Running head: ASSIGNMENT UNIT 4

FERNANDO LUZERNO AUGUSTO CARLOS LICHUCHA

This assignment is submitted in partial fulfilment of the requirements for

5522S2091 DF Derivative Instruments & Markets R2

Assignment Unit 4

School of Management

Dr. Igor Gvozdanovic

April 8, 2016

ASSIGNMENT UNIT 4

Table of Contents
List of Abbreviations.......................................................................................................................3
List of Figures..................................................................................................................................3
List of Tables...................................................................................................................................3
Introduction......................................................................................................................................4
PART A............................................................................................................................................5
Why are currency derivatives important in currency trading?........................................................5
How is the valuation of currency derivatives performed?...............................................................7
Describe major elements of risk management in currency derivatives trading...............................8
PART B..........................................................................................................................................12
What are the major features of trading Interest Rate derivatives?.................................................12
How is risk management for Interest Rate Derivatives performed?..............................................16
What are interest rate swaps? How are they used?........................................................................18
How do caps, floors and collars used in trading of interest rate derivatives?...............................20
Describe the important models used in interest rate derivatives trading.......................................21
How is bond valuation performed?................................................................................................24
References......................................................................................................................................28

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List of Abbreviations
CAD
CBT..
CDR
CME.
.
BIS...
PHLX...
OTC.....

Canadian Dollar
Chicago Board of Trade
Collateralized Depository Receipts
Chicago Mercantile Exchange
Bank for International Settlements
Philadelphia Stock Exchange
over- the-counter

List of Figures
Figure 1 Market values of bonds and stocks outstanding in the United States as of December 31,
2003...............................................................................................................................................13
Figure 2 Three-period binomial lattice for no-arbitrage pricing model assuming the short rate is
log-normally distributed, the zero-coupon yield curve is R(t) = 0.10 0.05 e0 . 18(t1) ,
where t is measured in years, and the volatility rate is (t) = 0.20 for all t...................................25
Figure 3 Valuation of a four-year zero-coupon bond using a no-arbitrage pricing model that
assumes the short rate is log-normally distributed, the zero-coupon yield curve is R(t) = 0.10
0.05 e0 . 18(t1) where t is measured in years, and the volatility rate is (t) = 0.20 for all t.
.......................................................................................................................................................25
Figure 4 Valuation of a four-year 6% coupon-bearing bond using a no-arbitrage pricing model
that assumes the short rate is log-normally distributed, the zero-coupon yield curve is R(t) = 0.10
0.05 e0 . 18(t 1) where t is measured in years, and the volatility rate is (t) = 0.20 for all
t......................................................................................................................................................26

List of Tables
Table 1 Selected terms of euro futures option contract...................................................................6
Table 2 Selected terms of euro option contract................................................................................6
Table 3 Implied yield to maturity of US bonds (debt).....................................................................9
Table 4 Implied yield to maturity of second alternative..................................................................9
Table 5 Selected terms of CMEs Eurodollar futures contract.....................................................14
Table 6 selected terms of CBTs U.S. Treasury bond futures contract..........................................15
Table 7 Selected terms of CBTs 10-year U.S. Treasury note futures contract.............................15

ASSIGNMENT UNIT 4

Introduction
This short essay is divided into two parts:
Part A answers the following questions.
a. Why are currency derivatives important in currency trading?
b. How is the valuation of currency derivatives performed?
c. Describe major elements of risk management in currency derivatives trading
Part B answers the following questions.
a. What are the major features of trading Interest Rate derivatives?
b. How is risk management for Interest Rate Derivatives performed?
c. What are interest rate swaps? How are they used?
d. How do caps, floors and collars used in trading of interest rate derivatives?
e. Describe the important models used in interest rate derivatives trading
f. How is bond valuation performed?

