7 May 2001

1
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
2
Three forms of derivatives activity

• Exchange-traded
• Futures
• Exchange-traded options
• Over-the-counter (OTC)
• Swaps
• Forwards
• OTC options
• Structured securities

3
Interest rate risk
Situation

• A U.S. bank (Client) expects to receive a loan
  repayment of US100 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
Liabilities
Deposit (1-year Libor) US100 MM
Loan (2-year, fixed rate) US100 MM
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Interest rate risk
Situation
2-year Fixed Rate
1-year Libor
Client
Loan
Deposit
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Forward rate agreement (FRA)
A forward contract on interest rates
One year from now
Fixed Rate
Libor
Client
Loan
Deposit
ReferenceRate
Contract Rate
Forward rate, determined when contract is agreed
(dealing date)
Libor, determined at settlement date
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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)

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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

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Interest rate exposure
Situation

• Client has purchased a US100 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
Liabilities
Deposit (1-year Libor) US100 MM
U.S. Agency Note (5-year fixed _at_6.5) US100 MM
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Interest rate swap
Fixed Rate (6.5)
Libor
Client
Deposit
Agency Note
Swap Rate (6.1)
Libor
Net Funding Cost 5-Year Swap Rate 6.1
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Swap cash flows

• Time Deposit Swap Net
• 0 100 -- -- 100
• 1 (LIBOR) LIBOR (6.1) (6.1)
• 2 (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)
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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

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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

13
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
Liabilities
Deposit (1-year _at_ 1-year DM Libor) DM180 MM
_at_3.95
Note (1-year, fixed rate) US100 MM _at_5.90
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Currency forward
One year from now
DM 187.11 MM
US105.90 MM
Client
Deposit
Note
US105.90 MM
DM 187.11 MM
Spot rate 1.800 Forward rate 1.767
Note Currency forwards are normally
physically-settled, that is, each party makes a
currency payment to the other
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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

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Interest rate parity
Two ways to get to the same result...
1.767
US105.90 MM
DM187.11 MM
5.90
3.95
US100 MM
DM180 MM
1.800
Money rates (1-year) US Libor 5.90 DM Libor
3.95
Exchange rates Spot 1.800 1-year forward
1.767
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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) US100MM _at_6.8
Note (5-year, fixed-rate) DM180 MM _at_4.8
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Currency risk
US Loans
US Interest
US100 million
German Bank
German bank exposed to rising deutschmark
DM Interest
DM180 million
DM Note
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Currency swap
100 million
US Loans
DM180 million
Initial principal exchange
US100 million
Dealer
German Bank
DM180 million
DM Note
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Currency swap
US Loans
6.8
Dealer
German Bank
6.1 (US)
4.8 (DM)
Payments during swap
4.8
DM Note
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Currency swap
US Loans
US100 million
Dealer
German Bank
DM180 million
Final principal exchange
US100 million
DM Note
DM180 million
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Currency swap
100 million
US Loans
DM180 million
Initial principal exchange
6.8
Dealer
German Bank
6.1 (US)
4.8 (DM)
Payments during swap
4.8
Final principal exchange
US100 million
DM Note
DM180 million
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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

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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)

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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

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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
Max (L-Strike,0) (on each Payment Date)
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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

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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) US100MM _at_6.8
Note (5-year, fixed rate) DM180MM _at_4.8
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Variations on swap and options contracts

• Types of contracts
• Basis swaps
• Options on swaps (swaptions)
• Credit derivatives
• Credit default swap
• Total return swap

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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
Liabilities
Deposits (3-month Libor) US100 MM
Loans (Prime Rate) US100 MM
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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
Loans
Deposits
Prime 2.75
Libor
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Cross-currency basis swap
DM Libor
US Libor 50
German Bank
US Loans
DM Deposits
US Libor
DM Libor 10
Swap includes initial and final principal
exchanges
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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

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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

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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 five-year swap as receiver
  starting in one year

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Credit (default) swaps
The plain vanilla of credit derivatives
X bp per annum
Protection buyer
Protection seller
Contingent payment

• 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

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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