Fixed Income and Derivatives

(IV) FI Derivatives- Forward, FRA, IRS

Reading: 60

Dr. Samer HajYehia

IDC
• Derivatives:
Derivatives
• A financial derivative is a financial instrument that offers a return derived from the
return or state of another asset (underlying asset) at a pre-determined strike
(maturity) date for a pre-determined strike (maturity) price.
• Delivery can be physical or in cash (or netting in cash).
• Party may and may not pay some/any amount to the other at initiation.
• Basis = spot price – future price
• A party is in a long (short) position if agrees/must buy (sell) the underlying asset.
• Types of derivatives:
• Future and Forward contracts
• Forward rate agreement (FRA)
• Swap:
• Interest rate swap
• Credit Default Swap (CDS)
• Option (embedded or standalone)
• Swaption
 Derivatives
• Importance of derivatives:
• Risk management and hedging
• Financial engineering
• Provide liquidity
• Low transaction cost
• Price discovery
• Making markets more efficient
• Trading:
• Exchange-traded derivatives are created, standardized, authorized, and traded on a
derivatives exchange backed by a clearinghouse.
• Clearinghouses require margins and mark to market on a daily basis.
• Over-the-counter (OTC) derivatives are tailor-made by two parties off of a
derivatives exchange, and each party assumes the credit risk of the other.
• OTC derivatives require that both parties to the transaction have a high degree of
credit worthiness.
 Derivatives
• Mark to market:
• The act of daily transfer of money to the margin account to reflect the profits or
losses.

• Offsetting:
• At some point in the life of the contract prior to expiration, a party may wish to
offset its obligation and close out its position by re-entering the market in the
opposite position- a long party shorts a new but similar contract, and a short party
long a new but similar contract.
• Netting:
• At the event of default, transactions are netted out against each other at market
value.
• A clearinghouse
• A clearing house is a financial institution that provides clearing and settlement
services for financial transactions between its two financial members.
• It offsets the counterparty risk by requiring collateral deposits (margins) and
monitoring party’s credit risk.
 T-Bill Forward
• Pricing at inception:
𝑇
𝐵𝐹𝑜 = 𝐵𝑆0 1 + 𝑅𝑓

• Valuation prior to expiration:

𝐵𝐹0
𝑉𝐵𝐹𝑡 = 𝐵𝑆𝑡 − 𝑇−𝑡
1+𝑅𝑓

• Valuation at expiration:
𝑉𝐵𝐹𝑇 = 𝐵𝑆𝑇 − 𝐵𝐹0

• Where:
• 𝐵𝐹𝑜 : forward price of a T-bill at inception
• 𝐵𝑆𝑡 : spot price of a T-bill
• 𝑉𝐵𝐹𝑡 : value of a T-bill forward contract at time t, prior to expiration
• 𝑉𝐵𝐹𝑇 : value of a T-bill forward contract at expiration
• Rf: risk-free interest rate
 T-Bill Forward
• Pricing and valuation- Example:
• Assume a 9 month forward contract on a one-year T-bill with a face
value of $1,000 that sells at $900. The risk-free APR is 5%.
9Τ12
$900 ∗ 1 + 1.05 = $933.54
Buy and hold

No arbitrage
Rf = 5%
Rf = 6%

t=2 T=9
BS0 = $900 BSt = $890 BSTBS
= $918

=BF0
T

Lock in a forward price BF0

• The value for the T-Bill Forward long position:

• At inception: 𝑉𝐵𝐹0 = $0
$933.54
• Prior to expiration: 𝑉𝐵𝐹𝑡 = $890 − = −$12.3
1 + 6% 7Τ12

• At expiration: 𝑉𝐵𝐹𝑇 = $918 − $933.54 = −$7

 T-Bond Forward
• Pricing at inception:
𝑇
𝐵𝐹𝑜 = 𝐵𝑆0 1 + 𝑅𝑓 − 𝐹𝑉𝐶𝐹𝑇
or
𝑇
𝐵𝐹𝑜 = 𝐵𝑆0 − 𝑃𝑉𝐶𝐹0 1 + 𝑅𝑓

• Valuation prior to expiration:

𝐵𝐹0
𝑉𝐵𝐹𝑡 = 𝐵𝑆𝑡 − 𝑃𝑉𝐶𝐹𝑡 − 𝑇−𝑡
1+𝑅𝑓

• Valuation at expiration:
𝑉𝐵𝐹𝑇 = 𝐵𝑆𝑇 − 𝐵𝐹0

• Where:
• 𝐵𝐹0 : forward price of a T-bond at inception t=0
• 𝐵𝑆𝑡 : spot price of a T-bond at time t
• 𝑉𝐵𝐹𝑡 : value of a T-bond forward contract at time t, prior to expiration
• 𝑃𝑉𝐶𝐹𝑡 : present value, at time t, of the future coupons
• 𝐹𝑉𝐶𝐹𝑇 : future value of the future coupons at the expiration of the forward contract
• Rf: risk-free interest rate, at time t
 T-Bond Forward
• Pricing at inception - Example:
• Assume a 1.25 year forward contract on a 10-year 7% T-bond with a face
value of $1,000 that sells at $1,040. The risk-free APR is 5%.

