In the Banc One case we introduced several derivatives instruments:

a. Financial Futures contracts

b. Interest rate swap contracts

Derivatives are financial instruments whose value depends on the value of other underlying instruments or indices.
Interest rate derivatives (IRDs) are financial instruments whose value depends on the price of underlying fixed-
income securities or on the level of underlying interest rate indices.
Here we will introduce several other derivatives:
a. Caps/floors/collars
b. Swaptions

A cap is a contract between two counterparties in which one counterparty (the seller, or writer) agrees to pay to the
other (the buyer, or purchaser) the greater of zero or the difference between a floating rate (the reference rate) and a
pre-determined fixed rate (the “strike” rate) on a fixed notional principal amount over the life of the contract at
each settlement date. In return, the buyer pays the seller an upfront premium.
Essentially, a cap can be compared to a series of call options on a floating interest rate that entitle the purchaser
to the difference between the floating rate and the strike rate. For example, assume Company A purchased from
Company B a $100-million 1-year 8% cap. Every 3 months (or whatever other interest payment period was agreed
to), if the then-prevailing 3-month LIBOR rate (or other agreed reference rate) exceeded 8%, Company B would
owe Company A the difference in rates multiplied by $100 million (adjusted for quarterly payment).
If the then-prevailing 3-month LIBOR rate was below the strike rate, B would owe A nothing. Thus, if 3-month
LIBOR was 10% on a reference date, Company B would owe Company A a 2% rate on $100 million to be paid at

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the next settlement date (3 months later). Payments would be calculated in a similar manner over the life of the cap
contract.

A floor can be thought of as the opposite of a cap. It is a contract between two counterparties in which one
counterparty (the seller, or writer) agrees to pay to the other (the buyer, or purchaser) the greater of zero or the
difference between a predetermined fixed rate (the “strike” rate) and a floating rate (the reference rate) on a fixed
notional amount over the life of the contract at each settlement date. In return, the buyer pays the seller an upfront
premium. A floor can be compared to a series of put options on a floating interest rate.
Just as a cap pays whenever the reference rate rises above the strike rate, a floor pays whenever the reference rate
drops below the strike rate. For example, assume Company A purchased from Company B a $100-million 1-year
4% floor. Every 3 months (or whatever other interest payment period was agreed to), if the then-prevailing 3-

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month LIBOR rate (or other agreed reference rate) fell below 4%, then Company B would owe Company A the
difference in rates multiplied by $100 million (adjusted for quarterly payment). If the then-prevailing 3-month
LIBOR rate was above the strike rate, B would owe A nothing. Thus, if 3-month LIBOR was 3% on a reference
date, Company B would owe Company A a 1% rate on $100 million to be paid at the next settlement date (3
months later). Payments would be calculated in a similar manner over the life of the floor contract.

A collar merely combines a floor and a cap. From the perspective of a floating-rate note issuer, purchasing a collar
is defined as both buying a cap and selling a floor, with the strike rate on the cap set higher than the strike rate on
the floor. The premium received for selling the cap offsets the premium paid to purchase the floor. One
specialized version of a collar is the costless collar, in which the premium paid for the floor exactly equals the
premium received for the cap. Thus, no upfront payment is made between counterparties entering into a costless
collar.

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Swaptions
A swaption is an option to enter into a swap; it can be defined as a contract between two counterparties that grants
one counterparty (the buyer, or purchaser) the right, but not the obligation, to enter into a specified swap in the
future with terms of the swap set at inception of the swaption contract. In return for obtaining this option, the
purchaser of a swaption contract pays the seller (or writer) an upfront payment (the “swaption premium”).
For example, if Company A purchased from Company B a 3-month swaption on an underlying 9-month $100-
million 5% fixed-pay swap, then 3 months’ time, Company A could either exercise its option and enter into the
swap or do noting and let the option expire worthless. Company A would make its decision based on then-
prevailing interest rates and predicted future interest rates over the 9-month life of the swap. If A decided to
exercise its option, then the swap would perform just like an ordinary swap, with A paying a 5% rate on $100
million every 3 months (if that was the predetermined interest payment period) and B paying the 3-month LIBOR
rate (if that was the predetermined reference rate) in exchange. Just as for a regular swap, these two payments
would in fact be netted, with the rates determined at the beginning of each interest payment period the payment
paid at the end of each period.
Swaptions are almost always “European-style” options; that is, they are exercisable only at the option expiry date
(in the above example, only on the specified exercise date 3 months in the future).
Rarely, though, swaptions will be structured as “American-style” options, which are exercisable any time on or
before the option expiry date. If a swaption is structured in this way, the underlying swap will begin on the exercise
date (in the above example, the 9-month swap would begin on the day that the buyer exercised its option).