ASSIGNMENT UNIT 4

PART A
Why are currency derivatives important in currency
trading?
Currency derivatives are important in currency trading because they help to manage the risk
caused by exchange rate fluctuations in regimes where the exchange rate is not fixed (Whaley,
2007).
(Geczy, Minton, & Schrand, 1997) report that currencies derivatives are needed in currency
trading because of exposure to foreign currency risk from foreign operations, foreigndenominated debt, capital market imperfections and the possibility to reduce the variation in cash
flows.
The market of currency derivatives is dominated by interbank market where major banks around
the world trade both spot and forward currencies. Spot transactions are delivered and paid within
two days. Forward transactions are delivered and paid at the time specified in the forward
contract. OTC currency derivatives market are more active than exchange-traded FX futures and
options markets because OTC market is more well suited to tailor FX derivatives contracts to
meet customer management needs (Whaley, 2007).
The highlights from the latest BIS semi-annual survey of over-the-counter (OTC) derivatives
markets reports that foreign exchange derivatives make up the second largest segment of the
global OTC derivatives market. At end-December 2014, the notional amount of outstanding
foreign exchange contracts totalled $76 trillion, which represented 12% of OTC derivatives
activity (OTC derivatives statistics at end-December 2014, 2015, p. 4):
FX futures contracts are traded all over the world. In the USA, the most active FX futures
contracts market is the Chicago Mercantile Exchanges International Monetary Market division.
Each of the exchanges contracts has present terms. In Chicago the FX futures contracts are
traded virtually 24 hours a day (Whaley, 2007).
In USA, the FX options contracts take two forms: options on FX futures and options on FX spot
currencies. The CMEs futures options are the most active, followed by the Philadelphia Stock
Exchanges spot currency options. These two markets are very similar in nature, however, there
are some minor distinction. The contract specifications of the CMEs EUR futures option
contract and the PHLXs EUR futures options contract are provided in (Table 1 and Table 2),
respectively. CMEs EUR futures options contracts require the delivery of the underlying futures
and a contract denomination of EUR 125000. The CMEs most active futures options are
American-style, although they also offer European-style contracts (Whaley, 2007).
The currency options traded on the PHLX are half the size of the CMEs futures option, EUR
62500 and require the delivery of the underlying currency. The most active FX options traded on

ASSIGNMENT UNIT 4

the PHLX are its customized currency options. PHLXs EUR futures options contract market
offers both American-style and European-style (Whaley, 2007).
Table 1 Selected terms of euro futures option contract

Source: (Whaley, 2007, p. 570)

Table 2 Selected terms of euro option contract

Source: (Whaley, 2007, p. 570)

ASSIGNMENT UNIT 4

How is the valuation of currency derivatives performed?

The valuation of currency derivatives is performed using continuous net carry cost assumption.
The net cost of carry rate of a foreign currency is the difference between the domestic and
foreign interest rates, that is, b = rd - rf (Whaley, 2007).
Forwards/Futures
The compute the value of foreign currency forwards and futures, the following net cost of carry
relation is used,
F=S e

( r d r f ) T

were F and S denotes the forward and spot prices of the currency in USD per unit of foreign
currency, rd is the domestic (U.S.) risk-free interest rate and rf is the risk-free rate of interest in
the foreign market. The net cost of carry relation (Equation 1) arises from the absence of costless
arbitrage opportunities in the marketplace (Whaley, 2007).
The terminal cost is
Sx e

rdT

rfT

(r d r f ) T
=S e

Since the two alternatives are perfect substitutes, the two sides of (Equation 2) must be equal
(Whaley, 2007).
Interest Rate Parity
Interest rate parity can be computed using (Equation 1), or can be expressed in relative terms,
that is,
FS
( r d r f ) T
= e
-1
S

were

FS
S

( r d r f ) T
is called forward premium or swap rate and e
-1 is the interest

differential between the two countries (Whaley, 2007).

Cross Rates and Triangular Arbitrage
The cross-rate relation is an arbitrage relation that involves three currencies. (Whaley, 2007) uses
an example of Canadian dollars, U.S. dollars and Euros to illustrates cross rates. First, Canadian
dollars are bought using , U.S. dollars. Second, euros are bought using Canadian dollars, and
then , U.S. dollars are bought using euros. Without trading costs and costless arbitrage
opportunities, the original value is recovered, that is,
CAD EUR
( USD
)(
CAD EUR )( USD )

=1

ASSIGNMENT UNIT 4

Another way of thinking about it is the U.S. dollars cost of euros should be the same if Canadian
dollars are bought using U.S. dollars and then use Canadian dollars to buy euros or use U.S.
dollars to buy euros directly, that is
USD
USD CAD
EUR
CAD EUR

) (

)(

If the two methods gave different answers an opportunity for triangular arbitrage would exist. In
the absence of triangular arbitrage opportunities, the following relation must hold for all triplets
of currencies:
Si,j = Si,kSk,j
4
Were Si,j is the number of units of the i th currency required to purchase one unit of the j th currency
(Whaley, 2007).

