Financial Engineering

Financial EngineeringIntroduction Need of a New System/ Instrument:

Q. Why do we need a new instrument/ system???

ExampleIn an informal financial system, there was a greater credit risk. To mitigate this risk, the need of a formal financial system was felt.

2. The basic forms of sources of funds (???) were not fulfilling the need of entrepreneurs and hence, there was need of development of new instruments to raise funds e.g: Hybrid instruments (FCCB, ECB etc.)DefinitionFinancial engineering involves the design, the development and the implementation of innovative financial instruments and processes and the formulation of creative solutions to problems in finance.Price Chart of NTPC

Q. You are a fund manager and have taken shares of NTPC in your portfolio. Share prices of NTPC are falling. What possible actions will you take ? (Before or/ and after the event )Functions Functions of financial engineers: Functions are not limited to the listed ones. Few of them are:Investment and Money Management: Mutual Funds, Money Market Funds, Repo market etc.

2. Security and Derivative Products Trading: To take advantage of arbitrage, innovation of program trading (??).Continue3. Corporate Finance: formulation of new instruments to raise funds, pay-off debts etc.

4. Investment Banks: IPO management, M & A ( Pricing methods of IPO, Innovative ideas to handle M&A like: issuance of junk bond, Leverage Buy-outs (LBO) etc.).5. Risk Management: Development of derivative instruments (Future, option, SWAP etc.)Case 1You are a financial engineer and standing at a time when only Debt, Equity and F.D are the sources of investment. Mr. X is having Rs. 10 lakh to invest but his risk appetite is not high. At the same time, he would like to take exposure in both equity as well as debt and short-term F.Ds. What type of instrument can you design/ suggest him to invest in??Tools of F.EsF.E.Conceptual ToolsPhysical ToolsAccounting Relationship, Valuation Theory, Portfolio Theory, hedging Theory etc.Instruments like: Equities, Derivatives, Bonds etc.Processes: Electronic Securities Trading, IPO, Private placements etc.Risk Define it ???Price Risk Risk is any deviation in expected value of a security/ portfolio/ asset class.

Ex: Share price of NTPC is Rs.130 per share today. But, What about tomorrows price??

Types of Financial RiskThe term "financial risk" covers the range of risks affecting financial outcomes, faced by a firm. Financial risk is essentially of two kinds: systematic and unsystematic.

Systematic RiskBusiness risk is the risk of fluctuations in sales revenue. It arises from macroeconomic factors such as economic swings and deregulation, and demand factors such as seasonality of demand. This risk is not totally systematic, however, and some of it can be reduced by diversification of the firm's operations.

Financing risk arises from leverage. It is possible to minimise it by restricting the amount of debt in the firm, even though there may be tax advantages to borrowing.

Continue..Inflation risk arises from unanticipated inflation Marketability, or liquidity risk: When it is difficult to buy or sell a financial instrument at its market price. This risk is un-diversifiable and also completely systematic. Political risk can be both domestic and foreign; it is particularly high when operating in some politically unstable economy. This risk is highly systematic and unavoidable.

Unsystematic RiskInterest rate risk arises both from fixed and floating rate debt. Unanticipated changes in floating interest rates can cause costs to rise. Floating-rate debt offers a long-run hedge against inflation risk. At the same time, a fixed rate debt can cause financial difficulties in case interest rates drop. This is therefore a major risk faced by almost all companies. It can be hedged against in many ways. ContinueCurrency (or foreign exchange) risk arises when cash inflows or outflows take place in foreign currency. This risk can be either diversified or hedged.

Commodity price risk arises from unanticipated changes in commodity prices and can be hedged.

Calculation of RiskSystematic Risk:Unsystematic RiskTotal RiskDiversificationWhat is beta ??

Future & ForwardWhy do we need it??

Forward MarketA forward contract is a contract between two parties to exchange assets or services at a specified time in the future at a price agreed upon at the time of the contract.

How do you the future price today ???What is risk here ??

Forward contact is non-standardized.Traded on OTC (Over the Counter).

Future MarketA futures contract is a contract between two parties to exchange assets or services at a specified time in the future at a price agreed upon at the time of the contract.

