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Interest rate Derivatives
&
Its applications & usefulness in India.
SMBA Batch 25Amit P. Kasar Pooja Jadhav
Dipika Yadav Smita Dumbre
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Meaning Of Derivatives
A derivative is any instrument or contractthat derives its value from anotherunderlying asset, instrument, or contract
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Interest Rate Derivatives
An interest rate derivative is a financial derivative wherethe underlying asset (interest-bearing instrument) is theright to pay or receive a notional amount of money at agiven interest rate.
An interest rate derivative is a derivative whose payoffs aredependent on future interest rates
The interest rate derivatives market is the largest derivativesmarket in the world
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Interest RateDerivatives
OTC
ForwardRate
Agreements
InterestRate
Swaps
Interest RateOptions
Caps Floors Collars
Exchange Traded
InterestRate
Futures
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Using Forward Rate Agreements to Manage Interest RateRisk
Forward Rate Agreements
A forward contract based on interest rates based on anotional principal amount at a specified future date
Buyer
Agrees to pay a fixed-rate coupon payment (at the
exercise rate) and receive a floating-rate paymentSeller
Agrees to make a floating-rate payment and receive afixed-rate payment
The buyer and seller will receive or pay cash when theactual interest rate at settlement is different than theexercise rate
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Forward Rate Agreements (FRA)
Similar to futures but differ in that they:
Are negotiated between parties Do not necessarily involve standardized assets
Require no cash exchange until expiration
There is no marking-to-market
No exchange guarantees performance
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Notional Principal
The two counterparties to a forward rate agreement agree toa notional principal amount that serves as a reference figurein determining cash flows.
Notional
Refers to the condition that the principal does notchange hands, but is only used to calculate the value
of interest payments.
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Notional Principal
Buyer
Agrees to pay a fixed-rate coupon payment and receive afloating-rate payment against the notional principal atsome specified future date.
Seller
Agrees to pay a floating-rate payment and receive thefixed-rate payment against the same notional principal.
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Example: Forward Rate Agreements
Suppose that Metro Bank (as the seller) enters into a receivefixed-rate/pay floating-rating forward rate agreement withCounty Bank (as the buyer) with a six-month maturitybased on a 1 million notional principal amount
The floating rate is the 3-month MIBOR and the fixed(exercise) rate is 7%
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Example: Forward Rate Agreements
Metro Bank would refer to this as a 3 vs. 6 FRA at 7percent on a 1 million notional amount from County Bank
The phrase 3 vs. 6 refers to a 3-month interest rateobserved three months from the present, for a security witha maturity date six months from the present
The only cash flow will be determined in six months atcontract maturity by comparing the prevailing 3-monthMIBOR with 7%
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Example: Forward Rate Agreements
Assume that in three months 3-month MIBOR equals 8%
In this case, Metro Bank would receive from CountyBank 2,451.
The interest settlement amount is 2,500:
Interest = (.08 - .07)(90/360) 1,000,000 = 2,500.
Because this represents interest that would be paidthree months later at maturity of the instrument, theactual payment is discounted at the prevailing 3-month MIBOR:
Actual interest = 2,500/[1+(90/360).08]=2,451
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Example: Forward Rate Agreements
The FRA position is similar to a futures position
County Bank would pay fixed-rate/receive floating-rateas a hedge if it was exposed to loss in a rising rateenvironment.
This is similar to a short futures position
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Interest Rate Futures in India
While the name interest rate futures suggests that theunderlying is interest
rate, it is actually bonds that form the underlying instruments.An important
point to note is that the underlying bond in India is a notionalgovernment
bond which may not exist in reality. In India, the RBI and theSEBI have
defined the characteristics of this bond: maturity period of 10years and
coupon
rate of 7% p.a. It is also worthwhile noting that several othercountries have
adopted the concept of notional bond, although thecharacteristics of the
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Rationale of IRFs
It is not just the financial sector, but also the corporate andhousehold sectors that are exposed to interest rate risk.
