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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$100 MM
9Net Funding Cost: 5-Year Swap Rate = 6.1%Net Funding Cost: 5-Year Swap Rate = 6.1%
Interest rate swap
DealerDealer
ClientClient
LiborSwapRate
(6.1%)
Fixed Rate
(6.5%)Libor
Deposit Agency Note
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Swap cash flows
At inception, PV(Floating Rate Leg) = PV(Fixed Rate Leg)
Time Deposit Swap Net
0 100 -- -- 100
1 (LIBOR) LIBOR (6.1) (6.1)
2 (LIBOR) LIBOR (6.1) (6.1)
3 (LIBOR) LIBOR (6.1) (6.1)
4 (LIBOR) LIBOR (6.1) (6.1)
5 (100 + LIBOR) LIBOR (6.1) (106.1)
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Interest rate swaps
Interest rate swap – A contractual agreement between two counterparties to exchange cash flows on a notional principal amount at regular intervals during a stated period (maturity)
– Notional amount is never exchanged
Trade Date – The date on which the parties commit to the swap and agree to its terms
Effective Date – The date on which payments begin to accrue
– Normally two days after trade date– Forward starting swap: Effective date can be any future date
Definitions
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Result of hedging with swap
Client has given up interest rate risk by locking in swap rate (replaced risk with certainty)– Client will be protected from rising deposit
rates over term of swap,– But will not benefit if rates fall
Client assumes credit exposure to Dealer (and vice versa) over term of swap
13
Currency risk
Situation
Client has purchased a one-year US$ 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
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