It is standardized.It is traded on Exchanges. Continue

An exchange acts as an intermediary and guarantor, and also standardizes and regulates how the contract is created and tradedPay-off Diagram of Future

Strike Price (K)Delivery PriceSTContinuePay-off from Long position in future/ Forward = ST -K Where ST = Spot price of asset at maturity K = Strike Price (Delivery price)

- Short position in future/ Forward = K - ST

Pay-off of Nifty Future (long)Strike Price 8200SymbolDateExpirySettle PriceUnderlying ValuePay-offNIFTY18-Dec-1424-Dec-148,180.808,324.00124.00NIFTY19-Dec-1424-Dec-148,239.858,267.0067.00NIFTY22-Dec-1424-Dec-148,334.208,225.2025.20NIFTY23-Dec-1424-Dec-148,271.558,159.3040.70NIFTY24-Dec-1424-Dec-148,174.108,174.10 -25.90Pay-off DiagramMargin CalculationSettlement is made on daily basis in future market while,

In Forward market, it is done at the end of the contract period. ( Why ???)

Task: Take an index future or stock future of your interest and calculate profit/loss in last 1 week.One more ObservationNSE - National Stock Exchange of India Ltd..htmhttp://www.nseindia.com/live_market/dynaContent/live_watch/derivative_stock_watch.htmNormal Market: When the future prices of the underlying increases as the time to maturity increases. (also known as Contango).Inverted Market: If the future price of the underlying decreases as the time to maturity increases. (also known as Backwardation).Purpose of Future MarketsTo HedgeMinimize or manage risksHave position in spot market with the goal to offset risk

To SpeculateTake a position with the goal of profiting from expected changes in the contracts priceNo position in underlying assetMarking to Market

One of the unique features of futures contracts is that the positions of both buyers and sellers of the contracts are adjusted every day for the change in the market price that day.

In other words, the profits or losses associated with price movements are credited or debited from an investors account even if he or she does not trade. This process is called marking to market.Excel file VaR (Value at Risk)My Financial advisor made a portfolio of Rs. 10 lakh for me by investing in different asset class in 2006 when market was in boom.

Now, My heart-beat started increasing looking at the market condition.

What is the most I can lose on this investment? ContinueValue at Risk measures the potential loss in value of a risky asset or portfolio over a defined period for a given confidence interval.

Ex:VaR on an asset is $ 100 million at a one-week, 95% confidence level. i.eThere is a only a 5% chance that the value of the asset will drop more than $ 100 million over any given weekContinue..The VaR can be specified for an individual asset, a portfolio of assets or for an entire firm.

Task: Take a security (Share of any company). Collect data of last one week-trading price and calculate VaR assuming that you knew this can be the lowest price of share in one-week.Basis RiskBasis is the difference between the spot price of an asset and its future price.

Basis = Spot price of hedged asset - Futures price of contract

Where is risk ??

Hint: What should be basis at Maturity ?

Hedge RatioThe ratio of the size of the position taken in future contract to the size of the position taken in spot is known as Hedge Ratio.

Hedge Ratio = Number of future contract/ Number of spot position.

Number of future required = (Beta of portfolio * Value of portfolio)/value of one index future contract

Mr. X buys three future contracts of company ABC ltd. to hedge the risk of 6 number of bought shares of ABC ltd. What is hedge ratio? ( Is there anything wrong in this strategy??).Stop and Think for a moment !!Why Mr. X is taking position in future market ? Which type of risk does he want to mitigate? How does it work?Calculation of number of futuresMr. X is having a portfolio of Rs. 660 lakhs and he wants to hedge his portfolio using NIFTY Index Future. The strike price of future contract is Rs. 6600 and beta of his portfolio is 0.8. NIFTY index future trade in multiples of 50. Find number of future contract that he should buy or sell to hedge his portfolio.Rolling Hedge

ContinueIf Mr. X wants to buy future of Month May in India on 1-Feb. (Can he buy??)

The possible strategy he could have:

Buy future of April monthAt the expiration of April month contract buy contract of next1 month

TaskBuy 50 shares of SBI at todays price. Find beta of SBI. Hedge this asset using NIFTY Index future.

Buy 50 shares of MARUTI and 50 shares of SBI. Find beta of SBI and MARUTI. Calculate beta of the portfolio and hedge this portfolio using NIFTY index futures.Interest Rate Futureinterest rate futures suggests that the underlying 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 notional government bond which may not exist in reality.In India, the RBI and the SEBI have defined the characteristics of this bond: maturity period of 10 years and coupon rate of 7% p.aContinueOne other salient feature of the interest rate futures is that they have to be physically settledUnlike the equity derivatives which are cash settled in India. Physical settlement entails actual delivery of a bond by the seller to the buyerTrading StrategyIf an investor is of the view that interest rates will go up, he would sell the IRF.

