Convexity - Overview Revu - Merger PDF

Convexity overview
Didier Faivre
Convexity on CMS : explanation by static hedge
CMS pricing by replication
Convexity on Libor in arrears : explanation by static hedge
Quanto effect : correlation impact when rebalancing hedge
portfolio ; case study : Forward, Quanto swap
Other convexity effect : future vs forward
2
topics
The presentation will focus on the Investment Bank risk-

management, which is the real life explanation for convexity,
not on formula.
3
CMS definition
Reminder : CMS definition

A CMS rate nYears is the rate at which one would exchange at time T’
the swap rate of maturity n Years, this swap rate being fixed at time T
with : T'≥ T
t T T’
S(T,nY) =
CMS(T,T,T ’)
CMS(t,T,T’)
Fixing of the swap rate of

Flows exchange
Pricing at date t of the CMS maturity nY : S(T,nY)
nY which will be fixed at T
and paid at date T’ :
CMS(t,T,T’)
4
CMS definition
Remarks
CMS swap = swapping CMS against fixed rate or Libor + margin
If T’-T = one or two business days, the difference can be ignored
If T’-T = 3M or 6M, one speaks of CMS with delay ; this delay doesn’t
really change the main result regarding convexity effect, so we will
forget this case (even if generally CMS swaps follow the same rules
than plain vanilla swap, i.e fixing and payment 3M or 6M latter on the
CMS leg).
Conclusion : for the rest of the document T = T’
5
Examples of the Bank Quotations as of 19/5/2003
10Y swap : CMS10Y-120 against EURIBOR6M

10Y swap : CMS10Y-111 against EURIBOR6M without convexity adjustment (vol = 0)


6
Examples of the Bank Quotations as of 19/5/2003
swaps forwards and swaps forwards with convexity adjustment : 10 Y vs EURIBOR6M
5.80%
0.15%
5.60%
0.13%
5.40%
5.20% 0.11%
5.00%
0.09%
rates
4.80%
0.07%
4.60%
0.05%
4.40%
0.03%
4.20%
4.00% 0.01%
0.5 1.5 2.5 3.5 4.5 5.5 6.5 7.5 8.5 9.5
horizon
fwd fwd with convexity adjustment convexity adjustment
7
Convexity effect on CMS
Start with an example :

Quotation, as of 15/5/2003, EUR market, 30/360 fixed rate swap against
Libor 3M :
CMS 10Y in 5Y, paid in 5Y : 5.480%
Forward swap 10Y in 5Y : 5.381%
In 5Y, the client will receive :
Notional ×(fixing Swap10Y in 5Y-5.48%) ×coverage
We take coverage =1, just for illustration purpose
8
Remark :
The difference is the same whatever the frequency of the Libor : 3M,
6M, 12M…
How can the difference be explained ?
9
Assume now the trade is done at 5.38%, notional 100M€

The P&L of the CMS in 5Y for the bank will be :
Notional * (5.38%-swap10Y(5Y))
10
What would be a static hedge ?

The only static hedge without options would be selling
forward swap
Suppose that we want to hedge the 10Y in 5Y CMS by a
payer swap forward 10Y in 5Y, the nominal of a deal being
100M.
What would be the notional ?
We start by giving some formulas for valuation of a the P&L

of a payer 10Y forward swap
11
P & L at T of a 10Y payer (initially forward ) swap starting at T (notional

1M€) is :
10
1 − B(T , T + 10) − ∑ B(T , T + i )δ S (0, T , T + 10)
i
i =1
PV at T of the 10Y fixed

PV at T of the 10Y
leg starting at T
float leg starting at T
S (0, T , T + 10) is the forward swap rate fixed at 0 for In our example:
a 10Y forward swap starting at T
T = 5Y
B(t ,t ')
is the usual notation for the discount
factor for date t’ at date t : price at S (0, T , T + 10 ) = 5.38%
date t of 1€ at date t’
12
Then again, the P & L at T of a 10Y payer swap starting at T is :
10
1 − B(T , T + 10 ) − ∑ B(T , T + i )δ S (T ) = 0
i 10Y
i =1
PV at T of the 10Y
float leg starting at T PV at T of the 10Y fixed
leg starting at T
S10Y (T ) = S (T , T + 10) is the swap rate fixed at T for a 10Y

swap starting at T
We just replaced S (0, T , T + 10 ) by S10Y (T ) = S (T , T + 10)
13
Then we get for the P&L of the 10Y payer swap starting at T :
10
∑ (S10Y (T ) − S (0, T , T + 10)) δ i B(T , T + i ) =
i =1
Levelphysical × (S10Y (T ) − S (0, T , T + 10))
Just for simplification, we set :
δi = 1∀ i
14
Then, if we use a flat yield curve, so replacing the zero-coupon by the