Banks, insurance companies, primary dealers and providentfunds bear significant interest rate risk on account of themismatch in the tenure of their assets (such as loans andGovt. securities) and liabilities. These entities therefore needa credible institutional hedging mechanism. Interest rate
risk is becoming increasingly important for the householdsector as well, since the interest rate exposure of severalhouseholds are rising on account of increase in their savingsand investments as well as loans (such as housing loans,vehicle loans ,etc.). Moreover, interest rate products are theprimary instruments available to hedge inflation risk, which
is typically the single most important macroeconomic riskfaced by the household sector.
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Benefits of Exchange traded IRF
Interest rate futures provide benefits typical to any Exchange-traded product, such as
StandardizationOnly contracts with standardized featuresare allowed to trade on the exchange. Standardizationimproves liquidity in the market.
The following features are standardized:
Only certain expiry dates are allowed in India viz. last workingday of the months of March, June, September and December.
The size of contract can only be in multiples of a certainnumber called the lot size. The lot size currently in India is Rs. 2
lakhs.Only some specific bonds can be used for delivery.
TransparencyTransparency is ensured by dissemination oforders and trades for all market participants. Also, competitive
matching of orders of buyers and sellers boosts transparency.
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Application of Interest Rate Derivatives
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IRF: Contract Specifications
IRF contracts can be traded on the Exchange.
Standardization is done both in terms of the features of theproduct and the mechanism of its trading and settlement.Various features of standardization are discussed in thissection.
Product Features
The features of the product are as follows:
Underlying bond: Underlying bond is a notional 10 year, 7%coupon-bearing Government of India bond.
Lot size: The minimum amount that can be traded on theexchange is called the lot size. All trades have to be a multipleof the lot size. The interest rate futures contract can be enteredfor a minimum lot size of 2000 bonds at the rate of Rs. 100 perbond (Face Value) leading to a contract value of Rs. 200,000
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Contract cycle:
New contracts can be introduced by the Exchange on anyday of a calendar month. At the time of introduction, theduration of any contract can vary from 1 month to 12months. The expiry has to be on Last Thursday of theExpiry month.
Expiry dayInterest rate future contracts shall expire on the lastThursday of the expiry month. If the last Thursday is atrading holiday, the contracts shall expire on the previous
trading day.
Further, where the last Thursday falls on the annual or half-yearly closing dates of the bank, the expiry and last trading
day in respect of these derivatives contracts would be pre-oned to the revious tradin da .
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Trading Parameters
Contract sizeThe permitted lot size for the interest rate futures contracts shall be 2000. The
minimum value of a interest rate futures contract would be Rs. 2 lakhs at thetime of introduction.
Price stepsThe price steps in respect of all interest rate future contracts admitted to dealingson the Exchange is Re.0.01.
The Futures contracts having face value of Rs 100 on notional ten year couponbearing bond and notional ten year zero coupon bond would be based on pricequotation and Futures contracts having face value of Rs. 100 on notional 91 daystreasury bill would be based on Rs. 100 minus (-) yield.
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Cont
Base Price & operating rangesBase price of the Interest rate future contracts onintroduction of new contracts shall be theoretical futuresprice computed based on previous days closing price of thenotional underlying security. The base price of the contractson subsequent trading days will be the closing price of the
futures contracts. However, on such of those days when thecontracts were not traded, the base price will be the dailysettlement price of futures contracts.
Quantity freezeOrders which may come to the Exchange as a quantityfreeze shall be 2500 contracts amounting to 50,00,000 whichworks out on the day of introduction to approximately Rs
50 crores.
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Settlement Procedure & Settlement Price
Daily Mark to Market Settlement and Final settlement for Interest Rate Futures Contract
Daily Mark to Market settlement and Final Mark to Market settlement in respect of admitted
deals in Interest Rate Futures Contracts shall be cash settled by debiting/ crediting of theclearing accounts of Clearing Members with the respective Clearing Bank.
All positions (brought forward, created during the day, closed out during the day) of a F&OClearing Member in Futures Contracts, at the close of trading hours on a day, shall bemarked to market at the Daily Settlement Price (for Daily Mark to Market Settlement) andsettled.
