TEMASEK INFORMATICS & IT SCHOOL

Advanced Derivatives Processing (ADERV)
AY 2007/2008 October Semester 

Module 3
Exotic Derivatives Tutorial

1. What is an Overnight Index Swap and how is it used?

2. What is an Amortizing Swap?

3. What is a Swaption? Imagine that Joe is in Mexico and he knows that there is an
election coming up. Joe has some variable rate bonds that are paying very well,
but would like to hedge against the risk of political upheaval. Dave is in the UK
and rates are low and constant. Dave would like some extra money and thinks
that political change will not affect the rates too significantly. In this case, what
can Joe do, if he wants to hedge against the above risk with Dave, if he chooses to
use a swaption?

4. What is a Barrier Option? What are the four main types of barrier options
available?

5. What is a Binary Option? When are they used?

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Suggested Answers:

1. What is an Overnight Index Swap and how is it used?

Overnight index swap

Overnight index swap is an interest rate swap involving the overnight rate being
exchanged for some fixed interest rate. Generally short-term, the interest of the
overnight rate portion of the swap is compounded and paid at maturity.

An overnight indexed swap (OIS) is a fixed/floating interest rate swap with the
floating leg tied to a published index of a daily overnight rate reference. The term
ranges from one week to two years (sometimes more). The two parties agree to
exchange at maturity, on the agreed notional amount, the difference between
interest accrued at the agreed fixed rate and interest accrued through geometric
averaging of the floating index rate.
The OIS swap can be used to manage interest rate risk for flexible periods,
without taking liquidity risk and with minimum credit risk (hence there is efficient
usage of capital). This will lead to deeper and more efficient markets.
OIS allow the interest rate risk profile of a portfolio to be changed as if by the
addition of a cash asset or borrowing but with no use of cash and with minimal
use of credit. These features allow much better risk management and separate
funding maturity from interest rate duration.

2. What is an Amortizing Swap?

A swap whose notional principal decreases over the life of the instrument. In the
simple versions the notional principal decreases according to a fixed schedule that
is determined at the outset of the swap
This allows, for example, users to convert amortizing fixed-interest securities (i.e.
bonds with sinking funds or early redemption provisions) into floating-rate
securities.

This type of amortizing swap can be seen as a series of separate swaps with the
total swap price reflecting a weighted average of the individual swap rates or it
can be seen as one swap of a particular duration and priced as a swap with this
maturity.

An interest rate swap that converts the cash flows from an amortizing debt
instrument or index into a fixed-swap payment is also known as a level payment
swap.

In the more complex versions the amortization is linked to an underlying index,

for example interest rates, a foreign exchange rate or mortgage prepayment rates,
but the timing of the amortization is not known at the outset of the swap and

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 depends on the path of the underlying index. These are known as index
amortizing swaps.

3. What is a Swaption?

A swaption is an option granting its owner the right but not the obligation to enter
into an underlying swap (normally a vanilla interest rate swap). Although options
can be traded on a variety of swaps, the term "swaption" typically refers to
options on interest rate swaps.

There are two types of swaption contracts:

A payer swaption gives the owner of the swaption the right to enter into a swap
where they pay the fixed leg and receive the floating leg.
A receiver swaption gives the owner of the swaption the right to enter into a
swap where they will receive the fixed leg, and pay the floating leg.
The buyer and seller of the swaption agree on:

• the premium (price) of the swaption

• the strike rate (equal to the fixed rate of the underlying swap)
• length of the option period (which usually ends two business days prior to
the start date of the underlying swap),
• the term of the underlying swap,
• notional amount,
• amortization, if any
• frequency of settlement of payments on the underlying swap

In case you are wondering why anyone would want to buy a swaption, the answer
is often that they don't want to. Frequently, they want to sell a swaption. Consider
a corporation that has issued debt in the form of callable bonds paying a fixed
semiannual interest rate. The corporation would like to swap the debt into floating
rate debt. The corporation enters into a fixed-for-floating swap with a derivatives
dealer.

Swaptions can be for American, European or Bermudan exercise. They can be

physically settled, in which case an option is actually entered into upon exercise.
They can also be cash settled, in which case the market value of the underlying
swap changes hands upon exercise.

The purchaser of the swaption pays an up front premium. If she exercises, there is
no strike price to pay. The two parties simply put on the prescribe swap. Note,
however, the fixed rate specified for the swaption plays a role very similar to that
of a strike price. The holder of the swaption will decide whether or not to exercise
based on whether swap rates rise above or fall below that fixed rate. For this
reason, the fixed rate is often called the strike rate.

