futures, FRAs are contracts between two

Sun National Banks jumbo CD pays a rate equal to

Currently such rates are yielding 5.5%.

Kendall is concerned that short-term interest rates

3. Contract rate = Rk = 5.5%

4. Day count convention = 90/365

The exhibit slide shows Kendalls FRA receipts or

As shown, Kendall is able to earn a hedged rate of

On the payoff date:

Payoff Max[R R x ,0]()( NP)

The exercise rate on the option usually is set

Furthermore, suppose that the company expects rates to

As shown in Column 6 of the slide, the company is

On the payoff date:

Payoff Max[R x R ,0]()( NP)

To hedge against interest rate decreases occurring 60

At the maturity of the CD, the company would therefore receive

Based on an investment of $10,000,000 plus the

On the other hand, if the LIBOR exceeds 7%, the

A popular option offered by financial

A plain-vanilla cap is a series of European

Note: Typically, the payoff does not occur on the reset

At each reset date, the company would receive a payoff

Thus, with a cap, the company is able to lock in a

Thus, with a floor, an investor with a floating-rate

We have examined how a strip of Eurodollar futures

Using such exchange-traded options to establish

As a result, many financial and non-financial

Financial institutions typically provide caps

In cases where a floating-rate loan (or investment)

The exercise rate is often set so that the cap or floor

In entering this loan agreement, suppose the

In each of these cases, the higher interest on the loan

For the first 2 reset dates on the loan, 6/1/Y1 and

As an example, suppose the Commerce Bank in the

With the 8% exercise rate, Commerce Bank would be

In the exhibit slide, Commerce Banks quarterly

For example, the Diamond Company in the preceding case

By forming a collar to hedge its floating-rate debt, the

By using the collar instead of the cap, the company

However, when the LIBOR is less than 7%, the company

These payments, in turn, offset the benefits of the

Thus, for LIBORs less than 7%, Diamond has a floor

An alternative financial structure to a collar is

A corridor is a long position in a cap and a

The sale of the higher exercise-rate cap is

For example, instead of selling a 7% floor for

If cap purchasers believe there was a greater chance

A reverse collar is combination of a long position in a

For example, the Commerce Bank in the floor