10Y swap rate at T, we finally get :
10
(S10Y (T ) − S (0, T , T + 10)) =
∑ (1 + S (T ) )i
i =1 10Y
10
1
∑ (1 + S (T ))i × (S10Y (T ) − S (0, T , T + 10)) =
i =1 10Y
LevelCash(S10Y (T ),10Y )× (S10Y (T ) − S (0, T , T + 10 ))
15
In our example, the P&L in 5Y of a10Y payer swap (notional 1M€)

starting in 5Y :
10
1
∑ (1 + S (T ))i × (S10Y (T ) − 5.38%)
i =1 10Y
We remind that the P&L on the CMS is :
Notional * (5.38% - S10Y (T ) )
16
So in our example, the static hedge would be to do at date 0 :
100/(1/(1+5.38%)+1/(1+5.38%)^(2)+…+(1/(1+5.38%)^(10))
notional of payer 10Y swap in 5Y…=100/7.58 = 13.19
We have to use the today swap forward to calculate the hedge ratio
17
o Is this static hedge perfect ?
Of course not !
18
What happens if the bank prices the CMS at the forward swap
rate ?
In 5Y the client will receive the fixing of the swap 10Y in 5Y and pay 5.38%
The P&L of the Bank in 5Y on the CMS deal is :
P&L Bank = P&L swap
fwd + P&L CMS
 (S (T ) − 5.38%) (S10Y (T ) − 5.38%) (S10Y (T ) − 5.38%) (S10Y (T ) − 5.38%) 

100× (5.38% − S10Y (T )) + 13.19×  10Y + + + L+
 (1+ S10Y (T )) (1+ S10Y (T ))2 (1+ S10Y (T ))3 (1+ S10Y (T ))10 
P&L swap fwd

CMS P&L (Formula of page 15)
19
-P&L Bank on a 10Y CMS in 5Y, if pricing of CMS = forward rate and static hedge
in M EUR, 100M nominal transaction
2.0
1.8
1.6
1.4
1.2
-P&L Bank
1.0
0.8
0.6
0.4
0.2
0.0
0.50% 1.00% 1.50% 2.00% 2.50% 3.00% 3.50% 4.00% 4.50% 5.00% 5.50% 6.00% 6.50% 7.00% 7.50% 8.00% 8.50% 9.00% 9.50% 10.00 10.50 11.00 11.50 12.00 12.50
% % % % % %
swap10Y (in 5Y)
20
- Bank P&L density of proba on CMS 10Y in 5Y, static hedge by a forward swap, forward = 5.38%, vol
= 10%, drift = 0 for monte-carlo simulation
0.2
0.15
0.1
0.05
0
0.000644 0.010644 0.020644 0.030644 0.040644 0.050644 0.060644
21
- Bank P&L density of proba on CMS 10Y in 5Y, static hedge by a forward swap, forward = 5.38%, vol
= 10%, drift = 1% for monte-carlo simulation
0.06
0.05
0.04
0.03
0.02
0.01
0
0.00193 0.02193 0.04193 0.06193 0.08193 0.10193
22
Some remarks :
Of course the P&L is 0 if swap10Y is 5.38% in 5Y.
The first order derivative of the P&L with respect to the swap10Y is 0 at
5.38% value, by definition of the chosen hedge ratio.
P&L of the Bank in function of the swap10Y :
As we can see on the graphs page 11 ( –P&L of the Bank as a function
of swap10Y ) and page 12 and 13 (distribution of -P&L of bank, from two
monte-carlo simulations), this P&L is always negative !
It means that a static hedge is not efficient
23
We also see on the graph that –P&L the Bank is a convex function of
the swap10Y ; this can also be checked by immediate calculation :
(Swap10Y − 5.38%) is a linearfunctionof Swap10Y

5.38% 5.38% 5.38% 5.38% 1
+ + + L+ + is a convexfunctionof Swap10Y
(1+ swap10Y ) (1+ swap10Y ) (1+ swap10Y )
2 3
(1+ swap10Y ) (1+ swap10Y )10
10
See Annex 1 for some definitions/interpretations of convexity
24
Conclusions :
The static hedge leads to negative P&L, whatever the swap10Y in 5Y
This means that the Bank has to settle a dynamic hedge; the previous
results can also be used to show that any hedge rebalancing (and a
fortiori two way ticket due to gamma rebalancing) generate a negative
P&L
25
the Bank is gamma negative (we could also say short of volatility) and
this must be taken into account in the price made to the client (10bp of
“convexity adjustment”).
the hedge in volatility is in practice dynamically done by buying
swaptions on 10Y underlying the maturity of which is the horizon of
the CMS (5Y in or example), in order to be both delta and gamma
neutral hedged : this hedge has a price, and this another interpretation
for the additional 10bp of convexity adjustment.
26
Additional Remarks :
Of course the previous results are true whatever the CMS underlying
swap or the horizon of the CMS
The higher the maturity of the CMS underlying swap, the higher the
convexity adjustment
27
The higher the horizon of the CMS, the higher the convexity adjustment
The higher the implied volatility on the CMS underlying swap, the higher
the convexity adjustment
We give in annex 2 an approximate formula to calculate the convexity
adjustment using one unique implied volatility (ATM) ; a more acute and
complex method use the full smile on the CMS underlying swap
28
Last but not least remark :

