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EFB344 Risk Management

and Derivatives
Lecture 07:
Forward Rate Agreements
(FRAs)
and Swaps
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Unit Outline
Week 1: Introduction to Risk, Risk Management and Derivatives
Week 2: Financial Statistics
Week 3: Value-at-Risk 1
Week 4: No Classes Ekka Public Holiday
Week 5: Value-at-Risk 2
Week 6: Forwards and Futures 1
Week 7: Forwards and Futures 2
Week 8: Mid-Semester Exam
Week 9: Forward Rate Agreements (FRAs) and Swaps
Week 10: Reflective Practice and Options 1 (intro and binomial model)
Week 11: Options 2 (Black-Scholes model)
Week 12: Options 3 (trading strategies and risk management)
Week 13: Derivative Disasters
Week 14: Revision
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Lecture Content

Interest Rates
Zero-Coupon Rates
Forward Rates
FRAs
Interest Rate Swaps

Readings:
Hull et al. (2014), Ch. 4 and Ch. 7: 7.1 7.7

Interest Rates
Interest Rates:
The amount charged, expressed as a percentage of principal, by
a lender to a borrower for the use of assets. (Investopedia
http://www.investopedia.com/terms/i/interestrate.asp ).
defines the amount of money a borrower promises to pay a
lender (Hull et al., 2014, p.80).

Rate Types
Treasury Rate: rates on government bonds and notes.
LIBOR: London Interbank Offered Rate (more next slide)
REPO Rate: Repurchase agreement where a dealer sells a security
but agrees to repurchase the security at a higher price at a later
date. Reserve Bank provides overnight liquidity to banks through
the repo window where the repo rate is Cash Rate + 25 basis
points where banks provide acceptable security for repo-ing.
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Interest Rates
LIBOR
At 11am each day, a group of banks contribute their
interbank borrowing rates (the rate at which they are
willing to trade with other banks) for 15 maturities from
overnight to 12 months to Reuters.
They answer the survey questions,
"At what rate could you borrow funds, were you to do
so by asking for and then accepting inter-bank offers in a
reasonable market size just prior to 11 am?"
For derivative markets, LIBOR is often considered the
true risk-free because of tax and regulatory issues
related to treasury rates.
Can you manipulate LIBOR for your own gain? Ask
Barclays Bank
In Australia, BBSW (Bank Bill Swap reference rate) is the 5
equivalent of LIBOR and is set in a similar manner to

Interest Rates
Equivalent
Annual Interest Rates

as , we have a continuously compounding rate such that


To calculate equivalent rates between different compounding
frequencies

Calculate continuous rate


for given discrete rate

Calculate discrete rate


for given continuous rate

Zero Coupon Rates


Zero-Coupon
Rates:

Interest rate for an investment made today that matures in


n years and has no cash flows between 0 and n (e.g. zero
coupon).
It is referred to as the n-year spot rate or the zero rate (z).
If you have the zero rates for each period in which a bond
pays a coupon, you can price the bond as

Note that the zero rate is note the same as the yield on a
bond with n years to maturity that is, generally .
It is important to note, there are no interest payments
between 0 and n, hence why it is referred to as a zerocoupon rate and why .
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Zero Coupon Rates


Zero-coupon
Rates Example:

Bond: FV = 100, T = 2, CS/A = 6%, where S/A stands for


semi-annual
Zero-Coupon Rates: z0,1 = 5.0%, z0,2 = 5.8%, z0,3 = 6.4%
and z0,4 = 6.8%

To
calculate yield, solve for
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Zero Coupon Rates


Calculating zero coupon rates

Bootstrapping the zero-coupon curve.