Describe major elements of risk management in

currency derivatives trading
Risk management
In the context of this short essay, risk management employs currencies derivatives to manage
different types of currency risk exposures. (Whaley, 2007) demonstrates a) how to use currency
swaps to Obtain Foreign financing, b) how to manage the risk of a large foreign currency
transaction, c) how to hedge multiple transactions, d) how to manage the balance sheet risk
Using Currency swaps to Obtain Foreign financing
(Whaley, 2007) illustrates currency swaps to obtain foreign financing that hedge interest
payments and repayment of principal due to exchange rate risk. A Canadian company needs to
acquire land costing 5 million U.S. dollars in USA to build a facility to expand its operations. It
faces two alternatives to borrow in Canada or to borrow in USA. In principle, borrowing in USA
looks attractive because the debt will be paid from sales within America. However, borrowing in
Canada to invest in USA the company will face exchange rate risk. If the company decides to
borrow (to issue bonds) in USA market, a three years loan of 5 million will cost 7.5% fixed
interest rate, while in Canada, the company home country, it will get the loan at cost of 6% fixed
interest rate, with the current exchange rate of CAD 1.40/USD the company will need to 5
million USD x CAD 1.40 = CAD 7 million.

ASSIGNMENT UNIT 4

US Bonds
The implied yield to maturity of borrowing in U.S. market is shown in (Table 3)
Table 3 Implied yield to maturity of US bonds (debt)

Source: (Whaley, 2007, p. 589)

CAD Bonds Plus currency Swap
In this alternative, the company wants to borrow domestically in Canada and use a currency
swap to hedge U.S. dollars sales against exchange rate risk. The company manages to enter into
a fixed-for-fixed currency swap in which it will receive interest at a rate of 6% on a CAD 7
million par amount and will pay interest at a rate of 7.25% on USD 5 million par. The implied
yield to maturity of this alternative is 7.12% lower than the implied yield to maturity from
borrowing in USA market, 7.32% (Whaley, 2007).
Table 4 Implied yield to maturity of second alternative

ASSIGNMENT UNIT 4

10

Source: (Whaley, 2007, p. 589)

The value of the currency swap at origination from the Canadian companys perspective is
= Bd DBf
where Bd is the present value of what the company will receive in Canadian dollars, B f is the
present value of what the company will pay in U.S. dollars, and S is the CAD/USD exchange
rate (Whaley, 2007).
Using FX futures and Options to Manage Transaction Risk single flow
According to (Whaley, 2007) transaction risk refers to the currency risk of a particular future
transaction denominated in a foreign currency. When transactions involve two currencies in
which the invoice is to be paid sometime in future, the currencies involved may face foreign
exchange rate risk. So short hedging strategies may be used to reduce transaction risk exposure.
Short-hedging using a forward contract
Suppose a Swiss intends to buy an asset from USA costing SF 750 million, given the current
exchange rate of USD 0.66/SF and six month forward rate of USD 0.66667/SF. Without a
hedge, if the exchange rate varies the USD value of the transaction will also vary. To eliminate
the risk exposure, the Swiss company can hedge the transaction by selling the SF 750 million
exposure in forward market. With the current six month forward rate of USD 0.66667/SF,
selling the forward implies that the company will receive exactly USD 500 million in six months.
If the exchange rate falls, the net proceeds in USD are gains for the short forward position. If the
exchange rate rises, the net proceeds in USD are loss for the short forward (Whaley, 2007).

ASSIGNMENT UNIT 4

11

Short hedging in the money market

The Swiss company debt of SF 750 million or USD 500 million can be short hedged in the
money market by the cost of carry relation. For this purpose, the U.S. risk-free rate of interest is
assumed to be 5.25%, the current exchange rate is USD 0.66/SF and the six-month forward
exchange rate is USD 0.66667/SF. Using interest rate parity, the six-month risk-free in
Switzerland is 3.24%. Thus, the amount to borrow today against the SF 750 million payment that
3.24 0.5
the company will receive in six months is 737 947 886 computed as SF 750 000 000 e
.
Then, the company converts the amount borrowed into USD, multiplying SF 737 947 886 by
exchange rate USD 0.66/SF, resulting in USD 487 045 605 that are invested at the U.S. risk-free
rate. The company uses the payment of SF 750 million to pay the debt and gets USD 500
million that resulted from its capitalized investment of USD 487 045 605 plus interest, USD 487
0.05250.5
045 605 e
(Whaley, 2007).
Short hedging using an option
This is another alternative for hedging the debt from exchange rate risk. In this case, the Swiss
company will buy a European-style USD/SF put option. This strategy results in a gain whenever
the Swiss franc appreciates relative to the U.S. dollar and results zero loss whenever the Swiss
franc depreciates in that the reduced sales proceeds are offset by the exercise proceeds of the put
even with the payment of the put (Whaley, 2007).
Long hedging using a forward
This strategy consists in buying a six-month forward contract on U.S. dollars to hedge exchange
rate risk. If the Swiss franc depreciates relative to the U.S. dollar it profit from its long forward
position otherwise with appreciation of the Swiss franc relative to the U.S. dollar the company
still will be able to cover the purchase and the forward obligations without any loss. Thus all the
transaction risks are eliminated by using a forward contract (Whaley, 2007).
Long hedging using an option
The transaction can also be hedged using a European-style call option. This strategy has two
benefits. First, if the U.S. dollar appreciates relative to the Swiss franc, the Swiss company will
use the exercise proceeds on call to cover excess francs. Second, if the U.S. dollar depreciates the
Swiss franc payment is reduced and the call expires out of the money. In either case the cost of
the hedge is the cost of call (Whaley, 2007).
Hedging an uncertain transaction
This strategy assumes that transaction may be uncertain not necessarily to take place in six
months. In this case, a put option short-hedging strategy can lock the maximum exposure a the
cost of the put option. If the Swiss franc appreciates in value the Swiss company gains. However,