In the previous pages, we made an approximation to calculate the P&L :
the coupon 5.38 was discounted with a unique discount rate, the 10Y
swap, not a zero-coupon curve ; using a zero-coupon curve would have
given the same results, but with far less easy graphical representation or
monte-carlo simulation (of course the P&L remains a convex function of
the 10 zero-coupon rates).
29
CMS pricing by adjustement
The formula :
Swap ATM Swap convexity

volatility Swap
sensitivity
∂ 2 P(SwapFwd)
1
2
2
( ( ) )
CMS(T , N ) = SwapFwd− SwapFwd exp σ T −1
2 ∂SwapFwd2
∂P(SwapFwd)
=
∂SwapFwd
T = horizon of the CMS

N = maturity of the underlyingswap to the CMS(CMSN yearsin T years)
σ = volatility (ATM) of the underlyingswap to the CMS
30
CMS pricing by adjustment
Simplified version of the formula (same result)
CMS (T,N ) =
 
( ( ) )
SwapFwd + SwapFwd exp σ 2T − 1 1 −
aNSwapFwd

(
 (1 + aSwapFwd ) (1 + aSwapFwd ) − 1 
N
)

  
 ( ( ) )

SwapFwd 1 + exp σ T − 1 1 −
2 aNSwapFwd
  > SwapFWd

  (1 + aSwapFwd ) (1(+ aSwapFwd )N
− 1 )


a = 1/frequency of the swap on the fixed leg

N = total number of coupons
exemple :10Y, semi annuel, a = 0.5, N = 20
 
( ( ) )
1 + exp σ 2T − 1 1 −
aNSwapFwd
is called convexity adjustment
( 
 (1 + aSwapFwd ) (1 + aSwapFwd ) − 1 
N
)
31
A sketch of proof for convexity adjustment
We consider first a bond :

with N year maturity at date T
We note r(T) the forward yield at date T, P(T) the forward price at date
T.
The dynamic of r is (under forward neutral probability) :
drt (T ) = µ t dt + σdWt
(warning : here σ standard deviation, not volatility)
The dynamic of P(T) is then (Ito lemma) :
( )
dPt = µ t P rt (T ) dt + (σ
′ 1
2
) P ″ (r (T ))dt + σ P ′ (r (T ))dW
2
t t t
32
A sketch of proof for convexity adjustment
The forward price of the bond is by definition a martingale

under the forward neutral probability :
1
″
(
P
µ it = − (σi ) i t
2 r)i
(T ) dt
2 ( ′
)
Pi rti (T )
This gives formula of previous slide when seeing a swap as a
bond and by replacing standard deviation by volatility
33
A few easy calculations :
10  (S10Y (T ) − S (0, T , T + 10 )) 
∑ 

i =1  (1 + S10Y (T )) i
=


10
S10Y (T ) 1 10
S (0, T , T + 10 ) 1
∑
i =1 (1 + S10Y (T ))
i
+ − ∑ −
(1 + S10Y (T )) i =1 (1 + S10Y (T )) (1 + S10Y (T ))
10 i 10
=
1
1−
S10Y (T ) (1 + S10Y (T ))10 + 1  10 S (0, T , T + 10 ) 1 
−∑
 + =
(1 + S10Y (T )) 1 − 1 10 i 10 
(1 + S10Y (T ))  i =1 (1 + S10Y (T )) (1 + S10Y (T )) 
(1 + S10Y (T ))
 10 S (0, T , T + 10) 1 
1−  ∑
 + 
10 
 i =1 (1 + S10Y (T )) (1 + S10Y (T )) 
i
34
35
The adjustment method takes into account :

ATM volatility for the forward swap n years fixed at time T
Sensitivity and convexity of the n years fixed at time T
Some drawbacks of the formula
As the vol used is ATM volatility, some scenarios are not priced :
Twist of the yield curve
Scenarios where a bump on the swap rate induces a bump on the volatility
36
New approach : the static super-replication for
CMS option
Reminder 1 :
the pay-off of a cash-settled swaptions of strike K on a n years swap
is given by :
n
1
POcw(S(T ,Tn ), K ) = ∑ (i S(T ,Tn ) − K )+ =
i =1 (1+ S (T ,Tn ))
1− (1+ S(T ,Tn ))

−n
(S(T ,Tn ) − K )+ =
S(T ,Tn )
LVL(S(T ,Tn ))(S(T ,Tn ) − K )
+
1 − (1 + S (T ,Tn ))
n −n
1
∑ = = LVL(S (T ,Tn ))
i =1 (1 + S (T ,Tn ))
i
S (T ,Tn )
37
CMS option
1 − (1 + S (T ,Tn ))
−n
The number : n
1
∑ = = LVL(S (T ,Tn ))
i =1 (1 + S (T ,Tn ))
i
S (T ,Tn )
is called the level cash of the swap. (value of LVL is similar to
duration). After we just say level.
The pay-off of a call of strike K on CMS n years is given by :
POCMS (S (T , Tn ), K ) = (S (T , Tn ) − K )
+
38
CMS option
Cash-settled Swaptions and CMS options pay-off at
maturity are both functions of the swap rate :
Pay-off of CMS call and Cash-settled swaption (20Y swap)
70.00%
7.79%
60.00%
6.79%
50.00%
5.79%
40.00% 4.79%
3.79% cash-settled swaption

