7 May 2001
International Swaps and Derivatives Association
Mexico City
Derivatives and Risk Management in Mexico
Interest Rate and Currency Derivatives
David Mengle
Vice President, J.P. Morgan Securities Inc.
Associate Professor, Fordham University
Graduate School of Business
Three forms of derivatives activity
 Exchange-traded
– Futures
– Exchange-traded options
 Over-the-counter (OTC)
– Swaps
– Forwards
– OTC options
 Structured securities
2
Interest rate risk
Situation
 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
Assets
Loan
(2-year, fixed rate)
US$100 MM
Liabilities
Deposit
(1-year Libor)
US$100 MM
3
Interest rate risk
Situation
1-year
Libor
Deposit
2-year
Fixed Rate
Client
Loan
4
Forward rate agreement (FRA)
A forward contract on interest rates
One year from now
Fixed
Rate
Libor
Client
Deposit
Reference
Rate
Libor, determined
at settlement
date
Loan
Contract
Rate
Dealer
Forward rate,
determined when
contract is agreed
(dealing date)
5
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)
6
Futures contracts
An alternative to forward 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
7
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
U.S. Agency Note
(5-year fixed @6.5%)
US$100 MM
Liabilities
Deposit
(1-year Libor)
US$100 MM
8
Interest rate swap
Fixed
Rate
(6.5%)
Libor
Client
Deposit
Agency Note
Swap
Rate
(6.1%)
Libor
Dealer
Net Funding Cost: 5-Year Swap Rate = 6.1%
9
Swap cash flows
Time
Deposit
Swap
0
100
--
1
(LIBOR)
2
Net
--
100
LIBOR
(6.1)
(6.1)
(LIBOR)
LIBOR
(6.1)
(6.1)
3
(LIBOR)
LIBOR
(6.1)
(6.1)
4
(LIBOR)
LIBOR
(6.1)
(6.1)
5
(100 + LIBOR)
LIBOR
(6.1)
(106.1)
At inception, PV(Floating Rate Leg) = PV(Fixed Rate Leg)
10
Interest rate swaps
Definitions
 Interest rate swap – A contractual agreement between two
counterparties to exchange cash flows on a notional principal
amount at regular intervals during a stated period (maturity)
– Notional amount is never exchanged
 Trade Date – The date on which the parties commit to the
swap and agree to its terms
 Effective Date – The date on which payments begin to
accrue
– Normally two days after trade date
– Forward starting swap: Effective date can be any future date
11
Result of hedging with swap
 Client has given up interest rate risk by locking
in swap rate (replaced risk with certainty)
– Client will be protected from rising deposit
rates over term of swap,
– But will not benefit if rates fall
 Client assumes credit exposure to Dealer (and
vice versa) over term of swap
12
Currency risk
Situation
 Client has purchased a one-year US$ 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
Note
(1-year, fixed rate)
US$100 MM @5.90%
Liabilities
Deposit
(1-year @ 1-year DM Libor)
DM180 MM @3.95%
13
Currency forward
One year from now:
US$105.90 MM
DM 187.11 MM
Client
Note
US$105.90 MM
Note: Currency forwards are
normally physically-settled,
that is, each party makes a
currency payment to the
other
Deposit
DM 187.11 MM
Dealer
Spot rate = 1.800
Forward rate = 1.767
14
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
15
Interest rate parity
Two ways to get to the same result...
US$105.90 MM
1.767
DM187.11 MM
5.90%
US$100 MM
3.95%
DM180 MM
1.800
Money rates (1-year)
Exchange rates
US$ Libor = 5.90%
Spot:
1.800
DM Libor = 3.95%
1-year forward:
1.767
16
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$100MM @6.8%
Note
(5-year, fixed-rate)
DM180 MM @4.8%
17
Currency risk
US$ Loans
US$
Interest
US$100
million
German Bank
DM
Interest
German bank exposed to rising
deutschmark
DM180
million
DM Note
18
Currency swap
$100 million
US$ Loans
DM180 million
Initial principal exchange
US$100
million
German Bank
Dealer
DM180
million
DM Note
19
Currency swap
US$ Loans
6.8%
6.1% (US$)
German Bank
Dealer
4.8% (DM)
Payments during swap
4.8%
DM Note
20
Currency swap
US$ Loans
US$100
million
Dealer
German Bank
DM180
million
Final principal exchange
US$100 million
DM Note
DM180 million
21
Currency swap
$100 million
US$ Loans
DM180 million
Initial principal exchange
6.8%
6.1% (US$)
German Bank
Dealer
4.8% (DM)
Payments during swap
4.8%
Final principal exchange
US$100 million
DM Note
DM180 million
22
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
23
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)
24
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
25
Options
Interest rate cap
 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
Up-front premium
(on Trade Date)
Libor
Deposit
Client
Dealer
Max (L-Strike,0)
(on each Payment Date)
26
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
27
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$100MM @6.8%
Note
(5-year, fixed rate)
DM180MM @4.8%
28
Variations on swap and options contracts
 Types of contracts
– Basis swaps
– Options on swaps (swaptions)
 Credit derivatives
– Credit default swap
– Total return swap
29
Interest rate risk
 A U.S. bank makes floating rate US$ 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
Loans
(Prime Rate)
US$100 MM
Liabilities
Deposits
(3-month Libor)
US$100 MM
30
Solution: Basis swap
 Definition: An interest rate swap in which both payments involve
floating rates
 Purpose: To lock-in spread between assets & liabilities
Prime
Rate
Libor
Client
Deposits
Loans
Prime –
2.75%
Libor
Dealer
31
Cross-currency basis swap
DM Libor
DM
Deposits
US$ Libor +
50
German
Bank
DM Libor
+ 10
US$
Loans
US$
Libor
Dealer
Swap includes initial and final principal exchanges
32
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
33
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
34
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 fiveyear swap as receiver starting in one year
35
Credit (default) swaps
The ‘plain vanilla’ of credit derivatives
X bp per annum
Protection buyer
Contingent payment
Protection seller
 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
36
Total return swaps
LIBOR + X bp p.a.
TR Receiver
TR Payer
TR of reference
obligation
 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
37