All positions (brought forward, created during the day, closed out during the day) of a F&OClearing Member in Futures Contracts, at the close of trading hours on the last trading day,shall be marked to market at Final Settlement Price (for Final Settlement) and settled.
Daily Settlement Price shall be the closing price of the relevant Futures contract for theTrading day.
Final settlement price for an Interest rate Futures Contract shall be based on the value of thenotional bond determined using the zero coupon yield curve computed by National Stock
Exchange or by any other agency as may be nominated in this regard.
Open positions in a Futures contract shall cease to exist after its expiration day.
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A Summary of Contract Specification
Contractunderlying
Notional 10year bond(6 % coupon )
Notional 10year zerocoupon bond
Notional 91 dayT-Bill
Contractdescriptor
N FUTINTNSE10Y0626JUN2003
N FUTINTNSE10YZC26JUN2003
N FUTINTNSETB91D26JUN2003
ContractValue
Rs.2,00,000
Lot size 2000
Tick size Re.0.01
Expirydate
Last Thursday of the month
Contract
months
The contracts shall be for a period of a maturity ofone year with three months continuous contracts
for the first three months and fixed quarterlycontracts for the entire year.
Pricelimits
Not applicable
Settlement Price
As may be stipulated by NSCCL in this regardfrom time to time.
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Daily Settlement PriceDaily settlement price for an Interest Rate Futures Contractshall be the closing price of such Interest Rate Futures Contract
on the trading day. The closing price for an interest rate futurescontract shall be calculated on the basis of the last half an hourweighted average price of such interest rate futures contract. Inabsence of trading in the last half an hour, the theoretical pricewould be taken or such other price as may be decided by therelevant authority from time to time.
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Participants in the Interest Rate Futures market
The participants in the IRF market are broadly classified into threegroups, depending on what is the purpose of their participation.
Hedgers: Companies and institutions having exposure to interest rates--because of their holdings of government bonds or their borrowing(liabilities) and lendings (assets)--hedge the risk arising from adverseinterest rate movement by using IRF. These entities are called hedgers.
Speculators: Speculators participate in the future market to take up theprice risk, which is avoided by the hedgers. They take calculated riskand gain when the prices move as per their expectation.
Arbitrageurs: Arbitrageurs closely watch the bond and futures marketsand whenever they spot a mismatch in the alignment in the prices of thetwo markets, they enter to make some profit in a risk-free transaction.
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Hedging Applications of IR Derivatives
One way to hedge a position in the spot bond market is to take anopposite position in the IRF market. This ensures that a change in
interest rates will not affect the value of a portfolio and this strategy isalso called Interest rate immunization.
IR derivatives in general and IR futures in particular have huge hedgingapplications unlike equity derivatives. This is because, almost everyeconomic entity has an exposure to interest rate fluctuation in some
form or the other. Also, given its very nature, interest rates get affectedby a number of macro-economic factors. Hence, hedging through IRderivative becomes crucial. This is particularly so in turbulent times,when economic uncertainty is high.
As we have discussed, individuals, corporate, banks and insurance
companies all are exposed to interest rate risk. So they need interest ratefutures to hedge their risks.
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Hedging Applications of IR Derivatives contd
Broadly the various uses of the IR derivatives are as mentioned below:
Asset-liability management: Banks typically have lot of government
bonds and other long term assets (loans given to corporates) in theirportfolio, while their liabilities are predominantly short-term (depositsmade by individuals range from 1 to 5 years). To address the riskresulting from the asset-liability mismatch, they generally sell IRF andthereby, hedge the interest rate risk. On the other hand, for the
insurance companies and several big corporates, the tenure of theirliabilities is longer than that of their assets. So, they buy IRF to hedge theinterest rate risk.
Investment portfolio management: Mutual funds and similar assetclasses having a portfolio of bonds can use IR futures to manage their
interest rate exposure in turbulent times.
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Speculation strategies
Long Only Strategy:
In the view of some investors, by consistently having a long position in assets,
particularly in bonds, one can achieve fair returns. They hold this view for IRFalso, as IRF has the bond as its underlying. These investors buy IRF andrepeatedly roll them over before each expiry. This strategy is called Long OnlyStrategy.