30.00%
CMS call
2.79%
20.00%
1.79%
10.00%
0.79%
0.00%
-0.21%
0% 2% 4% 6% 8% 10% 12% 14%
-10.00% -1.21%
swap
39
CMS option
Tricky issue : CMS call is linear function of the swap and
swaption is concave in the swap rate
Anyway, one can try to replicate the pay-off of the CMS call
with a string of cash-settled swaptions with different strikes
with same maturity and underlying swap :
Let’s note
K = K1 < K 2 < L < K n
the strikes of the cash-settled swaptions for the super-replication.
40
CMS option
We want to find the weights wi such that :
n
POCMS (S (T , Tn ), K ) ≈ ∑ wi POcw (S (T , Tn ), K i )
i =1
We will choose the weights wi so that the

previous equality between the pay-off of the call
on CMS and the weighted sum of cash-settled
swaptions is exact each time the swap S (T , T ) is n
equal to one the strikes K j :

POCMS (K j , K ) = ∑ wi POcw (K j , K i ), ∀ j
n
i =1
41
CMS option
If S = K1 = K, the pay-off of the CMS call is zero, same thing
for basket of swaptions.
If S = K 2 , we just have to write :
n
(K 2 − K1 ) = POCMS (K 2 , K ) = ∑ wi POcw (K 2 , K i ) = w1LVL(K 2 )(K 2 − K1 )
i =1
If S = K3
n
(K 3 − K1 ) = POCMS (K 3 , K ) = ∑ wi POcw (K 3 , K i )
i =1
= w1 LVL(K 3 )(K 3 − K1 ) + w2 LVL(K 3 )(K 3 − K 2 )
42
CMS option
So
w2 =
(K 3 − K1 )  1 − 1 
(K 3 − K 2 )  LVL(K 3 ) LVL(K 2 ) 
By iteration, it can be shown that for I ≥ 3 :
1 K i +1− K1 1 K i − K1 K i +1 − K i −1
wi = −
LVL(K i +1 ) K i +1 − K i LVL(K i ) K i − K i −1 K i +1 − K i
1 K i −1 − K1
+
LVL(K i −1 ) K i − K i −1
43
CMS option
Weights Properties
Weights are independent of the level of the swap
as well as the smile
The replication is a static one

Replication methodology provides both
Exact pricing
Hedging
Then, for CMS pricing, just use the call-put parity, hoping you
get the same CMS whatever the strike !
(use swap forward as a good choice for strike)
44
CMS option : Call CMS
45
CMS option
For the put on CMS we find the same formula with decreasing
strikes.
Then we have an under-replication
the first weight is positive and the other negative.
46
CMS option : Put CMS
47
CMS option : summary
48
CMS option
In practice, to begin with replication :
To price a Cap, choose a geometric step h, let’s say 10-3
Choose K1 = K and set K2 = K1 ×(1+h) and so on…
To price, a put do the same thing
To price a CMS, price the call and the put of same strike, choosing
the forward swap or the CMS with convexity adjustment as a strike
49
CMS option
But in fact, it’s more complex :
You need a smile modelling and use the following formulas for CMS
option of maturity T0 and swap starting at Tf :
50
CMS option
You have to define upper and lower bound for integration in the
previous formulas
And also upper and lower bound for your smile modeling
(outside the bounds, take constant formulas)
Of course
the greater the maturity of the CMS underlying,
the greater the maturity of the CMS option or CMS fixing
The greater the sensitivity of the price to the bounds !
51
Ex 1 Call 3.80% on CMS30Y, replication between
3.8% and 5.30%, step 50bp
1.6000% 0.90 bp
0.80 bp
1.4000%
0.70 bp
1.2000%
0.60 bp
1.0000%
0.50 bp
c a s h -s e t t le d s w a p t io n
0.8000% C M S c a ll
s p re a d
0.40 bp
0.6000%
0.30 bp
0.4000%
0.20 bp
0.2000%
0.10 bp
0.0000% 0.00 bp
3.500% 3.700% 3.900% 4.100% 4.300% 4.500% 4.700% 4.900% 5.100% 5.300% 5.500%
52
Ex 2 Put 3.80% on CMS30Y, replication between
2.3% and 3.80%, step 50bp
1.6000% 0.10 bp
0.00 bp
1.4000%
-0 . 1 0 b p
1.2000%
-0 . 2 0 b p
1.0000%
-0 . 3 0 b p
c a s h -s e t t le d s w a p t io n
0.8000% -0 . 4 0 b p CM S put
s p re a d
-0 . 5 0 b p
0.6000%
-0 . 6 0 b p
0.4000%
-0 . 7 0 b p
0.2000%
-0 . 8 0 b p
0.0000% -0 . 9 0 b p
2.300% 2.500% 2.700% 2.900% 3.100% 3.300% 3.500% 3.700% 3.900%
53
Ex 3 CMS EURO against EURIBOR6M
CMS+ margin against EURIBOR 6M

margin quotations
10Y CMS
replic adjust difference of margin
5Y -129bp -128bp -0.48bp
10Y -96bp -95bp -1.03bp
15Y -82bp -80bp -2.17bp
20Y -72bp -69bp -2.92bp
30Y -64bp -60bp -3.72bp
20Y CMS
5Y -163bp -162bp -0.79bp
10Y -121bp -118bp -2.57bp
15Y -101bp -96bp -4.32bp
20Y -88bp -83bp -5.79bp
30Y -79bp -72bp -7.34bp
30Y CMS
5Y -169bp -168bp -1.03bp
10Y -124bp -120bp -3.29bp
15Y -103bp -97bp -5.54bp
20Y -90bp -83bp -7.49bp
30Y -83bp -73bp -9.71bp
54
Ex 4 cap prices, 10M euros notional
CAP CMS 10Y, strike 5%
replic adjust diff of prices

