Lecture 3: Interest Rate Forwards and Options Nattawut - - PDF document

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Lecture 3: Interest Rate Forwards and Options

Nattawut Jenwittayaroje, Ph.D., CFA NIDA Business School 01135532: Financial Instrument and Innovation

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Forward Rate Agreements (FRAs)

• Definition

 A forward contract is an agreement between two parties in which one

party, the buyer (long), agrees to buy from the other party, the seller (short), underlying asset at a maturity date at a price agreed upon today (i.e., delivery or forward prices)

 An FRA is a forward contract in which the underlying is an interest rate.  One party agrees to make a payment at a fixed interest rate, while the

• ther agrees to make a payment at a floating interest rate, which is

determined at the expiration date.

• Long FRA  pay fixed, receive float
• Short FRA  receive float, pay fixed

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FRAs (continued)

• The Structure and Use of a Typical FRA

 Underlying is usually LIBOR  Since payoff is made today (contrast with swaps), discounting is

• required. For FRA on m-day LIBOR, the payoff today is

 Example: Long an FRA on 90-day LIBOR expiring in 30 days.

Notional principal of $20 million. Agreed upon rate is 10 percent. Payoff will be

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FRAs (continued)

 For example, if 90-day LIBOR at expiration is 8 percent,

• So the long has to pay $98,039 to the party who is short.

 If 90-day LIBOR at expiration is 12 percent, the payoff is

• So the long receives $97,087 from the party who is short.

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FRAs (continued)

• Note the terminology of FRAs: A  B means FRA expires in

A months and the underlying is B-A month LIBOR.

• For example, a 6 x 9 FRA is an FRA that expires in six

months with underlying 90-day LIBOR.

• For example, a 12 x 18 FRA is an FRA that expires in twelve

months and the underlying is 180-day LIBOR.

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• Applications of FRAs

 FRA users are typically borrowers or lenders with a single future

date on which they are exposed to interest rate risk.

 See Table 13.3 and Figure 13.2 for an example.

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Interest Rate Options

• Definition: an option in which the underlying is an interest

rate;

 it provides the right to make a fixed interest payment and

receive a floating interest payment  interest rate call option

 the right to make a floating interest payment and receive a

fixed interest payment  interest rate put option.

• The fixed rate is called the exercise rate.

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Interest Rate Options (continued)

• The Structure and Use of a Typical Interest Rate Option

 With an exercise rate of X, the payoff of an interest rate call is  The payoff of an interest rate put is  The payoff occurs m days after expiration (as well as interest rate

swap), so no discounting is required.

 Example: notional principal of $20 million, expiration in 30 days,

underlying of 90-day LIBOR, exercise rate of 10 percent.  m = 90 days, X = 10%

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Interest Rate Options (continued)

• The Structure and Use of a Typical Interest Rate Option

(continued)

 If 90-day LIBOR is 6 percent at expiration, payoff of a call is  The payoff of a put is  If 90-day LIBOR is 14 percent at expiration, payoff of a call is  The payoff of a put is  These payoffs are made 90 days after the expiration of the options.

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Interest Rate Options (continued)

• Interest Rate Option Strategies

 See Table 13.5 and Figure 13.3 for an example of the use of

an interest rate call by a borrower to hedge an anticipated loan.

 See Table 13.6 and Figure 13.4 for an example of the use of

an interest rate put by a lender to hedge an anticipated loan.

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Interest Rate Option Strategies

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Interest Rate Option Strategies

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Interest Rate Option Strategies

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Interest Rate Option Strategies

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Interest Rate Options (continued)

• Interest Rate Caps, Floors, and Collars

 A combination of interest rate calls used by a borrower to

hedge a floating-rate loan is called an interest rate cap. The component calls are referred to as caplets.

 A combination of interest rate puts used by a lender to hedge

a floating-rate loan is called an interest rate floor. The component puts are referred to as floorlets.

 A combination of a long cap and short floor at different

exercise prices is called an interest rate collar.

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• Interest Rate Cap

 Each component caplet pays off independently of the others.  See Table 13.7 for an example of a borrower using an interest

rate cap.

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• Interest Rate Floor

 Each component floorlet pays off independently of the others  See Table 13.8 for an example of a lender using an interest

rate floor.

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Interest Rate Options (continued)

• Interest Rate Collars

 A borrower using a long cap can combine it with a short floor so that

the floor premium offsets the cap premium. If the floor premium precisely equals the cap premium, there is no cash cost up front. This is called a zero-cost collar.

 The exercise rate on the floor is set so that the premium on the floor

• ffsets the premium on the cap.

 By selling the floor, however, the borrower gives up gains from falling

interest rates below the floor exercise rate.

 The net result is that maximum and minimum rates are established on

the loan.

 See Table 13.9 for example.

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Interest Rate Collars