This is so, because interest rates are inversely related to prices of bonds, which form the underlying of IRF. So, expecting a rise in interest rates is same as expecting a fall in bond prices. Similarly, if an investor expects a decline in interest rates (equivalently, a rise in bond prices), he would buy interest rate futures.Lot Size in IRFLot size: The minimum amount that can be traded on the exchange is called the lot size.All trades have to be a multiple of the lot size. The interest rate futures contract can be entered for a minimum lot size of 2000 bonds at the rate of Rs. 100 per bond (Face Value) leading to a contract value of Rs. 200,000.ContinueAt any given time, a maximum of four contracts can be allowed for trading on the exchange (Viz., March, June, September and December contracts).

Currently, at NSE only three contracts are allowed to be tradedSettlementMark-To-Market Settlement and Physical settlement:

For IRF, settlement is done at two levels:

Mark-to-market (MTM) settlement which is done on a daily basis and Physical delivery which happens on any day in the expiry monthApplication of IRFAsset-liability management

Banks typically have lots of government bonds and other long term assets (loans given to corporate) in their portfolio.

while their liabilities are predominantly short-term (deposits made by individuals range from 1 to 5 years).

To address this risk (Where is the risk???)

ContinueThe risk resulting from the asset-liability mismatch, they generally sell IRF and thereby, hedge the interest rate risk.

On the other hand, for the insurance companies and several big corporates, the tenure of their liabilities is longer than that of their assets.

So, they buy IRF to hedge the interest rate risk.

Continue2. Investment portfolio management:

Mutual funds and similar asset classes having a portfolio of bonds can use IR futures to manage their interest rate exposure in turbulent times.Questions for Practice What do you mean by derivative? What are differences between Future and Forward contracts? What is Index future?What is stock future?What is IRF ? What is Forward Agreement?What is future agreement?Why the underlying bond in IRF is a notional bond?

Continue A hypothetical banks is having more short term asset and more long-term liabilities. Using the concept of IRF explain, which type of hedging strategy the bank should use?

A company has taken loan from a bank of 20 years term and have fixed deposits in banks of tenure 5 years. The interest rates on both ( loan as well as F.D.) are floating. Suggest which type of strategy the company should follow to hedge Interest rate risk. Also explain how interest rate fluctuation can bring risk in its portfolio if not hedged?Foreign Currency FutureWhat is foreign exchange rate?Value of a foreign currency relative to domestic currency.

The participants in this markets are: banks, exporters, importers etc. Foreign exchange deal is always done in currency pairs. Ex: US-INR : US dollar & Rs.GBP-INR : British pound & INRJPY-CHF:Japanese Yen and Swiss-Franc.ContinueIn a currency pair, first currency is called base currency and second currency is called Counter/ term/Quote currency.Ex: USD-INR = 62.45 The price fluctuation in currency market is expressed as appreciation/ depreciation or strengthening/ weakening of a currency with respect to other.Ex: a change of US-INR from 35 to 36 indicates that US dollar has ????Continue..USD is the most widely traded currency and is referred as Vehicle currency.Why Vehicle currency ?? A vehicle currency helps a market in reducing the number of quotes at any point of time.

Any quote not against the USD is termed as Cross. Ex: Cross Quote for GBP-CHF can be arrived through GBP-USD USD-CHF Quote.Therefore the availability of USD quote helps in finding cross quote for any other currency.TaskFrom NSE collect last days data of exchange rate of following:USD-INREUR-INRGBP-INR &JPY-INRAnd calculate the following:USD-EUR exchange rate. EUR-GBP exchange rate GBP-JPY exchange rateVerify your answer with real data of these exchange rates from other sources and find reason of deviation, if any.Pricing Currency Futures

Continue

Long-Short Concept clarityQ1. If I would like to own an asset in future, I should take ..position?Q2. If I would like to sell an asset in future, I should take ..position?Q3. If I have taken a liability and I want to hedge it, I will take .position?Q4. If I have an asset and I want to hedge it, I will take .position?Options Options are fundamentally different from forward and futures contracts. An option gives the holder of the option the right to do something, but the holder does not have to exercise this right. By contrast, in a forward or futures contract, the two parties have committed themselves to some action.Types of Options Call Option: gives the holder of the option the right to buy an asset by a certain date for a certain price. Put Option: gives the holder the right to sell an asset by a certain date for a certain price.