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Example:
Over-the-counter Swaption:
Counterparty has the right, at the end of the exercise period, to force the other party (the seller) to pay six-month
LIBOR and receive the fixed rate for the length of the swap:

Exercise period Maturity of the swap Fixed rate Premium (in basis points)
2 years (2 by 5) 3 years 9% 89-108
3 years (3 by 5) 2 years 9% 94-111

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 GM finds to raise $400 million through a public offering

1. Non-callable 5-year note

2. Fixed interest rate of 7.625% with coupon paid semi-annually.

Position Initial Proceeds Semi-Annual Cash Flows Principal repayment All-in-costs

Issue fixed-rate debt and Gross proceed $397.9M To noteholders: -$15.25M To noteholders $400M 7.75%
do nothing
Underwriting fees -1.8M

Expenses -0.2M

Cash flows - Periods

1 2 3 4 5 6 7 8 9 10
15.25 15.25 15.25 15.25 15.25 15.25 15.25 15.25 15.25 415.25
Cash flows

Discount
factor 0.962679 0.92675 0.892162 0.858866 0.826812 0.795954 0.766248 0.73765 0.71012 0.683618 Sum to PV
@7.75% of CFs
Present value 14.68085 14.13294 13.60548 13.0977 12.60888 12.1383 11.68528 11.24917 10.82933 283.8722
of CFs 397.9001

All-in- costs
for the above
option
0.077537
The do nothing option reflects the costs of issuing the 5-year debt, paying $15.25 million to noteholders semi-annually and the return of
principal amount of $400 million at maturity of the bonds. The all-in-costs of this option is 7.75%.

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 Interest rate swap example:

Position Initial Proceeds Semi-Annual Cash Flows Principal repayment All-in-costs

Issue fixed-rate debt and Gross proceed $397.9M To noteholders: -$15.25M To noteholders $400M LIBOR +49.5 bp

Swap fixed for floating Underwriting fees -1.8M From: counterparty+14.26M

Expenses -0.2M To: Counterparty -$400M*LIBOR/2

For this option, GM would:

1. Pay 7.625% TO DEBTHOLDERS

2. Pay LIBOR to the Counterparty in the Swap Contract

3. Receive 7.13% from Counterparty in the Swap Contract

Total cost: 7.625%+LIBOR – 7.13% = LIBOR + 0.495%

This option combines the issuance of fixed-rate debt with the sale of an interest rate swap in which GM receives from the swap counterparty the
fixed rate of (7.13%/2)*$400 million every 6 months and pay to the counterparty $400 million * (LIBOR/2). The all-in-costs of this option is LIBOR
+49.5 basis points. As you can see, this cost varies with LIBOR. This could get expensive real quick with rising interest rates!

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 Cap Option:

Position Initial Proceeds Semi-Annual Cash Flows Principal repayment All-in-costs

Issue fixed-rate debt and Gross proceed $397.9M To noteholders -$15.25M To noteholders $400M If LIBOR < 9%;
7.32%
Sell 9% cap Underwriting fees -1.8M To cap holder
If LIBOR > 9%
Expenses -0.2M If LIBOR < 9% 0
7.32% + CAP PMTS
Cap premium +7.1M If LIBOR > 9% 400M*(LIBOR – 9)/2

GM WILL RECEIVE:

1. $397.9 FROM THE DEBT ISSUANCE

2. $7.1 ($400 *0.0177) MILLION FOR SELLING THE 9% CAP. 0.0177 IS THE CAP PREMIUM.

