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Interest Rate Exposure

Management of Interest rate Exposure

Interest Rate Swap

Currency Swap


Interest Rate Options

Interest Rate caps , floors and collars

Interest Rate Swap

A standard fixed to floating interest rate swap, known in the market as a plain vanilla coupon swap is an agreement between two parties, in which each contracts to make the payment to the other on particular date in future till a specified termination date It consists of: Fixed Rate Payer Floating Rate Payer

Notional Principal

The fixed and floating payments are calculated as if they were interest payment on a specified amount borrowed or lent. The parties do not exchange this amount at any time. Only used to compute sequence of payments.

Fixed Rate Floating rate

Rate applied to the notional principal to calculate the size of fixed payment. A dealer may quote these rates: 2yrs Treasury(4.50%)+45/52 4 yrs treasury(4.75%)+52/60

Ina standard swap at market rates, the floating rate is one of the market indexes such as LIBOR, prime rate etc. The maturity of underlying index equals the interval between payment dates.

Date On which swap deal is concluded

Trade Date

Effective Date

Date from which first floating and fixed payments start to accrue

Payment Dates

D(S), the setting date is the date on which the floating rate applicable for the next payment is set. D(1) is the date from which the next floating payment starts to accrue. D(2) is the date on which the payment is due.

Fixed and Floating Payments

Fixed payment= P*Rfx*Ffx

Floating Payment= P*Rfl*Ffl

P = notional principal

Rfx = fixed rate Rfl = floating rate Ffx = Fixed rate day count fraction Ffl= floating rate day count fraction

Currency Swap


Two payment streams being exchanged are denominated in two different currencies


Fixed-to-fixed Currency Swap Fixed-to-floating Currency Swap

Motivation Underlying swaps

Quality Spread Differential XYZ ABC

Cost Fixed $ Cost Floating $

Fixed Rate $
11% Prime+0.75%

Floating Rate $
9.5% Prime

Bank ABC has an absolute advantage over the corporation XYZ

But the corporation has a comparative advantage in the floating rate market

9.75% s.a FIxed

Swap bank earns a margin of 25 bp Swap Bank

9.50% s.a FIxed

Prime -25bp

Prime -25bp ABC Bank: 9.5%9.5%+prime-0.25%= prime-0.25%,25 bp below its own cost of floating funds.

XYZ Corp

ABC Bank

Prime +75bp To floating Rate Lenders

XYZ corp: 9.75% +[Prime+0.75-(prime0.25)]%= 10.75% fixed rate, 25 bp below its own rate of fixed rate funds 9.50% s.a. To Fixed Rate Lenders

Motivation Underlying swaps

Market Saturation

Differing Financial Norms

Hedging Price risks

Swap Market
Growth & Size of the interest rate swap market


A Forward rate agreement is notionally a agreement between two parties in which one of them contracts to lend to the other, a specified amount of funds, in a specific currency, for a specified period starting at a specified future date, at an interest rate fixed at the time of agreement.

The buyer of the Forward rate agreement in turn agrees to borrow, funds for a specific duration, starting at a specified future date, at a rate fixed at the time the Forward rate agreement is brought.

Seller of the FRA

Forward Rate Agreement

Buyer of the FRA

A typical FRA quote from a bank may look like : USD 6/9 months: 7.20-7.30% p.a

The bank is willing to accept a 3-month US dollar deposit, i.e. borrow funds, starting six months from now, maturing nine months from now, at an interest rate of 7.20% p.a. (the bid rate)

The bank is willing to lend dollars for a period of three months, starting six months from now at an interest rate of 7.30% p.a. (the ask rate).

t= 0

t= S

t= L


DS DL FRA contracted at t= 0


Applicable for the period between t= S and t= L. DS and DL are actual number of days from t= 0 to t= S and t=0 to t= L respectively. The period from t= S to t= L is the contract period. t= S is the settlement date DF is the number of days in the contract period.

One of the two following formulas is used for calculating settlement payment from the seller to the buyer :
P = (L-R) * DF * A / [(B*100) + (DF*L)]

P = (R-L) * DF * A / [(B*100) + (DF*L)]

Here the notation is L: The settlement Rate (%) R: The Contract Rate (%) DF: The number of days in the contract period

A: The notional principal B: Day count basis (360 or 365)


(A less conservative hedging device for interest rate exposure)


A call option on interest rate gives the holder the right to borrow funds for a specified duration at a specified interest rate, without an obligation to do so.

A put option on interest rate gives the holder the right to invest funds for a specified duration at a specified return, without an obligation to do so.


Consider first a European call option on 6-month LIBOR. The contract specifications are as follows:
Time to expiry: 3 months (say 92 days) Underlying interest rate: 6-month LIBOR Strike rate: 9% Face value: $5 million The current three and six months LIBORS are 8.60% and 8.75% respectively. Assume that the option has been purchased by a firm which needs to borrow $5 million for six months in three months time.

3 months later 6month LIBOR = 9% The option is not exercised. The firm borrows in the market.

3 months later the 6-month LIBOR > 9% The option exercised. is


Consider an investor who expects to have surplus cash 3 months from now to be invested in a 3-month Euro deposit. The amount involved in $10 million. The current 3 month rate is 10.50% which the investors considers to be satisfactory. A put option on LIBOR is available with the following features: Maturity: 3 months Strike rate: 10.50% Face Value: $10 million Underlying: 3-month LIBOR

To hedge the risk, the investor goes long in the put. Three months later, if the 3-month LIBOR is less than 10.50% he will exercise the option or else let it lapse.

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