ASSIGNMENT UNIT 4

12

if the transaction is cancelled the loss is limited to the cost of the put. In the event that the Swiss
franc appreciates may also gain (Whaley, 2007).
Using FX futures and options to manage a transaction risk
When multinational firms are faced with inputs or outputs denominated in a foreign currency
they may hedge the price risk of their inputs or outputs using fixed rate swaps and average rate
options contracts in addition to many others risk management tools (Whaley, 2007).
Using FX futures and options to manage balance sheet risk
Exchange currency risk is not only tied to a particular transaction but also to assets or liabilities
on the firms balance sheet such as accounts receivable and inventory denominated in various
foreign currencies. Managing balance sheet risk depends on whether the foreign currency
obligation is contractual or not. Since, the terms of a contractual foreign currency obligation are
fixed so the asset or liability is subject to exchange rate risk. The terms of a non-contractual
foreign currency obligation are not fixed so prices can adjust to offset changes in exchange rates
(Whaley, 2007).

PART B
What are the major features of trading Interest Rate
derivatives?
According to (Fabozzi, Fixed Income Analysis, 2007) interest rate derivative instruments
derive their value from some cash market instrument or reference interest rate. Examples of
interest rate derivative instruments include futures, forwards, options, swaps, caps, and floors.
(Fabozzi, Fixed Income Analysis, 2007) describes the following major features of trading
interest rate derivatives:
Interest rate derivatives markets
o Exchange Traded interest rate derivative instruments.
o OTC interest rate derivative instruments. According to (Whaley, 2007) more than
two thirds of OTC derivatives are written on interest rate instruments.
Cheaper (less execution cost) than underlying instrument transactions
Quicker to adjust the portfolio positions
More liquid than the underlying instrument
Popular interest rate derivative instruments are:
o interest rate Futures
o interest rate Swap
o interest rate Cap
Interest rate derivative instruments categories
o Short-term - Underlying security with maturity less than a year
Treasury bills futures contract

ASSIGNMENT UNIT 4

Eurodollar futures contract

Federal funds futures contract

13

o Long-term - Underlying security with maturity more than a year

Treasury bond futures

Treasury notes futures

Municipal note index futures

Other countries have similar future contracts on government bonds

Settlement - For interest-rate contracts that do not call for actual delivery (e.g., Eurodollar
futures), settlement is in cash at the settlement price on the delivery date otherwise
physical delivery (Fabozzi, Mann, & Pitts, 2005).

Features of the evolution of interest rate derivatives markets

According to (Whaley, 2007), apparently the interest rate derivatives markets do not have the
transparency of stock markets because bonds are not actively traded on exchanges. However, the
statistics dated from 2003 report the opposite (Figure 1), of the $34.34 trillion in outstanding
securities, 56% are bonds and 44% are stocks.

Figure 1 Market values of bonds and stocks outstanding in the United States as of
December 31, 2003.
Source: (Whaley, 2007, p. 604)
Chicago Board of Trades (CBTs) futures on GNMA Collateralized Depository Receipts (CDRs)
were the first interest rates futures contract to be introduced in the fall of 1975. The (CBTs)
futures contract on GNMA was delisted in the late 1980 because was not effective as a hedging
vehicle. The next interest rate futures contracts to be introduced were the Chicago Mercantile
Exchanges (CMEs) T-bill futures contract in January 1976 and the CBTs U.S. In December