Think of each cash flow from a bond being its own zero coupon
bond, such that the bond represents a package of zero coupon
bonds.
Then Bootstrap:
1. Start with a six-month zero coupon bond and find z 1
2. Find a 1-year bond, strip out the present value of the coupon
paid in six-months using z1 and then solve for z2

3. Repeat process iteratively by selecting bond with additional


period to maturity, stripping present value of all coupons prior
to maturity and then solving for z t at maturity, e.g. B4
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Zero Coupon Rates


Bootstrapping example:
Bond FV

Time to
Maturity

Coupon
(S/A)

Bond
Price

zt

100

0.25

97.5

100

0.50

94.9

100

1.00

90.0

0.10681

100

1.50

96.0

0.10808

100

2.00

12

101.6

0.10127
0.10469
0.10536

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Forward Rates
are the rates of interest implied by the current
zero rates for periods of time in the future (Hull
et al., 2014, p.89).
Best shown with an example, note rates are quoted per
0
1
2
period.
z0,1

R1,2

z0,2

Taking logs

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Forward Rates
Example 1-year forward rates, Hull et al. (2014) p.
90

z0,1 =
3.0%

R1,2
z0,2 =
4.0%

R2,3
z0,3 =
4.6%

R3,4
z0,4 = 5.0%

R4,5

z0,5 =
5.3%

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Forward Rates

cause the zero coupon curve is upward sloping, the 1-year forward sits above the
o coupon curve relates to market expectations theory of interest rates.
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Forward Rates
Example 2-year forward rates, Hull et al. (2014) p.
90

z0,1 =
3.0%

R1,3
z0,3 =
4.6%

Remember:

R1,2=
0.050

R2,3 =
0.058
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Forward Rates
Example 2-year forward rates, Hull et al. (2014) p.
90

z0,1 =
3.0%

R1,3
z0,2 =
4.0%

R2,4
z0,3 =
4.6%

R3,5
z0,4 =
5.0%

z0,5 =
5.3%

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Forward Rates
General
form of Formula from Hull et al. (2014)

where: is the longer rate over horizon


is the shorter rate over horizon
is the horizon of the forward rate

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FRAs
A forward rate agreement (FRA) is an over-thecounter agreement that a certain interest rate will
apply to either borrowing or lending a certain
principal (amount) during a specified future period
of time (Hull et al., 2014, p.91).
Notation:
RK: the rate of interest agreed to in the FRA
RF: the forward LIBOR between T1 and T2, calculated
today
RM: the spot LIBOR between T1 and T2, at T1
L: principal amount
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FRAs
Example:
Hull et al. (2014) p. 91

Company X agrees to lend money at LIBOR to Company


Y for the period T1 to T2.
Company Xs extra cash flow
Company Ys extra cash flow

If , then neither company earns an additional cash flow


If , Company X benefits
If , Company Y benefits
Given these cash flows, the FRA can be viewed as
The lender receiving the fixed rate and paying the floating rate .
The borrower paying the fixed rate and receiving the floating
rate .
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FRAs
FRA valuation at settlement

Settlement occurs at T1, such that the settlement payoff for


the lender is:

Example:
FRA to receive RK = 4.00%, L = $100m, T1 = 3.00 and T2
= 3.25.
Note that the future period is 3 months, 3.25 3.00 = 0.25
If RM = 4.50%,

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FRAs
FRA
valuation prior to settlement:

Hull et al. (2014) p.94, there exists a FRA with RK =


6.00% p.a. annual compounding, L = $100m, T1 = 1.00
and T2 = 2.00, R1,2 = 5.00% continuously compounded
and R0,2 = 4.00% continuously compounded. What is its
value today?
1. Convert R1,2 to annual compounding,

2. Calculate Value of FRA at 0

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FRAs
The
Australian FRA market
Term

1-month

3month

6-month

12-month

Minimum
Principal

$1b

$500m

$200m

$100m

Pricing Formula from the lenders perspective:

where: is the number of days to maturity


note: this is different to the calculations completed
earlier (they were RM - RK) because of different pricing
conventions between AUS and US.
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FRAs
Example:
Hull et al. (2014) p.95.

