INTEREST RATE
DERIVATIVE MARKETS
CHAPTER 15
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Dr David P Echevarria
1
First Objectives
A. Primary Function of Interest Rate
Derivatives
1. Protect the value of a fixed or variable rate
portfolio of debt securities
B. Secondary Function
1. Speculate on future interest rate moves
2. If rates expected to Rise – go short (maturities)
3. If rates expected to decline – go long (maturities)
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Dr David P Echevarria
2
FUNDAMENTALS
A. Interest Rate Swap: exchange one set of interest
payments for another
1. Notional Principal: valuation basis for stream of
payments to be received
2. Note this need not be an identity with the original
securities.
3. Bond Indexes are normal basis for setting interest rate.
B. Purpose of Swaps
1. Hedge future [adverse] movements of interest rates →
payments
2. Immunize portfolios of interest-sensitive assets
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Dr David P Echevarria
3
Interest Rate Swap Market
The world interest rate swap market has grown exponentially since the 1980's. As the
above graph shows the total notional outstanding is over $550,000,000,000,000 USD.
-source (BIS.ORG)
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Dr David P Echevarria
4
FUNDAMENTALS
C. Types of Swaps
1. Plain Vanilla Swaps (fixed for floating rate)
2. Callable Swaps (Swap options = fixed rate party
has option to terminate early)
3. Putable Swaps (floating rate party has option to
terminate early)
4. Forward Swaps (future stream of interest
payments)
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Dr David P Echevarria
5
Other Types of Swaps
A. Amortizing Swap - A swap where the
notional is reduced over time, generally to
match the amortization of the hedged item
such as a loan or mortgage.
B. Basis Swap - A swap between two floating
indicies, LIBOR vs EURIBOR.
C. Cross-Currency Swap - a swap where the
two legs are in different currencies. Can be a
basis swap, fix-float or fixed-fixed.
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Dr David P Echevarria
6
BASIC HEDGING STRATEGIES
A. Short-Term Interest Rate Hedges
1. If interest rates go up in the future, bond prices go down.
2. If a bond is purchased at time t(1) and sold at t(2) and
interest rates have gone down, (price of bond increases),
then profits on selling bond and vice-versa.
3. If you are going to invest, you want interest rates to rise prices to fall.
4. If you expect interest rates to fall, you want to avail
yourself of the opportunity to profit from the increase in
prices.
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Dr David P Echevarria
7
PRICING INTEREST RATE SWAPS
A. Prevailing Market Interest Rates
1. Supply and Demand
2. Level of interest rates: high, low, expectations
B. Availability of Counterparties
C. Credit and Sovereign Risk
1. Probability of default
2. Political risks: prevents one party from
delivering payments when due
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Dr David P Echevarria
8
INTEREST RATE CAPS, FLOORS,
AND COLLARS
A. Interest Rate Caps
1. Help offset [lower] interest payments when rates rise
2. Seller is betting rates will RTS or decline.
B. Interest Rate Floors
1. Hedge against declining rates
2. Seller is betting rates will RTS or increase.
C. Interest Rate Collars
1. Combination of Cap and Floor
2. Hedging against interest rate volatility
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Dr David P Echevarria
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HOMEWORK QUESTIONS
A. What is the purpose of a Swap?
B. What does the term notional principal mean?
C. What is a plain vanilla swap? What are the
expectations of the counterparties?
D. How does a callable swap differ from a
putable swap?
E. What is sovereign risk?
F. How do Rate caps work? Floor caps?
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Dr David P Echevarria
10
Arbitrage Hedging Example
 Alternative Time Value Play: Borrowing to finance
the buy
1. Suppose we buy a Zero-coupon (Zc) bond with
41 quarters remaining to maturity selling to yield
6%. Price = $ 543,115.59
2. Suppose further that we can borrow money at 5
% per annum for 3 months with the loan
collateralized by the Zc bond.
3. We borrow $ 543,115.59 and repay $ 543,115.59
* 1.0125 = $ 549,904.53 or a cost of $ 6,788.94
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Dr David P Echevarria
11
Arbitrage Hedging Example
4. We sell (= open a short position) a futures
contract to deliver the Zc-bond, 3 months hence,
priced to yield 6.00%: Price = $ 551,262.32 for a
expected profit of $ 8,146.73.
5. We have created an arbitrage portfolio in which
we have no money invested and have earned a
profit of $8,146.73 - $6,788.94 = $1,357.79 with
no risk.
6. In this example, the 6 % is the implied repo rate
or the IRR on Zc-bond.
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Dr David P Echevarria
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