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14

1981 the CME Eurodollar futures contract was introduced and this marked the first time an
interest rate futures specified cash-settlement rather than physical delivery. In late 1982, the CBT
and the CME simultaneously launched for the first time trading of options on interest rate
contracts on T-bond futures and Eurodollar futures, respectively (Whaley, 2007).
The last event of the the evolution of interest rate derivatives markets is the introduction of
interest rate swap in the early 1980s. the most common interest rate swap called a plain-vanilla
interest rate swap is to exchange payments on fixed rate debt for floating rate debt (Whaley,
2007).
Features details of interest rate Futures
According to (Whaley, 2007), stock, stock index, and foreign currency products have a single
source of risk underlying the derivatives contracts, namely, the price risks of a stock, stock index,
or foreign currency respectively. But, interest rate derivatives the risk come in three categories
namely, short-term, intermediate-term, or long-term. Futures contracts examples of these three
categories of temporal risk are: short-term interest rate contract is the CMEs three-month
Eurodollar futures, intermediate-term interest rate contract is the CBTs 10-year futures and
long-term interest rate contract is the CBTs T-bond futures.
The types of interest rate Futures being traded are:
Eurodollar futures - the contract specifications for the CMEs Eurodollar futures are
given in (Table 4). The Eurodollar futures is cash settled at expiration, which is set as the
second London business day.
Table 5 Selected terms of CMEs Eurodollar futures contract.

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15

Source: (Whaley, 2007, p. 608)

U.S. T-Bonds and T-Notes Futures the contract specifications of the CBTs T-bond
and 10-year T-note contracts are given in Table 6 and Table 7, respectively. Both
contracts follow a quarterly expiration cycle and delivery may take place at any time
during the delivery month at the discretion of the short (Whaley, 2007).

Table 6 selected terms of CBTs U.S. Treasury bond futures contract

ASSIGNMENT UNIT 4

Source: (Whaley, 2007, p. 610)

Table 7 Selected terms of CBTs 10-year U.S. Treasury note futures contract

Source: (Whaley, 2007, p. 611)

Aspects related to CBTs Treasure contracts delivery

16

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17

Conversion Factor - the CBTs Treasure contracts call for the delivery of any Treasury
instrument satisfying a particular maturity constraint. The conversion formula is
5

where CF is the conversion factor, C is the annual coupon rate of the bond in decimal form,
equals 0.06, n is the number of whole years to first call if the bond is callable or the number of
years to maturity if the bond is not callable, and X is the number of months that the maturity
exceeds n, rounded down to the nearest quarter (e.g., X =0, 3, 6, 9) (Whaley, 2007).

Invoice Price - the amount of the invoice price equals the sum of the futures price times
the conversion factor of the delivered bond and the accrued interest on the delivered bond
(Whaley, 2007).

Interest Rate Options

The most active exchange-traded interest rate options are those written on the CMEs Eurodollar
futures, and the CBTs five-year T-note, 10-year T-note, and T-bond futures.
Types of interest rate options

Eurodollar Futures Options the options are American-style, and expire together with the
underlying futures on the second London business day before the third Wednesday of the
contract month. Eurodollar futures options follow a quarterly expiration cycle like the
futures (Whaley, 2007).
U.S. T-Bond Futures Options Like the Eurodollar futures options, early exercise results
in receiving a position in the underlying futures (Whaley, 2007).

How is risk management for Interest Rate Derivatives

performed?
(Whaley, 2007) describes four ways for performing risk management for interest rate derivatives,
namely, a) Short term, Long Hedge, b) Long term, Short Hedge, c) Equivalence of DurationBased and OLS Regression Approaches and d) Asset Allocation.

Short term, Long Hedge - interest rate risk management is by buying and selling
Eurodollar futures contracts as a cost-efficient means of locking-in forward rates of
interest.

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18

Long term, Short Hedge - interest rate risk management is performed using duration
based hedging techniques applied to futures contracts. Here, hedging means finding the
number of futures to buy or sell such that the value of the overall hedged portfolio does
not change if interest rates change, that is,

where

BP

BP

nF

F = 0

and F are the changes in value of the bond position and the futures

resulting from a change in interest rates, . Duration-based hedging means

approximating the change the changes of values with the product of duration and bond
value, that is,
D P BP
Where

DP

and

DP

n F DF

F=0

are durations of the bond portfolio and the futures contract,

respectively. The number of units of the hedge instrument to buy or sell is therefore given
by

nF

=-

D P BP
D F BF

(Whaley, 2007).

Equivalence of Duration-Based and OLS Regression Approaches the optimal

hedge ratio is 1 in an OLS regression of the changes in bond portfolio value on the
changes in the value of the T-bond futures, that is,
and

Asset Allocation the asset allocation decision refers to the allocation of fund wealth
among various asset categories including stocks, bonds, and so on (Whaley, 2007).

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19

What are interest rate swaps? How are they used?