10Y 588 245 586 066 2 179
30Y 1 669 679 1 637 580 32 098
CAP CMS 30Y, strike 6%
replic adjust diff of prices

10Y 252 580 240 414 12 165
30Y 863 363 769 736 93 628
55
Ex 5 CMS10Y EUR
6.20%
6.00%
5.80%
5.60%
5.40%
fw d 1 0 Y
C M S 1 0 Y re p lic
C M S 1 0 Y a d ju s t
5.20%
5.00%
4.80%
4.60%
4.40%
11/12/03 02/06/09 23/11/14 15/05/20 05/11/25 28/04/31
56
Ex 6 CMS30Y EUR
6.20%
6.00%
5.80%
fw d 3 0 Y
5.60% C M S 3 0 Y re p lic
C M S 3 0 Y a d ju s t
5.40%
5.20%
5.00%
11/12/03 06/09/06 02/06/09 27/02/12 23/11/14 19/08/17 15/05/20 09/02/23
57
58
Convexity on Libor in arrears : explanation by
static hedge
Reminder on Libor in arrears vs Libor standard
Flow = Flow = Flow =
3.20*90/360 3.05*90/360 3.25*90/360
Libor
standard
0 3M 6M
Fixing Lib3M Fixing Lib3M Fixing Lib3M

Flow = Flow = = 3.25 Flow =
= 3.20 = 3.05
3.20*90/360 3.05*90/360 3.25*90/360
Libor in
arrears
3M 3M 6M
Fixing Lib3M Fixing Lib3M Fixing Lib3M

= 3.20 = 3.05 = 3.25
59
FRA, Zero-coupon and plain vanilla swap : Libor
in Arrears vs Standard libor swap
Examples (18/4/2003, USD market): (same frequency and

coverage convention (ex/360) for fixed leg and Libor leg for the
standard swaps, the Bank prices)
2Y
spread swap fwd 2Y in 3M vs swap 2Y 23.17bp
Libor 3M vs Libor 3M in arrears, over 2Y 23.75bp
Libor 12M vs Libor in arrears, over 2Y 112.58bp
5Y
Libor 3M vs Libor 3M in arrears 19.98bp
Libor 12M vs Libor in arrears 84.53bp
60
static hedge
In almost all libor in arrears vs standard Libor swap (upward
curve), the Bank receives libor in arrears and pays Libor
Standard + margin
• Suppose the Libor in arrears swap would be priced only by
calculating FRA, without taking account of the (caplets)
volatilities
Pricing at date t of a
• Suppose also that we want to hedge each Libor in arrears flow
FRA(T,T+3M) = 3.25
by a static hedge, using a FRA :
t
T T+3M
Payment of the FRA cash Flow :
(Libor3M(T)-
Fixing and paiment of the
Pricing at date t of a Libor 3.25)*90/360/(1+Libor(3M)*90/360))
Libor 3M at T
in arrears 3M paid at T
Flow = Libor3M(T)*90/360
61
FRA, Zero-coupon and plain vanilla swap : Libor
in Arrears vs Standard libor swap
Example 3 (22/4/2003, USD market): annual frequency and

coverage convention (ex/360) for fixed leg and Libor leg for the
standard swaps, the Bank prices)
Swap 5Y 3.31
Swap 5Y/1Y 4.09
Libor 12M vs Libor in arrears, 5Y 83.9bp
Libor 12M vs Libor in arrears, 5Y, all volatilities at 0 78.7bp
Swap 20Y 5.07

Swap 20Y/1Y 5.38
Libor 12M vs Libor in arrears, 20Y 41.91bp
Libor 12M vs Libor in arrears, 20Y, all volatilities at 0 32.9bp
The two margins are almost equal when volatilities at 0 ! 62

static hedge
Hedge ratio Libor in arrears/FRA

Obviously, the hedge ratio calculated at time t would be :
(1 + 3.25* 90 / 360) = 1.008125

