7 May 2001International Swaps and Derivatives AssociationMexico City

Derivatives and Risk Management in Mexico

Interest Rate and Currency Derivatives

David MengleVice President, J.P. Morgan Securities Inc.Associate Professor, Fordham University Graduate School of Business

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Three forms of derivatives activity

Exchange-traded– Futures– Exchange-traded options

Over-the-counter (OTC)– Swaps– Forwards– OTC options

Structured securities

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Interest rate risk

A U.S. bank (“Client”) expects to receive a loan repayment of US$100 million in two years from a domestic corporation

Loan funded with one-year US$ deposit

Client is concerned that US$ interest rates will rise

Situation

Assets Liabilities

Loan (2-year, fixed rate) US$100 MM

Deposit (1-year Libor)US$100 MM

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Interest rate risk

ClientClient

2-yearFixed Rate

Loan

Situation

Deposit

1-year Libor

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Forward rate agreement (FRA)

A forward contract on interest rates

DealerDealer

ClientClient

ReferenceRate

Contract Rate

Fixed Rate

Loan

Libor

Deposit

One year from now

Forward rate, determined when contract is agreed

(dealing date)

Libor, determined at settlement

date

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Result of hedging with FRA

Client has given up interest rate risk by locking in forward rate (replaced risk with certainty)– Client will be protected from rising deposit

rates,– But will not benefit if rates fall

Client assumes credit exposure to Dealer (and vice versa)

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Futures contracts

Institutional features that promote liquidity– Standardized contracts– Organized exchanges

Institutional features that reduce credit risk– Clearinghouse is counterparty– Daily settlement (mark to market)– Margin requirements– Loss-sharing arrangements

An alternative to forward contracts

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Interest rate exposure

Situation

Client has purchased a US$100 MM 5-year U.S. Government Agency note yielding 6.5%

Purchase funded with one-year US$ deposits

Client is concerned that US$ interest rates will rise

Assets Liabilities

U.S. Agency Note (5-year fixed @6.5%) US$100 MM

Deposit (1-year Libor)US$100 MM

9Net Funding Cost: 5-Year Swap Rate = 6.1%Net Funding Cost: 5-Year Swap Rate = 6.1%

Interest rate swap

DealerDealer

ClientClient

LiborSwapRate

(6.1%)

Fixed Rate

(6.5%)Libor

Deposit Agency Note

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Swap cash flows

At inception, PV(Floating Rate Leg) = PV(Fixed Rate Leg)

Time Deposit Swap Net

0 100 -- -- 100

1 (LIBOR) LIBOR (6.1) (6.1)

2 (LIBOR) LIBOR (6.1) (6.1)

3 (LIBOR) LIBOR (6.1) (6.1)

4 (LIBOR) LIBOR (6.1) (6.1)

5 (100 + LIBOR) LIBOR (6.1) (106.1)

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Interest rate swaps

Interest rate swap – A contractual agreement between two counterparties to exchange cash flows on a notional principal amount at regular intervals during a stated period (maturity)

– Notional amount is never exchanged

Trade Date – The date on which the parties commit to the swap and agree to its terms

Effective Date – The date on which payments begin to accrue

– Normally two days after trade date– Forward starting swap: Effective date can be any future date

Definitions

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Result of hedging with swap

Client has given up interest rate risk by locking in swap rate (replaced risk with certainty)– Client will be protected from rising deposit

rates over term of swap,– But will not benefit if rates fall

Client assumes credit exposure to Dealer (and vice versa) over term of swap

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Currency risk

Situation

Client has purchased a one-year US$ note, which it funded with a one-year DM deposit

Both the note and deposit rates are fixed

Client wishes to eliminate the DM/US$ currency risk

Assets Liabilities

Note (1-year, fixed rate) US$100 MM @5.90%

Deposit (1-year @ 1-year DM Libor)DM180 MM @3.95%

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Currency forward

DealerDealer

ClientClientDM 187.11 MMUS$105.90 MM

DepositNote

One year from now:

US$105.90 MM DM 187.11 MM

Spot rate = 1.800

Forward rate = 1.767

Note: Currency forwards are normally physically-settled, that is, each party makes a currency payment to the other

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Result of hedging with forward contract

Client has locked in forward exchange rate of 1.767

Client is protected against appreciating DM, but will not benefit if DM depreciates

Client assumes credit exposure to dealer

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Interest rate parity

Money rates (1-year)

US$ Libor = 5.90%

DM Libor = 3.95%

Exchange rates

Spot: 1.800

1-year forward: 1.767

5.90% 3.95%

1.800

1.767US$105.90 MM

US$100 MM

DM187.11 MM

DM180 MM

Two ways to get to the same result...

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Currency risk

Situation

German bank wants to lend in U.S.

Not well-known in US$ capital market

Will fund by borrowing in DM

Exposed to rising DM (falling US$)

Assets Liabilities

Loans (5-year, fixed rate) US$100MM @6.8%

Note (5-year, fixed-rate)DM180 MM @4.8%

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US$ LoansUS$ Loans

German BankGerman Bank

DMInterest

Currency risk

German bank exposed to rising deutschmark

DM NoteDM Note

US$Interest

DM180 million

US$100 million

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DM180 million

DealerDealer

Currency swap

US$ LoansUS$ Loans

German BankGerman Bank

US$100 million

DM NoteDM Note

DM180 million

$100 million

Initial principal exchangeInitial principal exchange

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6.1% (US$)

4.8% (DM)

DealerDealer

Currency swap

Payments during swapPayments during swap

US$ LoansUS$ Loans

German BankGerman Bank

4.8%

DM NoteDM Note

6.8%

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Currency swap

DealerDealer

US$ LoansUS$ Loans

German BankGerman Bank

DM NoteDM Note

DM180 million

US$100 million

US$100 million

DM180 million

Final principal exchangeFinal principal exchange

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DealerDealer

US$100 million

DM180 million

Currency swap

Final principal exchangeFinal principal exchange

German BankGerman Bank6.1% (US$)

4.8% (DM)

Payments during swapPayments during swap

DM180 million

$100 million

Initial principal exchangeInitial principal exchange

US$ LoansUS$ Loans

4.8%

DM NoteDM Note

6.8%

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Result of hedging with cross-currency swap

Client has given up currency risk by locking in spot rate on notional principal (replaced risk with certainty)

– Client will be protected from rising DEM over term of swap,

– But will not benefit if DEM falls

Client assumes credit exposure to Dealer (and vice versa) over term of swap

– Potential credit exposure substantially higher than interest rate swap of similar maturity because of final exchange of principal at maturity

– Implication: Cross-currency swaps make intensive use of dealer credit capacity

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Options: Definitions

A legal contract that gives the buyer, in exchange for the payment of a premium, the right but not the obligation to buy or sell a specified amount (contract amount) of the underlying asset at a predetermined price (strike price) at a stated time (maturity date or expiry).

Call option - option to buy– Interest rate cap

Put option - option to sell– Interest rate floor

Option buyer or holder (long)

Option seller or writer (short)

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Options: Definitions

Exercise (strike) price is the price specified in the option contract

Maturity date is the time after which the option is no longer valid– Also called expiration date or expiry– Maturity sometimes called tenor

European option can only be exercised at expiry

American option can be exercised any time up to expiry

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Options

DealerDealerClientClient

Max (L-Strike,0)(on each Payment Date)

Libor

Purchase interest rate cap struck at maximum rate client can tolerate

Client pays up-front premium for the option

Contrast: Swap locks in a rate, option insures against high rates

Interest rate cap

Deposit

Up-front premium(on Trade Date)

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Definitions: Caps and floors

Interest rate cap

Contract in which the seller compensates the buyer when the observed rate is greater than the predetermined strike rate.

Interest rate floor

Contract in which the seller compensates the buyer when the observed rate is less than the predetermined strike rate.