View Based Trading:
In contrast to Long Only investors, some investors take both long and shortpositions in the IRF market, depending on their views on interest ratemovements in future. If they expect interest rates to go up, they sell IRF and ifthey have the opposite expectation, they buy IRF. If the interest rate movementturns out to be the way the investor expected, he would make profit; otherwise,
he would make losses.
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Arbitrage strategy
Frequently, the price of a bond in spot market and price of futures maynot be aligned with each other because of some distortions in the
supply/demand factors. The arbitrage strategy employed to gain risk-free profits by exploiting the non-alignment (or mis-pricing of futuresrelative to spot bond prices) is called cash/futures arbitrage.Cash/Futures arbitrage is also called basis arbitrage or cash and carryarbitrage. Smart market participants take advantage of such situations
to make risk free profits. It involves buying a bond in cash (spot) marketand selling futures simultaneously or vice versa.
It should be noted that the cost of carry has to be considered whilecalculating the profits. Net basis is an important parameter to trackarbitrage in IRF market. Net basis is typically positive. If net basis turns
negative, however, an arbitrage opportunity arises, which can beexploited to make risk-free profits.
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Basic Interest Rate Swaps
Basic or Plain Vanilla Interest Rate Swap
An agreement between two parties to exchange a seriesof cash flows based on a specified notional principalamount
Two parties facing different types of interest rate risk canexchange interest payments
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Basic Interest Rate Swaps
Basic or Plain Vanilla Interest Rate Swap
One party makes payments based on a fixed interest rateand receives floating rate payments
The other party exchanges floating rate payments forfixed-rate payments
When interest rates change, the party that benefits from aswap receives a net cash payment while the party thatloses makes a net cash payment
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Basic Interest Rate Swaps
Conceptually, a basic interest rate swap is a package ofFRAs
As with FRAs, swap payments are netted and thenotional principal never changes hands
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Basic Interest Rate Swaps
Using data for a 2-year swap based on 3-month MIBOR asthe floating rate
This swap involves eight quarterly payments.
Party FIX agrees to pay a fixed rate
Party FLT agrees to receive a fixed rate with cash
flows calculated against a 10 million notionalprincipal amount
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Basic Interest Rate Swaps
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Basic Interest Rate Swaps
Firms with a negative GAP can reduce risk by making afixed-rate interest payment in exchange for a floating-rateinterest receipt
Firms with a positive GAP take the opposite position, bymaking floating-interest payments in exchange for a fixed-rate receipt
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Basic Interest Rate Swaps
Basic interest rate swaps are used to:
Adjust the rate sensitivity of an asset or liabilityFor example, effectively converting a fixed-rate loaninto a floating-rate loan
Create a synthetic security
For example, enter into a swap instead of investing ina security
Macrohedge
Use swaps to hedge the banks aggregate interest rate
risk
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Basic Interest Rate Swaps
Swap Dealers
Handle most swap transactions Make a market in swap contracts
Offer terms for both fixed-rate and floating rate payersand earn a spread for their services
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Basic Interest Rate Swaps
Comparing Financial Futures,FRAs, and Basic Swaps
There is some credit risk withswaps in that the counterpartymay default on the exchange ofthe interest payments
Only the interest payment
exchange is at risk, not theprincipal
Objective Financial Futures FRAs & Basic Swaps
Profit If Rates Rise Sell Futures Pay Fixed, Receive Floating
Profit If Rates Fall Buy Futures Pay Floating, Receive Fixed
Position
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Interest Rate
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Interest RateOptions
Interest RateCaps
Interest RateFloors
Interest RateCollars
Zero Cost Collar
Reverse Collar
(Hedge againsthigher interest ratesby fixing maximuminterest rate)
(Hedge againstfalling interestrates by fixing aminimum interest
rate)
(Combination of a capand a floor in order tofix a certain interestrate range)
C
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Interest Rate Caps
An agreement between two counterparties that limits thebuyers interest rate exposure to a maximum limit
Buying a interest rate cap is the same as purchasing a calloption on an interest rate
I R Fl
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Interest Rate Floors
An agreement between two counterparties that limits thebuyers interest rate exposure to a minimum rate.