If we keep a constant hedge ratio, the Bank P&L at T will be :
90
× (Libor3M(T ) - 3.25) −
90
×
(Libor3M(T ) - 3.25) ×1.008125
360 360  90 
1 + Libor3M(T ) × 
 360 
63
static hedge
P&L of Bank, 3M in arrears with static hedge in FRA 3M
0.007
0.006
0.005
P&L Bank, in M EUR
0.004
0.003
0.002
0.001
0
0.50% 1.50% 2.50% 3.50% 4.50% 5.50% 6.50%
Libor3M at the fixing
64
static hedge
P&L of the Bank in function of Libor3M(T)
As we see on the previous graph, of course at 0 if Libor3M(T)=3.25%, is
positive whatever the value of Libor3M(T).
It means that this time, the Bank is long the convexity, I.e or
equivalently long of caplet volatilities
The higher the caplet vol, the higher the convexity adjustement
65
static hedge
the Bank will have to sell options to pay the additional margin due to vol,
and to dynamically manages this position. the Bank can also managing
the position so as to be constantly delta-neutral and generate a positive
P&L thanks to the convexity.
In practice, of course, there is a global delta, gamma,
vega…management of IR derivatives.
66
67
Quanto effect
Forward quanto
the Bank sells a forward quanto of maturity T to a EUR
customer ; the forward quanto underlying is for instance a
forward on a USD bond, on the S&P 500…
The nature of the forward underlying doesn’t change the
following results
Let F be the USD forward on the S&P500
T
68
o Then, it can be shown that the EUR price of the forward quanto will be :
FT exp( −ρσ F σ USD / EURT )

σ F = volatility of the USD forward FT
σ USD/EUR = volatility of the USD/EUR forward exchange rate,
with USD/EUR = number of Euros for 1 USD $
ρ ( USD/EUR, FT ) = correlation of the USD/EUR forward exchange rate and the USD forward FT
69
Quanto effect
Important warning :
The convention used for the FX exchange rate is not the market
convention for quanto product with USD underlying and pay-off in EUR :
the FX rate used is USD/EUR and not EUR/USD.
For quanto product with underlying in EUR or USD and pay-off in Yen,
the market convention and quanto convention are the same (EUR/YEN).
70
Quanto effect : an example
Numerical application : fwd 2A S&P 500 = 940, vol S&P = 23%,

⇒
vol USD/EUR = 11%, correl (2A USD/EUR, 2A S&P500) = 0.6
fwd S&P 500 = 909.4
fwd quanto S&P 500 2A as a fucntion of correlation between fwd 2A USD/EUR and fwd 2A S&P 500
1000
980
960
fwd S&P 2A = 940

fwd quanto
940
920
900
880
-1 -0.8 -0.6 -0.4 -0.2 0 0.2 0.4 0.6 0.8 1
correlation
71
Quanto effect : interpretation
Interpretation
Suppose first the correlation between forward USD/EUR and the
forward S&P 500 is +1 :
Correlation = +1 means = that if the US $ falls, then the forward falls, if the
US $ goes up then the forward goes up. Each time the S&P500 goes up by
1%, a EUR investor in the standard forward FT also makes a currency
profit ($ goes up), each time the S&P500 goes down by 1%, the EUR
investor makes a loss but the effect of the $ decline is then favorable. If the
EUR investor buys a forward quanto, he doesn’t benefits from the correlation
effect. Of course, P&L the Bank = -P&L client.
72
Quanto effect : interpretation
P&L EUR client

fwd standard fwd quanto
fwd S&P500 up 10%, $ fwd up 5% 10.50% 10%
fwd S&P500 down-10%, $ fwd down -2.5% -9.75% -10%
Conclusion for a deal quanto such that currency of payment = EUR,

currency underlying = USD
ρ(EUR/USD,F ) < 0 ⇒ forwardquanto> forwardUSD

T
ρ(EUR/USD,F ) ≥ 0 ⇒ forwardquanto≤ forwardUSD

T
USD/EUR: numberof EUR per1 USD

73
Quanto : swap quanto
Swap Libor USD paid in EUR + margin vs Libor

EUR
EUR annuel 30/360 USD Semi 30/360 correl -0.3 correl 0 correl 0.3
2y 2.3 1.495 76 78 80.25
5y 3.06 2.695 25.5 34 42.25
10y 3.905 3.7575 -5.6 11 26.5
•Libor USD 6M vs EURIBOR 6M
•correl > 0 = if USD Libor falls, $ falls vs EUR
74
Quanto : general rule for closed formula
Do the model for product without quanto effect

Apply quanto adjustment formula to the underlying
75
76
Reminder :
Forward : contract of maturity T where the price you will buy underlying
S at T is fixed at date 0.
Remark : some forward are with real physical delivery of underlying, other
are forwards with cash-settlement
Future : contract of maturity T on underlying S whose price at T will be

S(T) is fixed in continuous time with a call-margin system :
If price at t is F(t,T), price at t+dt is F(t,T+dt), the buyer receives F(t,T+dt)-
F(t,T) at date t+dt and so on untill T.
77
It can be shown that futures are martingale under risk-neutral

probability, forward are martingale under forward neutral
probability
Future price : , Q risk-neutral probability
Forward price : , Q(T) forward-neutral
probability
78
Pricing :
the forward price of assets needs no modelling, you just need :
Today underlying price
Today yield curve
Dividends for equities or coupon for bonds
Example : The forward price at t for date T of an asset S with no dividend and no
coupon is (r continous zero-coupon rate) :
If there is a dividend yield a :
79
Future : if interest rates are assumed to be deterministic, future price =

forward price
It has been shown that :
If short rate and future processes are both gaussian, this formula is
simpler ! :
80
In practice :
F(t,T)-Fwd(t,T)=ρσ(r)σ(F)F(t,T)(T-t)
ρ correlation between short rate and future
σ(r) standard deviation of the short rate
σ(F) volatility of the future
All these numbers are assumed constant
81
Hedge between futures and forwards :