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 Joe and Dave engage in a swap; Joe gets fixed cash flows from the UK bond and
Dave gets the variable rate bonds. They agree on terms that set the swap as even
money (present valued) for both of them. However, they don't do the swap yet
because Joe's debt is about to expire and he is going to reinvest, and he only wants
to do the swap if the variable rates drop below a threshold (at which point his
income goes down; he wants to lock in profits). In order to lock in the profits,
Joe's willing to arrange the option on slightly favorable terms with Dave. Dave
wants the higher temporary cash flow and if the variable rates go down (which he
doesn't think will happen) and is willing to live with a little risk.
Everyone is happy; the swaption can be exercised and both people may still make
a profit, depending on the timing and amounts involved. At the very least, both
parties either reduced or enhanced their risks/rewards as they desired.

4. What is a Barrier Option? What are the four main types of barrier options?

A barrier option is a path dependent option that has one of two features:
1. A knockout feature causes the option to immediately terminate if the
underlier reaches a specified barrier level, or
2. A knock-in feature causes the option to become effective only if the underlier
first reaches a specified barrier level.

Premiums are paid in advance. Due to the contingent nature of the option, they
tend to be lower than for a corresponding vanilla option.

Barrier options were created to provide the insurance value of an option without
charging as much premium. For example, if you believe that IBM will go up this
year, but are willing to bet that it won't go above $100, then you can buy the
barrier and pay less premium than the vanilla option.

The four main types of barrier options are:

• Up-and-out: spot price starts below the barrier level and has to move up for
the option to be knocked out.
• Down-and-out: spot price starts above the barrier level and has to move down
for the option to become null and void.
• Up-and-in: spot price starts below the barrier level and has to move up for the
option to become activated.
• Down-and-in: spot price starts above the barrier level and has to move down
for the option to become activated.

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Consider a knock-in call option with a strike price of EUR 100 and a knock-in barrier at
EUR 110. Suppose the option was purchased when the underlier was at EUR 90. If the
option expired with the underlier at EUR 103, but the underlier never reached the barrier
level of EUR 110 during the life of the option, the option would expire worthless. On the
other hand, if the underlier first rose to the EUR 110 barrier, this would cause the option
to knock-in. It would then be worth EUR 3 when it expired with the underlier at EUR103.
This is illustrated in Exhibit 1:

Example: Up-And-In Barrier Call Option

Exhibit 1

An up-and-in barrier call option expires worthless unless the

underlier value hits the barrier at some time during the life of the
option.

The particular option in this example is known as an "up-and-in" option because the
underlier must first go "up" to the barrier before the option knocks "in."

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 5. What is a Binary Option? When are they used?

A binary option is a type of option where the payoff is either some fixed amount
of some asset or nothing at all. The two main types of binary options are the cash-
or-nothing binary option and the asset-or-nothing binary option. The cash-or-
nothing binary option pays some fixed amount of cash if the option expires in-the-
money while the asset-or-nothing pays the value of the underlying security. Thus,
the options are binary in nature because there are only two possible outcomes.
They are also called all-or-nothing options or digital options.
For example, a purchase is made of a binary cash-or-nothing call option on XYZ
Corp's stock struck at $100 with a binary payoff of $1000. Then, if at the future
maturity date, the stock is trading at or above $100, $1000 is received. If its stock
is trading below $100, nothing is received.

Binaries are typically bought and sold in the Over the Counter (OTC) markets
between sophisticated financial institutions, hedge funds, corporate treasuries, and
large trading partners. They are widely used where the underlying instrument is a
commodity, currency, rate, event, or index. For example: Binary call and put
options are popular in the platinum market, struck on the mid-market price of the
metal of a certain quality, quoted by several dealers over a stated time period.
Platinum trades in large varying quantities among major producers and
manufacturers, as well as between speculators and dealers. Prices are determined
between disparate parties, with varying frequency, and are not centrally reported
or confined to a centralized exchange. A third party calculation agent is often
agreed upon as part of the deal, to guarantee an uninterested price estimate
obtained by sampling various dealers on the expiration date.

Binary options are used widely to hedge weather events, such as hurricanes,
temperature, rainfall, etc. Major agricultural and transportation companies can be
severely affected by adverse weather conditions. Weather is highly unpredictable
and difficult to measure (e.g. what is a hurricane? How fast do the winds have to
be? How long does it need to last? Does it need to touch ground or can it remain
over water? What must the temperature be? Where is the exact location of the
measurement to take place?). This makes a binary option a perfect tool for
hedging weather events, as it allows the option seller (option writer) to assume a
fixed amount of risk tied to the occurrence of a future event whose magnitude is
impossible to predict. An uninvolved and highly reliable third party such as a
government weather bureau is typically used to determine whether the weather
event has occurred.
--- End of Tutorial ---

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