Interest rate collar

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Currency risk

German bank wants to lend in U.S.– Will fund by issuing fixed rate DM note– Exposed to rising DM (falling US$)

Wants to retain benefit if DM falls (US$ rises)

Solution: U.S. dollar put option– In exchange for up-front premium, client buys the right

but not the obligation to exchange US$ 100MM for DEM 180MM

Assets Liabilities

Loans (5-year, fixed rate) US$100MM @6.8%

Note (5-year, fixed rate)DM180MM @4.8%

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Variations on swap and options contracts

Types of contracts– Basis swaps– Options on swaps (swaptions)

Credit derivatives– Credit default swap– Total return swap

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Interest rate risk

A U.S. bank makes floating rate US$ loans to corporations priced at the Prime Rate

The bank funds the loans with floating rate deposits priced at Libor

Bank is exposed to changes in the difference between the two floating rates

Assets Liabilities

Loans(Prime Rate) US$100 MM

Deposits (3-month Libor)US$100 MM

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Solution: Basis swap

Definition: An interest rate swap in which both payments involve floating rates

Purpose: To lock-in spread between assets & liabilities

DealerDealer

ClientClient

Prime – 2.75%

Prime Rate

Libor

LoansDeposits

Libor

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Cross-currency basis swap

DealerDealer

German German BankBank

US$ Libor

US$ Libor + 50

DM LiborUS$

LoansDM

Deposits

DM Libor + 10

Swap includes initial and final principal exchanges

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Interest rate risk

A company expects to take out a floating-rate bank loan at US$ Libor plus 50 basis points one year from now

Client expects to need the funds for 5 years

Client is concerned that rates will rise

But client is not willing to lock in fixed rate yet– Forward-starting swap would lock in rate now– Five-year series of interest rate caps would be

relatively costly because of high amount of protection provided

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Solution: Swap option

A swap option (swaption) is an option on a forward-starting swap – Gives the holder the right, not the obligation, to enter into a swap contract in the

future– Can also be an option to cancel an existing swap in the future– Single option on a long-term fixed rate

• Contrast: caps are a series of options on short-term rates

Strike price is fixed rate of underlying swap

Up-front premiums normally quoted as percentage of underlying swap notional

Expiry is date on (or until) which swaption can be exercised

Can be exercised into underlying swap or cash-settled

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Types of swap options

Swap options can be European or American

Receiver swap option– Contract in which the buyer has the right, but not the obligation, to

enter into a swap receiving a predetermined fixed rate on a predetermined date in the future.

– Also known as a call swaption.

Payer swap option– Contract in which the buyer has the right, but not the obligation, to

enter into a swap paying a predetermined fixed rate on a predetermined date in the future.

– Also known as a put swaption.

Quotation– ‘1 into 5’ 7% receiver swation would be an option to enter into a five-

year swap as receiver starting in one year

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Credit (default) swaps

Buyer pays premium for protection against default by reference credit

Receives payout if reference credit(s) default (or other credit event occurs)– Can equal post-event fall in price of reference obligation below par; or– Fixed sum or percentage of notional (binary settlement); or– Par value in return for physical delivery of reference obligation

Results: – Credit swap hedges both default risk and credit concentration risk– Buyer trades credit risk of reference credit for counterparty credit risk of seller

X bp per annum

Contingent paymentProtection buyerProtection buyer Protection sellerProtection seller

The ‘plain vanilla’ of credit derivatives

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Total return swaps

Allows the transfer of the total economic performance of a reference obligation (loan, security, lease receivable, commodity)

Periodic payments are based on changes in market value of reference obligation, whether or not credit event has occurred

Total return: Interest + Fees + (Final Value Original Value)–TR Payer pays TR Receiver if total return is positive–TR Receiver pays TR Payer if total return is negative

LIBOR + X bp p.a.

TR of reference obligation

TR ReceiverTR Receiver TR PayerTR Payer