In order to hedge on forward of maturity T, sell
To get this formula no need complex maths, just need to know the
difference between one dollar today and one dollar at T!
82
Future-Forward spread interpretation :

What happens if correlation between short rate and future is -1 ?
Assume you buy one future, short rate is 4%
Second day short rate is 4.5%, future is 99
Margin call -1 you must borrow at 4.5%
Third day short rate at 4%, margin call at +1
Fourth day short rate 3.5, margin call at +1…
When rates are low positive margin calls, when rate are high negative
margin calls
83
Conclusion :
If correlation between future and short rate is negative, future < forward
If correlation between future and short rate is positive, future > forward
84
Numerical applications :
Future CAC 40, future Bund in one year
Standard deviation of short rate : 0.70%
Future 1Y CAC 40 4200
Implied vol CAC40 : 25%
Correlation : -0.5
Futur-forward = -3.7 points, i/e 37€ by contract
85
Future CAC 40, future Bund in one year

Standard deviation of short rate : 0.70%
Futur 1Y Bund : 119
Implied vol Bund : 5%
Correlation : 0.7
Futur-forward = 0.029%, i/e 29€ by contract
86
Futures on equity index or bonds are not very liquid over 6

months and correlation are not easy to estimate
Is there any significant and real application of this formula in financial
markets ?
Yes : futures on 3M interest rates !
87
Futures eurodollars (or euribor, or Libor Yen, GBP..)

Futures on (100-3M Libor $*100)
We apply the previous formula, in the following HJMframework :
This is the simplest version of HJM ! (modern version of merton or

vasicek model!)
88
It can be shown that spread between future and forward is

then :
In addition the forward price is :
The forward price is slightly above the forward yield you can
calculate using the yield curve!
89
Numerical application :
On US market futures on eurodollars are quoted untill 10Y maturity
Knowing the spread future-forward, the spread between forward and
forward rate calculated in the yield curve
You can fit the parameter σ in order to minimize
the average spread between :
swaps you can calculate from theoritical forwards, starting from the futures
Markets swaps
90
In Blue 3M rates calculated from the futures, in red after

convexity correction, in black market zéro-coupon, in green
theoritical zéro-coupon rates (using red rates), 10/8/2000
91
In blue theoritical swaps, in red market swaps, in black the spreads.
92
Historical value of implied σ : january 1994 to august 2000
93
So despite a very simple model (gaussian rates, constant

standard deviation, one factor), you fit very well the markets !
In real markets, the FRA (forward rate agreement) on
deposits rates contracts are cash-settled with the following
pay-off at T:
94
Where FRA is the initial price of the forward, V(T) the final value
of the deposit rate between T and T* at T.
It can be shown easily that the theoritical price of the forward is the the
forward rate you can calculate using the yield curve
Fortunately, this is the market practice !
In conclusion, the spread between future-forward on
eurodollars contracts is essentially :
Future –forward effect
Residual convexity effect (convexity relation between 3M rates and 3M
zéro-coupon bond).
95
Annex 1 : Convex one variable functions
Graphic definition
A function is convex if the surface above its graph is convex, i.e if we
take two points in this surface, each point of the segment defined by this
two points belongs to the surface.
8.5
7.5
6.5
5.5
4.5
3.5
2.5
2
B
1.5
0.5
A 0
-13 -8 -3
-0.5
2 7 12
96
-1
Annex 1 : Convex one variable functions
Definition by derivatives properties

The first order derivative is an increasing function, i.e the second order
derivative is positive
For instance, fixed rate bond are convex function of yield, i.e I win more
on a bond when yield falls by 10bp than when yield increases by 10bp.
97
Annex 2 : Approximate formula for CMS convexity
adjustment
It can be shown that :

∂ 2 P(SwapFwd)
1
2
2 2
( ( ) )
CMS(T , N ) = SwapFwd− SwapFwd exp σ T −1
∂SwapFwd2
∂P(SwapFwd)
=
∂SwapFwd
 
( ( ) )
SwapFwd+ SwapFwd exp σ2T −1 1 −
aN' SwapFwd

 (1 + aSwapFwd ) (
(1 + aSwapFwd)N'
− 1)

T = horizonof the CMS
N' = numberof cash flow on thefixedleg of underlyingswap( N ' = N/a)
σ = volatility(ATM)of the underlyingswap to the CMS
a = 1/frequency of the fixedleg of underlyingswap,frequency= 1, 2,4...
Example : T = 5, N = 10 ; vol of swap 10Y/5Y = 11.70%,

Swapfwd = 5.38%, a = 1
CMS =5.48%
98

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Convexity overview

 The presentation will focus on the Investment Bank risk-

 Reminder : CMS definition

Fixing of the swap rate of

10Y swap : CMS10Y-120 against EURIBOR6M

10Y swap : CMS5Y-81 against EURIBOR6M

5Y swap : CMS2Y-43 against EURIBOR6M

swaps forwards and swaps forwards with convexity adjustment : 10 Y vs EURIBOR6M

fwd fwd with convexity adjustment convexity adjustment

 Start with an example :

 How can the difference be explained ?

 Assume now the trade is done at 5.38%, notional 100M€

 What would be a static hedge ?