The date specified in the contract is known as the expiration date or the maturity date.The price specified in the contract is known as the exercise price or the strike price.Continue..Options can be either American or European, a distinction that has nothing to do with geographical location. American options can be exercised at any time up to the expiration date, whereas European options can be exercised only on the expiration date itself.Profit Diagram of ??

Option price =?? Strike Price = ?? Call / Put ? European/ American ??Task From NSE site identify the periods for which options are available? Note strike price corresponding to each period. Do analysis by taking volume also into consideration. Which option is most active option?Test 1Q1. In forward market credit risk is not present ? (True/ False)Q2. In a forward market daily settlement is done?(True/ False)Q3. In mark-to-market concept, the profit/loss for the day is settled on the same day. (True/ False)Q4. If I have a share, which type of hedging strategy should I use? (Long Future/ Short Future)Q5. If I hedge a share using NIFTY Future, which risk am I hedging. (Systematic/ Unsystematic)Q6. Total risk of the portfolio cant be mitigated. (True/ False). Q7. beta measures unsystematic risk of the portfolio. (True/ False)Q8. Forward and futures are obligatory contracts. (True/ False).Q9. We take opposite position in future market than spot market. (True/ False).Q10. VaR measures the minimum loss that my portfolio will make. (True/ False).Q11. beta of market is always 1.5? (True/ False)

Q12. VaR on an asset is $ 100 million at a one-week, 95% confidence level. Meaning of this is my portfolio will lose a value of $100 million with 95% confidence? (True/ False).Q13. An American option can be excised only at the expiration. (True/ False)Q14. If I want to buy share of NTPC in March, I will take position in Option Market today. ( Long Call/ Long Put)Q15. Higher the beta lower is the risk. (true/ False)Q16. I dont understand this subject at all. (True/ False).Option Positions Two parties on each Option: Buyer & Seller Call Option: Buyer as well as Seller (Writer)Put Option : Buyer as well as Seller The writer of an option receives cash upfront but have potential liabilities. The profit/ loss of writer is the reverse of that of buyers.

Continue

Parties in contract:Long Call & Short Call Long Put & Short PutIdentify the strategy

How does Option protect UsStock Vs Options : Draw Graph of stock price change and Option price change.Pay-off (Intrinsic Value)Long Call: Max(ST-K,0) Short Call: - Max(ST-K,0) = Min(K-ST,0) Long Put: Max(K-ST,0) Short Put: - Max(K-ST,0) = Min(ST-K,0)

Options are referred to as in the money, at the money, or out of the money. If S is the stock price and K is the strike price, a call option is in the money when S > K, at the money when S =K, and out of the money when S < K.NumericalAn investor buys a European put on a share for $3. The stock price is $42 and the strike price is $40. Under what circumstances does the investor make a profit? Under what circumstances will the option be exercised? Draw a diagram showing the variation of the investors profit with the stock price at the maturity of the option.Answer the followingQ1. If you expect prices of asset can increase, you will take:a). Long call b). Short call C) Long put d) Short put

Q2. If you expect prices of asset can decrease, you will take:a). Long call b). Short call C) Long put d) Short putQ3. I have share of NHPC trading at Rs. 18 per share. I want to sell this share @ Rs. 22 per share but am nervous about any fall in prices. What strategy should I follow?Other Strategies One share and a short position in one call option. Two shares and a short position in one call option. One share and a short position in two calls. One share and a short position in four calls.Option Pricing Binomial Model

Assumptions:Two price points up/down are known with certainty. There is no arbitrage opportunity. No transaction cost.

TaskFind value of an option with following details:

50 Strike price = 49Rf = 8%, 3 months 5052485645Black Scholes ModelThe Black-Scholes model is used to price European options ( Which assumes that they must be held to expiration). It takes into account that you have the option of investing in an asset earning the risk-free interest rate. It acknowledges that the option price is purely a function of the volatility of the stock's price (the higher the volatility the higher the premium on the option).Black-Scholes treats a call option as a forward contract to deliver stock at a contractual price, which is, of course, the strike price.Formula

Numerical on Black-Scholes ModelThe stock price 6 months from the expiration of an option is $42, the exercise price of the option is $40, the risk-free interest rate is 10% per annum, and the volatility is 20% per annum.Solution