(Whaley, 2007) defines interest rate swap as an agreement between two parties to exchange or
swap a series of periodic interest payments. The most common interest rate swap, a plainvanilla interest rate swap, is an agreement to exchange payments on fixed rate debt for floating
rate debt.
According to (What Are Interest Rate Swaps and How Do They Work?, 2008) webpage the
potential uses of interest rate swaps include:
Portfolio management. Interest rate swaps allow portfolio managers to add or subtract
duration, adjust interest rate exposure, and offset the risks posed by interest rate volatility.
By increasing or decreasing interest rate exposure in various parts of the yield curve
using swaps, managers can either ramp-up or neutralize their exposure to changes in the
shape of the curve, and can also express views on credit spreads. Swaps can also act as
substitutes for other, less liquid fixed income instruments. Moreover, long-dated interest
rate swaps can increase the duration of a portfolio, making them an effective tool in
Liability Driven Investing, where managers aim to match the duration of assets with that
of long-term liabilities (What Are Interest Rate Swaps and How Do They Work?, 2008).
Speculation. Because swaps require little capital up front, they give fixed-income traders
a way to speculate on movements in interest rates while potentially avoiding the cost of
long and short positions in Treasuries. For example, to speculate that five-year rates will
fall using cash in the Treasury market, a trader must invest cash or borrowed capital to
buy a five-year Treasury note. Instead, the trader could receive fixed in a five-year
swap transaction, which offers a similar speculative bet on falling rates, but does not
require significant capital up front (What Are Interest Rate Swaps and How Do They
Work?, 2008).
Corporate finance. Firms with floating rate liabilities, such as loans linked to LIBOR,
can enter into swaps where they pay fixed and receive floating, as noted earlier.
Companies might also set up swaps to pay floating and receive fixed as a hedge against
falling interest rates, or if floating rates more closely match their assets or income stream.
Risk management. Banks and other financial institutions are involved in a huge number
of transactions involving loans, derivatives contracts and other investments. The bulk of
fixed and floating interest rate exposures typically cancel each other out, but any
remaining interest rate risk can be offset with interest rate swaps (What Are Interest Rate
Swaps and How Do They Work?, 2008).
Rate-locks on bond issuance. When corporations decide to issue fixed-rate bonds, they
usually lock in the current interest rate by entering into swap contracts. That gives them
time to go out and find investors for the bonds. Once they actually sell the bonds, they
exit the swap contracts. If rates have gone up since the decision to sell bonds, the swap
contracts will be worth more, offsetting the increased financing cost (What Are Interest
Rate Swaps and How Do They Work?, 2008).

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20

Interest Rate Swap Valuation

Applying the valuation-by-replication technique, the value of an interest rate swap is the
difference between the values of affixed rate bond and a floating rate bound.
(Whaley, 2007) states that the value of a fixed rate bound can be calculated as
6
where FIXEDI is the amount of the fixed rate payment (i.e., the fixed rate times the notional
amount, NOTIONAL), ri is the annualized zero-coupon discount rate used to bring the cash flow
to the present, Ti is the number of years until the cash flow i occurs, and n is the number of
interest payments.
The value of a floating-rate bond is (Whaley, 2007),
7
The value of an interest rate swap from the perspective of someone receiving fixed and paying
floating is the difference (Whaley, 2007),
8
Valuation of an Inverse Floater
According to (Whaley, 2007), an inverse floater is like a floating rate bond in the sense that its
interest payments are based on a reference rate, that is,
Rate on inverse = Fixed rate Reference rate

The valuation formula of an Inverse Floater is

10

where, the first payment, is treated separately to reflect the fact that the amount of the first
interest payment was set at the beginning of the period and is already known. By definition, the
payment on an inverse floater equals a fixed rate less the reference floating rate, that is.
INVFLOAT = FIXED FLOAT

11

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21

Duration of an Inverse Floater

(Whaley, 2007) states that the formula to compute the duration of an inverse floater is

12

How do caps, floors and collars used in trading of

interest rate derivatives?
(Whaley, 2007) defines interest rate caps and floors as OTC agreements that protect buyers and
sellers of floating rate notes against adverse movements in interest rates. The example given by
(Whaley, 2007) to show how caps and floors are used in trading of interest rate derivatives
involves a firm with a floating rate loan facing a risk that its periodic interest payment will jump
to a level too high to manage given the firms current cash flow.
And interest rate collar involves buying an interest rate cap and selling an interest rate floor. By
buying an interest rate cap, the firm can eliminate its interest rate risk exposure above a specified
level. Conversely, an individual holding a floating rate note may want to limit his exposure to
rates falling below a certain level. Buying an interest rate floor protects the floating rate receiver
from such movements (Whaley, 2007).
(Whaley, 2007) notes that exist a put-call parity relation between the floating rate, a cap, and a
floor. For example, if someone borrows at a floating rate, buys an interest rate cap with a cap rate
of RX, and sells an interest rate floor with a floor rate of R X, he/she has transformed his/her
floating rate loan into a fixed rate loan at RX.