 We start by giving some formulas for valuation of a the P&L

 P & L at T of a 10Y payer (initially forward ) swap starting at T (notional

PV at T of the 10Y fixed

 Then again, the P & L at T of a 10Y payer swap starting at T is :

S10Y (T ) = S (T , T + 10) is the swap rate fixed at T for a 10Y

We just replaced S (0, T , T + 10 ) by S10Y (T ) = S (T , T + 10)

Levelphysical × (S10Y (T ) − S (0, T , T + 10))

 Just for simplification, we set :

 Then, if we use a flat yield curve, so replacing the zero-coupon by the

LevelCash(S10Y (T ),10Y )× (S10Y (T ) − S (0, T , T + 10 ))

 In our example, the P&L in 5Y of a10Y payer swap (notional 1M€)

 We remind that the P&L on the CMS is :

 Notional * (5.38% - S10Y (T ) )

 So in our example, the static hedge would be to do at date 0 :

notional of payer 10Y swap in 5Y…=100/7.58 = 13.19

o Is this static hedge perfect ?

 (S (T ) − 5.38%) (S10Y (T ) − 5.38%) (S10Y (T ) − 5.38%) (S10Y (T ) − 5.38%) 

P&L swap fwd

swap10Y (in 5Y)

(Swap10Y − 5.38%) is a linearfunctionof Swap10Y

 See Annex 1 for some definitions/interpretations of convexity

 Last but not least remark :

Swap ATM Swap convexity

T = horizon of the CMS

 Simplified version of the formula (same result)

a = 1/frequency of the swap on the fixed leg

 We consider first a bond :

 The forward price of the bond is by definition a martingale

 A few easy calculations :

 The adjustment method takes into account :

1− (1+ S(T ,Tn ))

 The pay-off of a call of strike K on CMS n years is given by :

Pay-off of CMS call and Cash-settled swaption (20Y swap)

3.79% cash-settled swaption

 We will choose the weights wi so that the

equal to one the strikes K j :

= w1 LVL(K 3 )(K 3 − K1 ) + w2 LVL(K 3 )(K 3 − K 2 )

 By iteration, it can be shown that for I ≥ 3 :

 The replication is a static one

 The greater the sensitivity of the price to the bounds !

CMS+ margin against EURIBOR 6M

CAP CMS 10Y, strike 5%

replic adjust diff of prices

CAP CMS 30Y, strike 6%

replic adjust diff of prices

Fixing Lib3M Fixing Lib3M Fixing Lib3M

Fixing Lib3M Fixing Lib3M Fixing Lib3M

 Examples (18/4/2003, USD market): (same frequency and

Payment of the FRA cash Flow :

 Example 3 (22/4/2003, USD market): annual frequency and

The presentation will focus on the Investment Bank risk-

Reminder : CMS definition

Start with an example :

How can the difference be explained ?

Assume now the trade is done at 5.38%, notional 100M€

What would be a static hedge ?

We start by giving some formulas for valuation of a the P&L

P & L at T of a 10Y payer (initially forward ) swap starting at T (notional

Then again, the P & L at T of a 10Y payer swap starting at T is :

Just for simplification, we set :

Then, if we use a flat yield curve, so replacing the zero-coupon by the

In our example, the P&L in 5Y of a10Y payer swap (notional 1M€)

We remind that the P&L on the CMS is :

Notional * (5.38% - S10Y (T ) )

So in our example, the static hedge would be to do at date 0 :

See Annex 1 for some definitions/interpretations of convexity

Last but not least remark :

Simplified version of the formula (same result)

We consider first a bond :

The forward price of the bond is by definition a martingale

A few easy calculations :

The adjustment method takes into account :

The pay-off of a call of strike K on CMS n years is given by :

We will choose the weights wi so that the

By iteration, it can be shown that for I ≥ 3 :

The replication is a static one

The greater the sensitivity of the price to the bounds !

Examples (18/4/2003, USD market): (same frequency and

Example 3 (22/4/2003, USD market): annual frequency and

Hedge ratio Libor in arrears/FRA

Numerical application : fwd 2A S&P 500 = 940, vol S&P = 23%,

Conclusion for a deal quanto such that currency of payment = EUR,

Swap Libor USD paid in EUR + margin vs Libor

Do the model for product without quanto effect

Future : contract of maturity T on underlying S whose price at T will be

It can be shown that futures are martingale under risk-neutral

If there is a dividend yield a :

Future : if interest rates are assumed to be deterministic, future price =

Hedge between futures and forwards :

Future-Forward spread interpretation :

Future CAC 40, future Bund in one year

Futures on equity index or bonds are not very liquid over 6

Futures eurodollars (or euribor, or Libor Yen, GBP..)

This is the simplest version of HJM ! (modern version of merton or

It can be shown that spread between future and forward is

In addition the forward price is :

In Blue 3M rates calculated from the futures, in red after

In blue theoritical swaps, in red market swaps, in black the spreads.

Historical value of implied σ : january 1994 to august 2000

So despite a very simple model (gaussian rates, constant

Definition by derivatives properties

It can be shown that :

Example : T = 5, N = 10 ; vol of swap 10Y/5Y = 11.70%,