BFo
Rf = 5%

CF1 CF2
T = 1.25 year
BS0 = $1,040
Rolling
7% backwards
𝑃𝐶𝐹1 = $34.16 = 1,000 (1+5%) −0.5
2
7%
𝐶𝐹2 = $33.33 = 1,000 (1+5%) −1
2

1.25
1 + 5%
𝐵𝐹0 = 1,040 − 34.16 − 33.33 𝐵𝐹0 = $𝟏, 𝟎𝟑𝟑. 𝟔𝟕
 T-Bond Forward
• Pricing at inception - Example:
• Assume a 1.25 year forward contract on a 10-year 7% T-bond with a face
value of $1,000 that sells at $1,040. The risk-free APR is 5%.

BFT
Rf = 5%

C1 C2
T = 1.25 year
BS0 = $1,040
𝐶𝐹1 = 1,040 (1+5%)1.25 = $1,105.40
Rolling 7%
𝐶𝐹1 = 1,000 (1+5%) 0.75 = $33.74
forwards 2
7%
𝐶𝐹2 = 1,000 (1+5%) 0.25 = $34.58
2

𝐵𝐹0 = 1,105.40 − 33.74 − 34.58 = $𝟏, 𝟎𝟑𝟕. 𝟎𝟖

 T-Bond Forward
• Valuation prior to expiration - Example:
• 7 months later, the spot price of the T-bond is $918. The risk-free APR is
4%.

BFT
Rf = 5%
Rf = 4%
8 months
5 months

C2
T = 1.25 year
BSt = $918.00
7%
𝐶𝐹2 = 1,000 (1+4%) −5/12 = $34.43
2

𝐵𝐹0 = 1,033.77 (1+4%) −8/12 = $1,006.99

𝐵𝐹0 = 918.00 − 34.43 − 1,006.99 = −$61.42

 FRA
• Forward rate agreement (FRA):
• A forward contract in which one party, the long, agrees to pay a fixed
interest payment at a future strike date and receive an interest payment at
a rate to be determined at expiration.
• Both sets of interest payments are made in the same currency.
• Backwardation (Contango) refers to a situation where the futures price
is below (above) spot price.
• Notation: “5.5% 3x9FRA” is:
❑ An FRA contract
❑ Its strike date is 3 months from today
❑ The underlying asset is a 6-month Eurodollar deposit that begins in
3 months, pays 5.5% interest 9 months from now
❑ The party with long position is long to borrow at a fixed rate; he
agrees to pay the fixed rate, thus will benefit if rates increase
❑ It is settled in cash at the end of the 3rd month (expiration date)
❑ The payoff is the present value of the interest saving on the loan
 FRA
• Eurodollar future rate agreement:
• Underlying asset: rate on a 90-day $1,000,000 Eurodollar deposit, with
annualized 360-day add-on rate basis.
• Quotation: 100 – rate (≡ 𝑰𝑴𝑴 𝑰𝒏𝒅𝒆𝒙= the International Monetary Market)
• Actual price: 100 – rate% * (90/360)
• Example:
• The rate priced into the contract is 6.25%.
➢ Quoted price: 100 – 6.25 = 93.75
➢ Actual price: $1,000,000 * [1 + 0.0625 * (90/360)] = $1,015.62
➢ Therefore, a bank depositing $1,000,000 at a rate of 6.25%, would
deposit today $1,000,000 and would get back three month from
today a total of $1,015,62.
• Each basis point change is equivalent to $25 change in price.
• Tick (minimum price rate change) = 1bps  $25 change in price
 FRA
• Pricing and valuation of Eurodollar future rate agreement:

r2
2
r1 F0
1  = 𝜏2 − 𝜏1

T0 T1

𝜏1 𝜏 𝜏2
• No-arbitrage argument  1 + 𝑟1 ∗ 1 + 𝐹0 ∗ = 1 + 𝑟2 ∗
360 360 360

𝜏2
360 1 + 𝑟2 ∗ 360
➢ No-arbitrage FRA rate: Annualized rate of 𝜏1 x𝜏2 FRA= −1
𝜏 1 + 𝑟1 ∗ 𝜏1
360
 FRA
• Pricing and valuation of an FRA on Eurodollar :