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22

Describe the important models used in interest rate

derivatives trading
According to (Groth, 2009) the models used in interest rate derivatives trading are; a) The Black
Model, b) Bond Option, c) Caps and Floors, d) Swaption
Black Model
(Groth, 2009) states that the standard market model to price interest rate derivatives is the Black
model and a large number of the commonly traded derivatives are priced via the Black model.
(Groth, 2009) had considered a European Call CK,T (V, t) with payoff max(VT K, 0) at time T
and K being the strike price in conjunction with following assumptions to compute the Black
Scholes value of the option. He assumes that, the value of the option today is its discounted
expected payoff, that VT has a lognormal distribution with the standard deviation of log VT
being T and that the expected value of VT at time t is the forward price Ft
Therefore using the Black Scholes framework this implies that:

13
with

Because interest rates now considered to be stochastic, the expected payoff is discounted by
multiplying with V (t, T). With the E(VT ) = Ft the value of the option at time t is:

14
with

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23

Valuation of Bond Option

(Groth, 2009) defines a bond options as an agreement which gives the holder the right to buy or
sell a particular bond at a specified time T for a specified strike price K.
(Groth, 2009) gives an example of a European call with a strike price K and a maturity T on a
zero bond with a maturity of S > T, i.e., the option to buy the bond at time T at a price K. So that:

To value a bond option, (Groth, 2009) applied Blacks model and changed the numeraire from
the current cash amount to a bond V (t, T) and in combination with the result from (Equation 15),
he considered that the current value of any security as its expected future value at time T
multiplied by V (t, T).
15
(Groth, 2009) shown that the expected value of any traded security at time T is equal to its
forward price. Thus the price of an option with maturity T on a bond V (t, S) with S > T is given
by:

and

16
with ET denoting the forward risk neutral expectation w.r.t to V (t, T) as the numeraire.
Again, (Groth, 2009) applied the same assumptions as above and he got

17
with

Valuation of Caps, floors, and Collars

(Whaley, 2007) states that the valuation of Caps uses a portfolio of European-style call options,
with each options expiration corresponding to a reset date of the underlying floating-rate bond.
As demonstration, the following information is assumed; the forward three-month LIBOR rate at
time i, Fi, is log-normally distributed and R X is the known interest rate cap, the value of the first
reset option (called a caplet) and RX is the interest rate cap,

ASSIGNMENT UNIT 4

24

18
where

ti represents the time until the reset date, and ti+1 represents the time until the payment date for the
ith reset. The overall value of the interest rate cap is the sum of the n caplets in the interest rate
cap agreement, that is,
19
(Whaley, 2007) states that an interest rate floor agreement can be developed in a similar manner.
Since the interest rate floor provides protection against downward movements in the floating
rate, each floorlet is valued using a put option formula, that is,
20
And the overall value of an interest rate floor is
21
If a cap is bought and a floor is sold with the same terms, the value of each combined caplet and
floorlet is
22

Valuation of Swaptions
A swaption is an option on an interest rate swap and it gives its holder the right to enter into a
certain interest rate swap at a certain time in the future (Whaley, 2007).
(Whaley, 2007) states that the valuation of a swaption assumes that the underlying forward
(swap) rate is distributed log-normally at the options expirations. The payoff from the swaption
at expiration consists of a series of cash flows equal to
23
where R is the rate on an n-year swap, L is the principal amount of the swap, m is a
compounding frequency per year. The value of the cash flow at time ti (where ti = T + ilm) is
24

ASSIGNMENT UNIT 4

25

where

is the forward rate on an n-year swap that begins at time T, and r i is the continuously
compounded zero-coupon interest rate for maturity ti. The swaption value is therefore

25

(Whaley, 2007) notes that this formula is the present value of an annuity, that is,
26
The value of put option is
27
Finally, (Whaley, 2007) notes that both caps/floors and swaptions are quoted in terms of the
Black (1976) model, as cited in (Whaley, 2007), in the marketplace even though it is
theoretically inconsistent to do so.

How is bond valuation performed?

(Whaley, 2007) explains the process of bond valuation by computing de value of zero-coupon
bonds first, and then generalizing the framework to handle coupon-bearing bonds. After this
stage, (Whaley, 2007) shows how the framework can be modified to handle bonds with
embedded options such as callable bonds and putable bonds.
Valuation of Zero-Coupon Bonds
(Whaley, 2007) assumes a 4-year discount bond that matures in year 4 with a payment of
principal to illustrate the process of valuation of zero-coupon bonds. He assumes that the
principal is 100, in year 3, the short-term interest in the uppermost node is 0.152051, so the value
0.152051(1)
of the bond at that interest rate is 100 e
=85.8994. At the second uppermost node, the
0.101923(1)
bonds value is 100 e
=90310, and so on.