Option Revisited There are two types of options:. There are four types of option strategies.. American option can be exercised at any time before expiration. (True/ False) Draw profit-loss diagram of :One long call and one short call A share and a short call.What is a Binomial option Model? What is Black-Scholes Model?SwapA swap is an over-the-counter agreement between two companies to exchange cash flows in the future. The agreement defines the dates when the cash flows are to be paid and the way in which they are to be calculated.Usually the calculation of the cash flows involves the future value of an interest rate, an exchange rate.Example:

Consider a hypothetical 3-year swap initiated on March 5, 2012, between Microsoft and Intel. We suppose Microsoft agrees to pay Intel an interest rate of 5% per annum on a principal of $100 million, and in return Intel agrees to pay Microsoft the 6-month LIBOR rate on the same principal.

Cash Flow in IRS

Comparison of Forward and SwapA forward contract can be viewed as a simple example of a swap. Suppose it is March 1, 2012, and a company enters into a forward contract to buy 100 ounces of gold for $1,200 per ounce in 1 year. The company can sell the gold in 1 year as soon as it is received. The forward contract is therefore equivalent to a swap where the company agrees that on March 1, 2012, it will pay $120,000 and receive 100S, where S is the market price of 1 ounce of gold on that date.BuyerSellerContinueWhereas a forward contract is equivalent to the exchange of cash flows on just one future date, swaps typically lead to cash flow exchanges on several future dates.Application of SwapTo Transform a Liability:Suppose that Microsoft has arranged to borrow $100 million at LIBOR plus 10 basis points. a. For Microsoft the risk is : ??How to mitigate this risk ??After Microsoft has entered into the swap, it has the following three sets of cash flows:1. It pays LIBOR plus 0.1% to its outside lenders.2. It receives LIBOR under the terms of the swap.3. It pays 5% under the terms of the swap.

LIBOR+0.1%ContinueFor Intel, the swap could have the effect of transforming a fixed-rate loan into a floating-rate loan. Suppose that Intel has a 3-year $100 million loan outstanding on which it pays 5.2%.After it has entered into the swap, it has the following three sets of cash flows:1. It pays 5.2% to its outside lenders.2. It pays LIBOR under the terms of the swap.3. It receives 5% under the terms of the swap.

5.2%Thus, for Intel, the swap could have the effect of transforming borrowings at a fixed rate of 5.2% into borrowings at a floating rate of LIBOR plus 20 basis points.Continue

2. To Transform an Asset:

Comparative Advantage Argument

AAA is credit Rating of AAA Corp and BBB is that of BBBCorp.

We assume that BBBCorp wants to borrow at a fixed rate of interest, whereas AAACorp wants to borrow at a floating rate of interest linked to 6-month LIBOR.In what condition AAAcorp is at advantage and what condition BBBCorp is at advantage (Floating/ Fixed)?

ANS????BBBCorp is at advantage at floating rate while AAAcorp at Fixed rate.This is known as comparative advantage. Swap Design

Role of Financial Intermediary

Usually two nonfinancial companies such as Intel and Microsoft do not get in touch directly to arrange a swap.financial institution has two separate contracts: one with Intel and the other with Microsoft. In most instances, Intel will not even know that the financial institution has entered into an offsetting swap with Microsoft, and vice versa.If one of the companies defaults, the financial institution still has to honor its agreement with the other company. The 3-basis-point spread earned by the financial institution is partly to compensate it for the risk that one of the two companies will default on the swap payments.Continue..

Problem

Swap RevisitedWhat is a Swap?How does Swap help to mitigate risk?Different types of Swaps?Other Types of SwapsCurrency SwapAmortizing swap: the principal reduces in a predetermined way.Step-up swap: the principal increases in a predetermined way.An equity swap : is an agreement to exchange the total return (dividends and capital gains) realized on an equity index for either a xed or a oating rate of interest. For example, the total return on the S&P 500 in successive 6-month periods might be exchanged for LIBOR, with both being applied to the same principal. Equity swaps can be used by portfolio managers to convert returns from a xed or oating investment to the returns from investing in an equity index, and vice versa.