Buying an interest rate floor is the same as purchasing aput option on an interest rate
Interest Rate Collars
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Interest Rate CollarsInterest Rate Collar:
The simultaneous purchase of an interest rate cap andsale of an interest rate floor on the same index for thesame maturity and notional principal amount
Zero Cost Collar
A collar where the buyer pays no net premium
The premium paid for the cap equals the premiumreceived for the floor
Reverse Collar
Buying an interest rate floor and simultaneously selling
an interest rate cap It protects a bank from falling interest rates
P i i I t t R t C d Fl
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Pricing Interest Rate Caps and Floors
The size of the premiums for caps and floors is determinedby:
The relationship between the strike rate and the currentindex
This indicates how much the index must move beforethe cap or floor is in-the-money
The shape of yield curve and the volatility of interestrates
With an upward sloping yield curve, caps will bemore expensive than floors
Floating Rate
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Basic Swapto Hedge
AggregateBalance
Sheet Riskof Loss
from
FallingRates
Bank SwapTerm-Pay
MIBOR,Receive4.18%
Current Rates
Constant
Rates Fall
100 Basis Points
Balance Sheet
Flows:
Loan
Deposit
Spread
6.50%
(3.75%)
2.75%
5.50%
(3.75%)
1.75%
7.50%
(3.75%)
3.75%
4.18%
(3.00%)
1.18%
4.18%
(2.00%)
2.18%
4.18%
(4.00%)
0.18%
3.93% 3.93% 3.93%
Interest Rate
Swap Flows:
Fixed
Floating
Spread
Margin
Rates Rise
100 Basis Points
PRIME 5.50%
MIBOR 3.00%
PRIME 4.50%
MIBOR 2.00%
PRIME 6.50%
MIBOR 4.00%
Loans
Prime + 1%
Bank
Fixed 3.75%
4.18% Fixed
Three-Month MIBOR
Deposits
Swap
Counterparty
Floor Terms: Buy a 2 50 Percent Floor on 3Floating Rate
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Buying aFloor on 3-
MonthMIBOR to
Hedge
AggregateBalanceSheet Risk
of LossFrom
Falling
Rates
Floor Terms: Buy a 2.50 Percent Floor on 3-Month MIBOR
Rates Fall
100 Basis Points
Balance Sheet
Flows:
Loan
Deposit
Spread
6.50%
(3.75%)
2.75%
5.50%
(3.75%)
1.75%
7.50%
(3.75%)
3.75%
0.00%
(0.30%)
(0.30%)
0.50%
(0.30%)
0.20%
0.00%
(0.30%)
(0.30%)
2.45% 1.95% 3.45%
Floor
Flows:
Payout
Fee Amort.
Spread
Margin
Rates Rise
100 Basis Points
PRIME 5.50%
MIBOR 3.00%
PRIME 4.50%
MIBOR 2.00%
PRIME 6.50%
MIBOR 4.00%
Loans
Prime + 1%
Bank
Fixed 3.75%
Three-Month MIBOR < 2.50%
Fee: (0.30%) per year
Receive when
Deposits
Counterparty
Current Rates
Constant
Loans Strategy: Buy a Floor on 3-Month MIBOR at
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Buying aReverseCollar toHedge
Aggregat
e BalanceSheet
Risk ofLoss from
Falling
Rates
Rates Fall
100 Basis Points
Balance Sheet
Flows:
Loan
Deposit
Spread
6.50%
(3.75%)
2.75%
5.50%
(3.75%)
1.75%
7.50%
(3.75%)
3.75%
0.00%
0.38%
0.38%
0.50%
0.38%
0.88%
(0.50%)
0.38%
(0.12%)
3.13% 2.63% 3.63%
Reverse Collar
Flows:
Payout
Fee Amort.