(Whaley, 2007) says that to compute the bonds value in year 2, it is necessary to include the
probabilities of upward and downward interest rate movements. So the value of the bond at the
uppermost node in year 2 is computed as

ASSIGNMENT UNIT 4

26

The value of the bond at the second uppermost node is

The price lattice of the four-year discount bond is shown in (Figure 2)

Figure 2 Three-period binomial lattice for no-arbitrage pricing model assuming the short
rate is log-normally distributed, the zero-coupon yield curve is R(t) = 0.10 0.05
e0.18(t1) , where t is measured in years, and the volatility rate is (t) = 0.20 for all t.

Source : (Whaley, 2007, p. 721)

Figure 3 Valuation of a four-year zero-coupon bond using a no-arbitrage pricing model that
assumes the short rate is log-normally distributed, the zero-coupon yield curve is R(t) =
0.18(t1)
0.10 0.05 e
where t is measured in years, and the volatility rate is (t) = 0.20 for
all t.

ASSIGNMENT UNIT 4

27

Source : (Whaley, 2007, p. 722)

Coupon-Bearing Bonds
(Whaley, 2007) uses interest rate lattice to value coupon-bearing bonds by working backward in
time adding in the coupon payments. He illustrates the process using a four-year coupon-bearing
bond with annual coupon payments equal to 6. The value of the bond at the uppermost in year 2
is

and at the second uppermost node is

The price lattice of the four-year coupon-bearing bond is provided in ()

Figure 4 Valuation of a four-year 6% coupon-bearing bond using a no-arbitrage pricing
model that assumes the short rate is log-normally distributed, the zero-coupon yield curve
0.18(t1)
is R(t) = 0.10 0.05 e
where t is measured in years, and the volatility rate is (t) =
0.20 for all t.

ASSIGNMENT UNIT 4

28

Source : (Whaley, 2007, p. 723)

Callable Bonds
A callable bond is a coupon-bearing bond that allows its issuer to retire the bond before its stated
maturity and in general, the call dates of the bond are coupon-payment dates, and the amount
that bondholders will be paid is the par value of the bond plus the current coupon (Whaley,
2007).

Putable Bonds
(Whaley, 2007) states the a putable bond permits the bondholder to sell the bound back to the
issuer, usually at the par value of the bond. This put gives the bondholder some protection from
loss of principal due to higher interest rates or credit deterioration of the issuer and can be valued
using the interest rate lattice procedure developed earlier.
Bond Option Valuation
(Whaley, 2007) indicates that lattice procedure can also be used to value bond options.

ASSIGNMENT UNIT 4

29

References
Fabozzi, F. J. (2007). Fixed Income Analysis (Second ed.). New Jersey: John Wiley & Sons, Inc.
Retrieved April 07, 2016, from
http://www.books.mec.biz/tmp/books/RTZCEJSF7HQOKE65XZFQ.pdf#page=1&zoom
=auto,-173,486
Fabozzi, F. J., Mann, S. V., & Pitts, M. (2005). INTRODUCTION TO INTEREST-RATE
FUTURES AND OPTIONS CONTRACTS. In F. J. FABOZZI, & S. V. MANN (Eds.),
THE HANDBOOK OF FIXED INCOME SECURITIES (Seventh ed., pp. 1163-1185).
New York: McGraw-Hill. Retrieved April 07, 2016, from
http://students.ceid.upatras.gr/~aggelidis/mort.pdf
Geczy, C., Minton, B. A., & Schrand, C. (1997). Why Firms Use Currency Derivatives. The
Journal of Finance, 52(4), 1323-1354. Retrieved April 5, 2016, from
http://www.jstor.org/stable/2329438
Groth, L. (2009). Interest Rate Derivatives. In L. Groth, & L. Sun, Models for Interest Rates and
Interest Rate Derivatives (pp. 16-21). Berlin: CASE - Center of Applied Statistics and
Economics. Retrieved April 08, 2016, from http://edoc.hu-berlin.de/master/sun-li-grothlasse-2009-05-12/PDF/sun.pdf
OTC derivatives statistics at end-December 2014. (2015, April). Retrieved March 29, 2016, from
http://www.bis.org/publ/otc_hy1504.pdf
Whaley, R. E. (2007). Markets, Valuation, and Risk Management. New Jersey: John Wiley &
Sons, Inc. Retrieved March 17, 2016, from http://reader.eblib.com/%28S
%28idx03suk1goej3lutbvlfpy2%29%29/Reader.aspx?
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What Are Interest Rate Swaps and How Do They Work? (2008, January). Retrieved April 7,
2016, from PIMCO:
http://www.pimco.co.uk/EN/Education/Pages/InterestRateSwapsBasics1-08.aspx