receive RK = 6.00% p.a., L = $100m, d = 365 and RM =


5.00%

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Interest Rate Swaps


An arrangement between two counterparts where
they agree exchange the periodic interest
payments based on a notional principal over a
fixed period of time.
Plain Vanilla Fixed-for-Floating Swap:
Counterpar
ty
A

BBSW + Margin
Fixed

Counterpar
ty
B

Need to set:

Notional Principal, L
Fixed Rate, RK
Floating Interest Rate, e.g. 6-month BBSW, R M
Floating Rate reset dates, e.g. every 6-months
Margin above Floating Rate
Settlement dates: generally on reset dates

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Interest Rate Swaps


Example Hull et al. (2014) pp. 155-157.
Other info: 3-year Swap, L = $100m, 6-month BBSW,
starts 5 March 2012
5%
Wesfarmer
s

ALCOA

BBSW

Swap from Wesfarmers Perspective


Date
BBSW
Float Rec.

Fixed Pay

5/3/12

4.20

7/9/12

BBSW2

+2.10

-2.50

5/3/13

BBSW3

BBSW2/2

-2.50

7/9/13

BBSW4

BBSW3/2

-2.50

5/3/14

BBSW5

BBSW4/2

-2.50

7/9/14

BBSW6

BBSW5/2

-2.50

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Interest Rate Swaps


Note that with a swap, principal is not exchanged.
However, if we include the exchange of principal
at the end, we get an interesting result
Date

BBSW

Float Rec.

Fixed Pay

5/3/12

4.20

7/9/12

BBSW2

+2.10

-2.50

5/3/13

BBSW3

BBSW2/2

-2.50

7/9/13

BBSW4

BBSW3/2

-2.50

5/3/14

BBSW5

BBSW4/2

-2.50

7/9/14

BBSW6

BBSW5/2

-2.50

5/3/15

100+BBSW6/
Long Floating-rate Bond2

-102.50
Short Fixed-rate Bond
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Interest Rate Swaps


Swaps and transforming a liability
e.g. Wesfamers has a three year $100m floating rate loan at BBSW
+ 0.1%
e.g. Alcoa has a three year $100m fixed rate loan at 5.2%
BBSW + 0.1% Wesfarmer

5%
BBSW

ALCOA

5.2%

Wesfarmers
Pays BBSW + 0.1%, receives BBSW and pays 5%, net pays fixed 5.1%

Alcoa
Pays 5.2%, receives 5% and pays BBSW, net pays floating BBSW +
0.2%
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Interest Rate Swaps


Swaps and transforming an asset
e.g. Wesfamers has a three year $100m fixed rate invest. at BBSW 0.2%
e.g. Alcoa has a three year $100m floating rate investment at 4.7%
4.7%

Wesfarmer
s

5%
BBSW

ALCOA

BBSW - 0.2%

Wesfarmers
Receives 4.7%, pays 5% and receives BBSW, net receives floating
BBSW 0.3%

Alcoa
Receives BBSW 0.2%, pays BBSW and receives 5%, net receives fixed
4.8%
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Interest Rate Swaps


Financial Intermediaries
non-financials are unlikely to deal with each other
Instead, a financial intermediary is generally the counterparty on
the other side of a swap
BBSW
BBSW + 0.1%
Wesfarmer

5.015%

Financial

BBSW

Institutio
n

4.985%

ALCOA

5.2%

Wesfarmers
Pay BBSW + 0.1%, receive BBSW and pay 5.015%, net pays 5.115%

ACLOA
Pay 5.2%, receive 4.985% and pay BBSW, net pays BBSW + 0.215%

Financial Institution
Pay BBSW, receive 5.015%, receive BBSW and pay 4.985%, net receives 0.03%.
The additional 3 basis points come from Wesfarmers and ALCOA paying 1.5 basis
points more than the earlier example.