Cash flows - Periods

1 2 3 4 5 6 7 8 9 10
15.25 15.25 15.25 15.25 15.25 15.25 15.25 15.25 15.25 415.25
Cash flows

Sum to PV
Discount 0.964683 0.930614 0.897747 0.866042 0.835456 0.80595 0.777487 0.750029 0.72354 0.697987 of CFs
factor
Present
value of 14.71142 14.19186 13.69065 13.20714 12.7407 12.29074 11.85667 11.43793 11.03398 289.839 405.0001
CFs

All-in- costs
for the
above
option if the
Cap is not
exercised
0.073219

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 At the time of the issuance of the $400 million debt, GM engages in the sale of a CAP with a premium of 1.77%. The net proceeds from
issuing the debt is $397.9 and the income from selling the CAP is $7.1, totaling $405. If the CAP is not exercised then the all-in-costs for
this option is 7.32%. This option is less expensive than doing nothing. And it could be less expensive than the interest rate swap option
cost that depends on LIBOR.

Now, if the cap is exercised (LIBOR > 9%), then the all-in-cost is a function of how often LIBOR exceeds 9% and by how much it exceeds
9%.

Suppose LIBOR settles in at 10% immediately after GM issues the $400 million 5-year note. And stays there over the next 5 years, then the Cap
will be exercised. The payoff structure will look like the results in the table below. So, you can see that if LIBOR is just 1% higher that the exercise
rate of 9%, the all-in-cost of this option is 8.31%. You can imagine what the cost would be if LIBOR is 2% higher than 9%.

Cash flows - Periods

1 2 3 4 5 6 7 8 9 10
Cash flows
to debt 15.25 15.25 15.25 15.25 15.25 15.25 15.25 15.25 15.25 415.25
holders
Cash flows $400*(0.1-
to the Cap 0.09)/2=2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00
holders
Sum to PV
Discount 0.960087 0.921768 0.884978 0.849656 0.815744 0.783186 0.751927 0.721915 0.693102 0.665438 of CFs
factor
Present
value of 16.56151 15.9005 15.26587 14.65657 14.07159 13.50995 12.97074 12.45304 11.95601 277.6542 405.0001
CFs

All-in- costs
for the
above
option if the
Cap is not
exercised
0.083144

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 Swaption option:

Position Initial Proceeds Semi-Annual Cash Flows Principal repayment All-in-costs

Issue fixed-rate debt and Gross proceed $397.9M
Sell SWAPTION Underwriting fees -1.8M
Expenses -0.2M
Swaption premium +3.76M
To noteholders (Yr 1-3): -$15.25M To noteholders $400M If swaption not
exercised: 7.52%
Payments in yrs 4 and 5
If swaption
To noteholders: -$15.25M
exercised: LIBOR –
From counterparty +18.00M 148 bp

To Counterparty -$400M*LIBOR/2

GM WILL RECEIVE:

1. $397.9 FROM THE DEBT ISSUANCE

2. $3.76 ($400 *0.0094) MILLION FOR SELLING THE swaption with 9% fixed rate and LIBOR as the floating rate. 0.0094 IS THE swaption
PREMIUM. Total proceed = 401.66

1 2 3 4 5 6 7 8 9 10
Cash flows to
debt holders 15.25 15.25 15.25 15.25 15.25 15.25 15.25 15.25 15.25 415.25
400
Sum of PVs
Discount factor 0.963744 0.928803 0.895129 0.862676 0.831399 0.801256 0.772206 0.74421 0.717228 0.691224 of CFs
Present value of
CFs 14.6971 14.16425 13.65072 13.15581 12.67884 12.21916 11.77615 11.3492 10.93772 287.0309 401.6599

All-in- costs for

the above
option if the
swaption is not
exercised
0.075239

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The swaption is not exercised at the end of the 3rd year. GM pockets the $3.76 million in premium income. The all-in-cost for this option is a fixed
rate of 7.52%. This option is cheaper than the do nothing option. But it is more expensive than the CAP option with no exercise (7.32% for that
option versus 7.52% for the swaption with no exercise).