r2
2
r1 F0
1 

T0 T1 11 
r11 F1
22
r22
• The value of the 𝜏1 x𝜏2 FRA:
• at inception: =0

𝜏
𝐹1 − 𝐹0
=𝑁𝑃 360
• Prior to maturity 𝜏22
1 + 𝑟22 ∗ 360

𝑆 𝑇, − 𝐹0
360
• At maturity: = 𝑁𝑃 
1 + 𝑆 𝑇,
360
 FRA =
360 1 + 0.05 ∗
120
360 − 1
• Pricing and valuation of Eurodollar future: 90 1 + 0.04 ∗ 30
360
r2 = 5% = 𝟓. 𝟑𝟐%
2 = 120 days
r1 = 4% F0
1 = 30 days 

T0 T1 11 = 20 days 
R11 = 5.7% F1
22
R22 = 5.9% 110
360 1 + 0.059 ∗
• The value of the long 1x4 FRA: = 360 − 1
90 1 + 0.057 ∗ 20
• at inception: =0 360
= 𝟓. 𝟗𝟐%
90
• 10 days later: = $1,000,000
𝟎.𝟎𝟓𝟗𝟐−𝟎.𝟎𝟓𝟑𝟐 360
= $1,487
110
1+𝟎.𝟎𝟓𝟗𝟎∗360

90
𝟎.𝟎𝟔−𝟎.𝟎𝟓𝟑𝟐 360
• At maturity: = $1,000,000 90 = $1,675
1+𝟎.𝟎𝟔∗360
Assuming, at maturity,
3-month spot rate = 6%
 FRA
• T-Bill futures rate agreement:
• Underlying asset: rate on a 90-day $1,000,000 US T-Bill.
• Quotation: 100 – rate
• Actual price: 100 – rate% * (90/360)
• Rate is on a discount interest basis
• Example:
• The rate priced into the contract is 6.25%.
➢ Quoted price: 100 – 6.25 = 93.75
➢ Actual price: $1,000,000 * [1 – 0.0625 * (90/360)] = $984,375
➢ An investor in a T-Bill future of $1,000,000 notional value quoted
at a rate of 6.25%, would pay $984,375 on the issuance day and
would receive $1,000,000 at expiration.
• Each basis point change is equivalent to $25 change in price
• Tick (minimum price rate change) = 0.5bps  $12.5 change in price
 FRA
• Pricing and valuation of a T-bill future rate agreement:

r2
2
r1 F0
1  = 𝜏2 − 𝜏1

T0 T1

𝜏1 𝜏 𝜏2
• No-arbitrage argument  1 − 𝑟1 ∗ 1 − 𝐹0 ∗ = 1 − 𝑟2 ∗
360 360 360

𝜏2
360 1 − 𝑟2 ∗ 360
➢ No-arbitrage FRA rate: Annualized rate of 𝜏1 x𝜏2 FRA = 1− 𝜏1
𝜏 1 − 𝑟1 ∗ 360

360
= 1 − 𝐵𝐹
𝜏
• Example:
150
• 60-days T-Bill is quoted at 6% 360 1 − 0.065 ∗ 360
2x5 FRA = 1− = 6.92%
90 60
• 150-day T-Bill is quoted at 6.5% 1 − 0.060 ∗ 360
 Interest Rate Swap
• A swap:
• A financial instrument through which two counterparties agree to
exchange one future stream of cash flow against another future stream.
• Typically, at least one of the two series of cash flow is uncertain before
the strike date.
• It is equivalent to a combination of forward contracts or/and options.
• Interest rate swap is equivalent to a series of FRAs.
• A plain vanilla swap is simply an interest rate swap in which one party
pays a fixed rate and the other pays a floating rate, with both sets of
payments in the same currency.
• The case of both sides paying floating is called a basis swap.
• The swap spread is the spread between the swap rate and the
comparable maturity T-Notes.
• Determining the swap rate is equivalent to “pricing” the swap.
• The market value of the swap at inception is zero.
• The market value of the floating-rate bond will always be worth its par
value at every settlement date.
 Interest Rate Swap
• An example of a swap:
• On Dec 31, GE borrows from BoA $25m for 1 year with a quarterly interest
payments at LIBOR+25bps, which is observed at the beginning of the
quarter. The first payment is Mar 31.
• GE prefers a fixed interest rate.
• It buys a swap to pay a fixed rate and receive a floating rate equals LIBOR.
• JPM offers a swap for a fixed rate of 6.2%.