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Interest Rate Swaps


Market Makers
Financial institutions often act as market-makers, i.e.
they do not necessarily have counterparts on both sides
of the swap.
To manage the risks associated with their marketmaking activities, the market maker can use FRAs and
interests futures.
Bid and Offer Fixed Rates in Exchange for
As with all bid/offer
Semi-Annual
Hull et al. (2014) Table 7.3 p.160
spreads you either
Swap Rate receive the lesser or pay

Maturity

Bid

Offer

6.03

6.06

6.045

6.21

6.24

6.225

6.35

6.39

6.370

6.47

6.51

6.490

6.65

6.68

6.665

10

6.83

6.87

6.850

the greater The market


maker aims to make the
spread.
Note that the Swap Rate
the rate where the swap
has a value of zero.
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Interest Rate Swaps


Day Counts
Floating side: actual/365
Fixed side: actual/365

Confirmations
ISDA (International Swaps and Derivatives Association)
Master Agreement
Sets out terms and conditions between two parties.
e.g. the closing-out of contacts and the netting of payments on a
swap (loser pays)
It allows for confirmation documents to cover brief information
related to the transaction at hand.

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Interest Rate Swaps


Swaps and Comparative Advantage
Two counterparties where one has a comparative
advantage in borrowing FIXED and the other has a
comparative advantage in borrowing FLOATING.
Hull et al. (2014)
Table 7.4Floating
p. 163(6
Fixed
month)
AAACorp

4.0%

BBSW 0.1%

BBBCorp

5.2%

BBSW + 0.6%

Difference

1.2%

0.7%

AAACorp has the comparative advantage in the Fixed rate, which


implies BBBCorp has the comparative
advantage in the Floating rate.
BBSW
4%

AAACorp

4.35

AAACorp pays BBSW 0.35%

BBBCorp

BBSW+0.6%

BBBCorp pays 4.95%

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Interest Rate Swaps


The Nature of Swap Rates
BBSW rates are not risk-free, but they are close to being riskfree.
To earn the swap rate (fixed rate), invest in 6-month, bank
accepted bills to roll (re-invest) every 6-months and swap
these cash flows for the fixed swap rate.
Therefore, they reflect the credit risk of a bank accepted bill.

BBSW/swap zero rates


Apply a bootstrapping procedure to determine the zero rates.
1 to 6 months:
spot BBSW
6-month to 2-years: 90 Day BAB Futures
2-years +:
swap rates

Value at Inception
The value of the swap at inception is zero or close to zero
given that fixed rate side is set at around the swap rate.
32

Interest Rate Swaps


Valuation
in Terms of Bonds:

For a receive fixed swap:

where:
is the value of the swap
is the standard fixed coupon bond valuation
equals par-value () at each coupon payment as the
coupon resets to be equal to the current 6-month in
the next
interest period. In between periods where
it is to the next
coupon of and is the rate that
corresponds to , then

33

Interest Rate Swaps


Example: Hull et al. (2014) Example 7.4, p. 168.
Pay 6-month BBSW, receive 8% fixed per annum (S/A), T =
1.25 years and notional principal = $100m.
Cont. comp. BBSW 3, 9 & 15 months are 10%, 10.5% and
11%, respectively.
BBSW 6 month at last rate reset was 10.2%.

Time

Bfix CF

Bfloat CF

Disc. Fact.

PV Bfix
CF

PV Bfloat
CF

0.25

4.00

105.100

0.9753

3.901

102.505

0.75

4.00

0.9243

3.697

1.25

104.00

0.8715

90.640

Total

98.238

102.505

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Interest Rate Swaps


Valuation
in Terms of FRAs:

For a receive fixed swap:

Time

Fixed
CF

Floating
CF

Net CF

Disc. Fact.

PV of CF

0.25

4.0

-5.100

-1.100

0.9753

-1.073

0.75

4.0

-5.522

-1.522

0.9243

-1.407

1.25

4.0

-6.051

-2.051

0.8715

-1.787

Total

-4.267

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