If the swaption is exercised then the payoff structure looks like the following:

1. GM’s effective payments to noteholders 7.75%

2. GM’s payment to counterparty in the interest rate swap LIBOR
3. GM’s payment from the counterparty in the interest rate swap 9%
4. GM’s receipt of the up-front premium of 0.0094 (we must annualize this over 5 years at GM’s cost of funds (7.75%):
0.23%

TOTAL ALL-IN-COST = 7.75% + LIBOR – 9% - 0.23% = LIBOR – 1.48%

The reason is to convert the annual premium into an annualized rate. You are not convert it
in a Present Value Mr. Cole Curtis! The annualizing of the up-front fee follows the work in
the below table (where C is the annual fee):
1 2 3 4 5
C C C C C

0.928074 0.861322 0.799371 0.741875 0.688515

0.0094
SET C *0.928074 + C*0.861322 + C*0.799371 + C*0.741875 +C*0.688515 = 0.0094
SOLVE FOR C, THE ANNUALIZED FEE. C= 0.0023

As you can see that this option varies with LIBOR like the second option (with debt issuance plus sale of an interest rate swap contract).

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 Treasury Option Example:

GM might engage in a “bull spread” using 5-year Treasury note options, in which GM would buy call options on the five-year Treasury note and
simultaneously sell call options on the same amount. These European over-the-counter options give their holders the right, but not the
obligation, to buy the five-year Treasury note on the maturity date at the exercise price. Both options would have the same maturity (60 days)
but have different strike prices. The calls GM would buy would have a strike price equal to the current price of the five-year Treasury note
(98.095), which is yielding 6.66%. The call options GM would sell would have a strike price of 99.045 to yield 99.045, to yield 6.46% or 20 basis
points below the current yield on the five-year Treasury notes.

How this worked – if interest rates rose from the current level, the note would fall in value, and GM’s position would expire worthless. If interest
rates were to fall 20 basis points or more, so that the note was worth 99.045 or more GM would earn the maximum payoff of ((99.045-
98.095)/100) x $400 mil = $3.8 million. To make this bet, GM must pay a net premium of $1.1 million up front ($400 mil x (0.00625 - .00328));
where 0.00625 is the premium charged for the call option on the five-year Treasury note with a strike price of 98.095 and 0.00328 is the
premium charged for the call option on the five-year Treasury note with a strike price of 99.045.

The bull-spread proposal, which seeks to profit from short-run changes in interest rates, but which does not change the firm’s long-run
exposure, seems to be a way in which to make the exact kind of bet consistent with the GM rate view. It is more difficult to reconcile this
alternative with GM’s long-run interest rate exposure management.

This is the example where the option expires worthless.

Cash flows - Periods

1 2 3 4 5 6 7 8 9 10
Cash flows 15.25 15.25 15.25 15.25 15.25 15.25 15.25 15.25 15.25 415.25

Sum to PV of
Discount factor 0.962373 0.926162 0.891313 0.857776 0.825501 0.79444 0.764547 0.73578 0.708095 0.681451 CFs
Present value of CFs 14.67619 14.12397 13.59253 13.08109 12.58889 12.1152 11.65935 11.22064 10.79844 282.9727 396.829

All-in-costs for the

above option
0.07819603

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 Gross Proceeds = $399.904 Mil
Underwriting fees = -$1.8 Mil
Other fees = -$0.175 Mil
Premium of options = -$1.1 Mil
Total net proceeds = $396.829 Mil

This is the example where the option is in the money.

Cash flows - Periods

1 2 3 4 5 6 7 8 9 10
Cash flows 15.25 15.25 15.25 15.25 15.25 15.25 15.25 15.25 15.25 415.25

Sum to
Discount factor 0.963453 0.928242 0.894318 0.861634 0.830144 0.799805 0.770574 0.742412 0.71528 0.689138 PV of
CFs
Present value of
CFs
14.69266 14.15569 13.63835 13.13991 12.65969 12.19702 11.75126 11.32179 10.90801 286.1647 400.6291

All-in- costs for

the above
option
0.075866153

Gross Proceeds = $399.904 Mil

Underwriting fees = -$1.8 Mil
Other fees = -$0.175 Mil
Premium of options = -$1.1 Mil
Payoff from the in-the-
Money option =$3.8 Mil

Total net proceeds = $400.629 Mil

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