Lecture 3: Interest Rate Forwards and Options Nattawut - PDF document

Lecture 3: Interest Rate Forwards and Options Nattawut Jenwittayaroje, Ph.D., CFA 01135532: Financial Instrument NIDA Business School and Innovation 1 Forward Rate Agreements (FRAs)  Definition  A forward contract is an agreement between two parties in which one party, the buyer ( long ), agrees to buy from the other party, the seller ( short ), underlying asset at a maturity date at a price agreed upon today (i.e., delivery or forward prices )  An FRA is a forward contract in which the underlying is an interest rate.  One party agrees to make a payment at a fixed interest rate, while the other agrees to make a payment at a floating interest rate, which is determined at the expiration date. • Long FRA  pay fixed, receive float • Short FRA  receive float, pay fixed 2 1

FRAs (continued)  The Structure and Use of a Typical FRA  Underlying is usually LIBOR  Since payoff is made today (contrast with swaps), discounting is required. For FRA on m-day LIBOR, the payoff today is  Example: Long an FRA on 90-day LIBOR expiring in 30 days. Notional principal of $20 million. Agreed upon rate is 10 percent. Payoff will be 3 FRAs (continued)  For example, if 90-day LIBOR at expiration is 8 percent, • So the long has to pay $98,039 to the party who is short.  If 90-day LIBOR at expiration is 12 percent, the payoff is • So the long receives $97,087 from the party who is short. 4 2

FRAs (continued)  Note the terminology of FRAs: A  B means FRA expires in A months and the underlying is B-A month LIBOR.  For example, a 6 x 9 FRA is an FRA that expires in six months with underlying 90-day LIBOR.  For example, a 12 x 18 FRA is an FRA that expires in twelve months and the underlying is 180-day LIBOR. 5  Applications of FRAs  FRA users are typically borrowers or lenders with a single future date on which they are exposed to interest rate risk.  See Table 13.3 and Figure 13.2 for an example. 6 3

7 Interest Rate Options  Definition: an option in which the underlying is an interest rate;  it provides the right to make a fixed interest payment and receive a floating interest payment  interest rate call option  the right to make a floating interest payment and receive a fixed interest payment  interest rate put option.  The fixed rate is called the exercise rate. 8 4

Interest Rate Options (continued)  The Structure and Use of a Typical Interest Rate Option  With an exercise rate of X, the payoff of an interest rate call is  The payoff of an interest rate put is  The payoff occurs m days after expiration (as well as interest rate swap), so no discounting is required.  Example: notional principal of $20 million, expiration in 30 days, underlying of 90-day LIBOR, exercise rate of 10 percent.  m = 90 days, X = 10% 9 Interest Rate Options (continued)  The Structure and Use of a Typical Interest Rate Option (continued)  If 90-day LIBOR is 6 percent at expiration, payoff of a call is  The payoff of a put is  If 90-day LIBOR is 14 percent at expiration, payoff of a call is  The payoff of a put is  These payoffs are made 90 days after the expiration of the options. 10 5

Interest Rate Options (continued)  Interest Rate Option Strategies  See Table 13.5 and Figure 13.3 for an example of the use of an interest rate call by a borrower to hedge an anticipated loan.  See Table 13.6 and Figure 13.4 for an example of the use of an interest rate put by a lender to hedge an anticipated loan. 11 Interest Rate Option Strategies 12 6

Interest Rate Option Strategies 13 Interest Rate Option Strategies 14 7

Interest Rate Option Strategies 15 Interest Rate Options (continued)  Interest Rate Caps, Floors, and Collars  A combination of interest rate calls used by a borrower to hedge a floating-rate loan is called an interest rate cap . The component calls are referred to as caplets .  A combination of interest rate puts used by a lender to hedge a floating-rate loan is called an interest rate floor . The component puts are referred to as floorlets .  A combination of a long cap and short floor at different exercise prices is called an interest rate collar . 16 8

 Interest Rate Cap  Each component caplet pays off independently of the others.  See Table 13.7 for an example of a borrower using an interest rate cap. 17  Interest Rate Floor  Each component floorlet pays off independently of the others  See Table 13.8 for an example of a lender using an interest rate floor. 18 9

Interest Rate Options (continued)  Interest Rate Collars  A borrower using a long cap can combine it with a short floor so that the floor premium offsets the cap premium. If the floor premium precisely equals the cap premium, there is no cash cost up front. This is called a zero-cost collar.  The exercise rate on the floor is set so that the premium on the floor offsets the premium on the cap.  By selling the floor, however, the borrower gives up gains from falling interest rates below the floor exercise rate.  The net result is that maximum and minimum rates are established on the loan.  See Table 13.9 for example. 19 Interest Rate Collars 20 10