Credit RatingRating agencies, such as Moodys, S&P, and Fitch, are in the business of providing ratings describing the creditworthiness of corporate bonds. The best rating assigned by Moodys is Aaa. Bonds with this rating are considered to have almost no chance of defaulting. The next best rating is Aa. Following that comes A, Baa, Ba, B, Caa, Ca, and C. Only bonds with ratings of Baa or above are considered to be investment grade.The S&P and Fitch ratings corresponding to Moodys Aaa, Aa, A, Baa, Ba, B, Caa, Ca, and C are AAA, AA, A, BBB, BB, B, CCC, CC, and C, respectively.Default Rates

Observations:For investment-grade bonds, the probability of default in a year tends to be an increasing function of time.Reason: the bond issuer is initially considered to be creditworthy, and the more time that elapses, the greater the possibility that its financial health will decline 2. For bonds with a poor credit rating, the probability of default is often a decreasing function of time.Reason: The longer the issuer survives, the greater the chance that its financial health improves.Hazard RatesHazard Rate is the probability that bond will default in a particular year on a condition that it will not default on no earlier year. The probability of a bond rated Caa or below defaulting during the third year as 38.682 29.384 = 9.298%.The probability that the bond will survive until the end of year 2 is 100 -29.384 =70.616%. The probability that it will default during the third year conditional on no earlier default is therefore 0.09298/0.70616 = 13.17%. (This is Hazard Rate)Note: This is similar to conditional probabilityP(A/B)= Probability of event A, when B has already occurred.ESTIMATING DEFAULT PROBABILITIES FROM BOND PRICES

Why Does a Corporate Bond trade at a price lower than a G-Bond?possibility of default

I his the average hazard rate (default intensity) per year, S: Spread of the corporate bond yield over the risk-free rate, and R is the expected recovery rate

ProblemIf a bond yields 200 basis points more than a similar risk-free bond and that the expected recovery rate in the event of a default is 40%; find default probability (Hazard Rate)?

Conclusion:

Higher the spread, more is the risk i.e. higher is the probability of default. Lower is the recovery rate, higher is the Prob. Of default.

Exotic OptionExotic Options are non-standardized options created by financial engineers to fulfill the gap in the traditional option instruments. Traditional Option instruments are standardized and hence, sometime dont meet the requirements of participants. Some of Exotic Options are:1. Rainbow Options: It is an option written on more than one underlying asset.

For example: a put option may specify that you have the option to deliver one from a range of different assets.Clearly if the exercise price is the same for all assets specified, and if you decide to exercise your option to sell, you will choose to deliver that asset with the lowest current priceContinue2. Non-Standard American Option:Bermudan option: Early exercise may be restricted to certain dates. 2. Early exercise may be allowed during only part of the life of the option. For example, there may be an initial lock out period with no early exercise.3. The strike price may change during the life of the option.3. Chooser Option: A chooser option (sometimes referred to as an as you like it option) has the feature that, after a specified period of time, the holder can choose whether the option is a call or a putDirect HedgeA form of derivatives hedge in which the cash market instrument being hedged is hedged by an options or futures contract on the same underlying instrument. For example, a 91-day U.S. Treasury bill hedged with a Treasury bill futureCross HedgeA form of derivatives hedge in which the cash market instrument being hedged is hedged by an options or futures contract on other underlying instrument. For example, a 91-day U.S. Treasury bill hedged with a 3-Month Stock future.

Hybrid SecuritiesSWAP-Options: SWAPTIONs. I.R. Swap options, or swaptions, are options on interest rate swaps.(They give the holder the right to enter into a certain interest rate swap at a certain time in the future).consider a company that knows that in 6 months it will enter into a 5-year floating-rate loan agreement and knows that it will wish to swap the floating interest payments for fixed interest payments to convert the loan into a fixed-rate loanContinueAt a cost, the company could enter into a swaption giving it the right to receive 6-month LIBOR and pay a certain fixed rate of interest, say 8% per annum, for a 5-year period starting in 6 months. If the fixed rate exchanged for floating on a regular 5-year swap in 6 months turns out to be less than 8% per annum, the company will choose not to exercise the swaption and will enter into a swap agreement in the usual way.However, if it turns out to be greater than 8% per annum, the company will choose to exercise the swaption and will obtain a swap at more favorable terms than those available in the market.Synthetic InstrumentSynthetic financial instruments are artificially created instruments intended to meet requirements not met by existing, conventional instruments. They are designed to reducerisk, increase diversification or offer a higher return. an asset with the same risks and rewards as the underlying sharecan be created by the purchase of acall optionand the simultaneous sale of aput optionon the same share.OrA synthetic floating rate instrument can be produced by combining a fixed-ratebondand aninterest rate swap.