Floating Floating
LIBOR LIBOR+25bps
JPM GE BoA
rw = Fixed 6.2%

➢ GE converts a floating rate to a fixed rate = 6.45% = rw

 Interest Rate Swap
• Pricing of an IRS at inception:
• A plain vanilla (fixed-for-floating) interest rate swap is equivalent to issuing
a fixed-rate bond and buying an otherwise identical floating-rate bond.
• The no-arbitrage condition requires that, the swap rate should make the
value of these two bonds equal.
• The value of the floating-rate bond is:
• At inception and on the reset dates- equals to its face value
• Other dates- can be selling at discount or premium
• Therefore, the fixed swap rate (𝑟𝑤 ) for a $100 par bond:
𝑟𝑤 ∗ 100 𝑟𝑤 ∗ 100 𝑟𝑤 ∗ 100 𝑟𝑤 ∗ 100 100
$100 = + + + +
1 + 𝑅1 1 + 𝑅2 1 + 𝑅3 1 + 𝑅4 1 + 𝑅4
• Where, Rn is the discount rate ≡ annualized spot rate  /365

1
1− 1+𝑅 1−𝑍4
4
𝑟𝑤 = 1 1 1 1 =
+ + + 𝑍1 +𝑍2 +𝑍3 +𝑍4
1+𝑅 11+𝑅 1+𝑅
2 1+𝑅3 4

• Where, Zn is the price of a $1 zero-coupon bond ≡ discount factor

 Interest Rate Swap
$PV
= PV of the floating-rate leg

$PV22
Z1
$PV11
Z1

Floating bond
& coupon
0 90 180 270 360

CF1 CF2 CF3 CF4

Z1
$PV1
Z2
$PV2

Z3
$PV3

Z4
$PV4

$PV = PV of the fixed-rate leg

 Interest Rate SWAP
• Pricing of an IRS at inception- example:
• A 1-year swap with quarterly payments and a notional principal of $5m, and
annualized LIBOR:
• 90-day = 3.0%
• 180-day = 3.5%
• 270-day = 4.0%
• 360-day = 4.5%

1
1− 360
1+0.045∗360
➢ 𝑟𝑤 = 1 1 1 1 =1.1%
90 + 180 + 270 + 360
1+0.030∗360 1+0.035∗360 1+0.040∗360 1+0.045∗360

➢ Swap fixed rate on annual terms = 1.1%*(360/90) = 4.4%

➢ Quarterly fixed payments = $5,000,000 * 1.1% = $55,000

 Interest Rate SWAP
• Market value of an IRS prior to expiration:
• A 1-year swap with quarterly payments and a notional principal of $1m, and
an IRS of 6.052% was issued when 90-day LIBOR was 5.5%.
• 30 days later, the annualized spot rates are:
• 60-day = 6.0%
• 150-day = 6.5%
• 240-day = 7.0%
• 330-day = 7.5%
• What is the value of the IRS to the fixed-rate payer after 30 days?
• Answer:
• The quarterly fixed-payment coupons:
• $1,000  6.052%  90/360 = $15,130
• The next floating-payment coupon:
• $1,000  5.5%  90/360 = $13,750
 Interest Rate Swap
Duration Rate PV factor Fixed leg Floating leg MV of
(Days) Payments PV(payments) Payments PV(payments) fixed-rate payer

60 6.0% 0.99010 $ 15,130 $ 14,980 $ 1,013,750 $ 1,003,713

150 6.5% 0.97363 $ 15,130 $ 14,731

240 7.0% 0.95541 $ 15,130 $ 14,455

330 7.5% 0.93567 $ 1,015,130 $ 949,829

$ 993,996 $ 1,003,713 $ 9,717

0 30 90 180 270 360

C1 = $15,130 C2 = $15,130 C3 = $15,130 C4 = $15,130

Z1 = 0.99010
$14,980
Z2 = 0.97363
$14,731

Z3 = 0.95541
$14,455

Z4 = 0.93567
$949,829

$993,996 = PV of the fixed-rate leg

 Interest Rate Swap
Duration Rate PV factor Fixed leg Floating leg MV of
(Days) Payments PV(payments) Payments PV(payments) fixed-rate payer

60 6.0% 0.99010 $ 15,130 $ 14,980 $ 1,013,750 $ 1,003,713

150 6.5% 0.97363 $ 15,130 $ 14,731

240 7.0% 0.95541 $ 15,130 $ 14,455

330 7.5% 0.93567 $ 1,015,130 $ 949,829

$ 993,996 $ 1,003,713 $ 9,717

0 30 90 180 270 360

C1 = $13,750 C2 = ?? C3 = ?? C4 = ??
Z1 = 0.99010
$13,613
BV = $1,000,000
Z1 = 0.99010
$990,100

$1,003,713 = PV of the floating-rate leg