Spread
Margin
Rates Rise
100 Basis Points
PRIME 5.50%
MIBOR 3.00%
PRIME 4.50%
MIBOR 2.00%
PRIME 6.50%
MIBOR 4.00%
Loans
Prime + 1%
Bank
Fixed 3.75%
Three-Month MIBOR < 2.00%Premium: 0.38% per year
Receive when
Three-Month MIBOR > 3.50%
Pay when
Deposits
Counterparty
Strategy: Buy a Floor on 3 Month MIBOR at2.00 Percent, and Sell a Cap on 3-MonthMIBOR at 3.50 Percent
Fixed Rate
Loans
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Using aBasicSwap toHedge
Aggregate
BalanceSheet
Risk ofLossFrom
RisingRates
Rates Fall
100 Basis Points
Balance Sheet
Flows:
Loan
Deposit
Spread
7.00%
(2.75%)
4.25%
7.00%
(1.75%)
5.25%
7.00%
(3.75%)
3.25%
(4.19%)
3.00%
(1.19%)
(4.19%)
2.00%
(2.19%)
(4.19%)
4.00%
(0.19%)
3.06% 3.06% 3.06%
Interest Rate
Swap Flows:
Fixed
Floating
Spread
Margin
Rates Rise
100 Basis Points
MIBOR 3.00% MIBOR 2.00% MIBOR 4.00%
Loans
Fixed 7.00%
Bank
3-Month MIBOR -0.25%
Three-Month MIBOR
4.19% Fixed
Deposits
Swap
Counterparty
Current Rates
Constant
Strategy: Pay 4.19 Percent, Receive 3-Month MIBOR
Fixed Rate
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Buy a Capon 3-
MonthMIBOR to
Hedge
BalanceSheet Rate
Risk ofLoss from
Rising
Rates
Rates Fall
100 Basis Points
Balance Sheet
Flows:
Loan
Deposit
Spread
7.00%
(2.75%)
4.25%
7.00%
(1.75%)
5.25%
7.00%
(3.75%)
3.25%
0.00%
(0.50%)
(0.50%)
0.00%
(0.50%)
(0.50%)
0.50%
(0.50%)
0.00%
3.75% 4.75% 3.25%
Cap
Flows:
Payout
Fee Amort.
Spread
Margin
Rates Rise
100 Basis Points
MIBOR 3.00% MIBOR 2.00% MIBOR 4.00%
Fixed Rate
Loans
Bank
Three-Month MIBOR -0.25%
Three-Month MIBOR > 4.00%
Fee: (0.50%) per year
Receive when
Deposits
Counterparty
Fixed 7.00%
Current Rates
Constant
Strategy: Buy a Cap on 3-Month MIBOR at 4.00 Percent
S B C 3 00 P d S ll Fl
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Using aCollar on3-Month
MIBOR toHedge
BalanceSheet Risk
of Lossfrom
Rising
Rates
Rates Fall
100 Basis Points
Balance Sheet
Flows:
Loan
Deposit
Spread
7.00%
(2.75%)
4.25%
7.00%
(1.75%)
5.25%
7.00%
(3.75%)
3.25%
0.00%
(0.75%)
(0.75%)
(0.00%)
(0.75%)
(0.75%)
1.00%
(0.75%)
0.25%
Collar
Flows:
Payout
Fee Amort.
Spread
Rates Rise
100 Basis Points
MIBOR 3.00% MIBOR 2.00% MIBOR 4.00%
Loans
Fixed 7.00%
Bank
3-Month MIBOR -0.25%
Three-Month MIBOR < 2.00%Fee: (0.75%) per year
Pay when
Three-Month MIBOR > 3.00%
Receive when
Deposits
Counterparty
Current Rates
Constant
Strategy: Buy a Cap at 3.00 Percent, and Sell a Floor at2.00 Percent
Conclusion
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Conclusion
Interest rate volatility is a major source of uncertaintyparticularly for financial institutions
A single-period interest rate exposure can be hedged usingFRAs, interest rate futures, simple interest rate options andoptions on interest rate futures
Multi-period risk can be managed with interest rate capsand floors
Valuation of interest rate derivatives must take account ofthe stochastic evolution of the entire term structure and incertain cases, simpler approaches using binomial lattice or
modifications of Black-Scholes model may be adequate
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