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CA Final Strategic Financial Management, Paper 2, Chapter 5

CA .Tarun Mahajan

Swaps basic
Valuation of swap
Swaption
Interest rate forwards
Caps, floors & collars

It is a bunch of forward contracts.

Here cash flows are exchanged periodically according to a


predefined formula.

In an interest rate swap one party agrees to pay fixed interest


and other party pays floating interest on a notional principal.

For example I will pay you 8% p.a. on Rs.100cr. for next 5 years
and you will pay me SBI-PLR.

Generic swap means


a swap where the floating rate is LIBOR. It is also named
as plain vanilla swap. In a generic swap fixed payment is
based on 30/360 days convention, i.e., assuming 30 days
in a month and 360 days in a year. Floating rate payment
is calculated on actual/360 days.
Actual/360 days is named as money market convention
while actual/365 is called bond equivalent.

Non generic swap:


all the swaps other than generic swap. For example: Libor
vs prime rate, deferred swap, swaption etc.

Overnight Index Swap


is an interest rate swap involving the overnight
rate being exchanged for some fixed interest
rate.

All in cost swap means


a swap in which rates are quoted in such a
manner that it includes transaction cost and
service charges also. Means no charges are
levied separately.

Suppose a swap dealer quotes an all is swap as Libor vs. 5.9/6.1.


It means that dealer will pay 5.9% p.a. fixed in return for Libor.
And will pay Libor in return for 6.1% p.a. fixed.

6.1%
Libor

Swap
Dealer

5.9%
Libor

To make valuation of a swap


we can divide it into two parts:
A bond paying fixed coupon and
A Variable rate note.

Now we can calculate present value of


both bonds. Difference in their value will
be the value of swap.
Mostly swaps have zero value at
inception, though there may be non par
swaps also.

In a swap A will B 6% p.a. fixed, while B will pay


Libor for next three year, at the end of each year.
If Libor is expected to be 5%, 6% & 8% and YTM
for a 3 years bond is 6% then:
Value of variable coupon bond =

5
6
8 +100
100.74 =+
+
1
2
2
(1.06) (1.06) (1.06)

Value of fixed rate bond is Rs.100 because YTM is equal to coupon.


For a fixed rate payer value of bond = 100.74-100 = Rs.0.74
While for a fixed rate receiver it is -0.74.

It is an option to enter
into swap.

A 3 months into 5 years


swaption means option
to enter into 5 years
swap after 3 months.

A call option would be


the right to enter into
swap as a fixed rate
payer.

If the strike rate is 6%


and actual fixed rate
after 3 months happens
to be 7% then holder
will exercise his option.

A put option would be the right to enter into swap as


a fixed rate receiver. If market rate falls then holder
will exercise his option.
If direction of interest rate is predictable then one
can enter into swaps to convert from floating to
fixed or vice versa.
But if direction is uncertain then one can use
swaption for the same.

Rate at which money is lent/borrowed as of today is called


Spot rate.
S3 means the rate of interest for a 3 years loan as of today.
Contract to borrow/lend money in future is called forward
contract and the relevant rate is called forward rate.
1f 2

means rate of interest for a one year loan to be taken 2


years from now.

Spot rate is equal to geometric mean of forward rates.


1f 0

= 10%, 1f1 = 11%, 1f2 = 12%, calculate S3.

S3= [(1+ 1f0) x (1+ 1f1) x (1+ 1f2) ]1/3 - 1


S3= [1.10 x1.11 x1.12 ]1/3 - 1= 11%
A shortcut would be to take arithmetic Mean instead of
geometric mean.

1f 2

(1 + S 3 )

(1 + S 2 )

3
2

-1

S2 = 10.5%, S3 = 11%, Calculate 1f1.


3/(1.105)2 - 1 = 12%
f
=
(1.11)
1 2
A shortcut would be 1f2 = S3x3 S2x2 = 11x310.5x2 = 12%

YTM is the single rate at which present value of


payment to bondholders becomes equal to current
price of bond.
While spot rate is the rate which can be used to
calculate present value of cash flow of a single
point of time.
If YTM for different maturity bonds is given then we
can calculate spot rates as follows:

Details of three semiannual coupon bonds


Bond

Maturity

Coupon

YTM

Price

A
B

6 months
12 months

8%
10%

8%
10%

1000
1000

18 months

12%

12%

1000

6 months Spot rate = 8%


It is same as 6 months YTM because there is only one payment for the 6 month Bond.
1 year Spot Rate:
50/(1.04) + 1050/(1+S/2)2 = 1000; S = 10.05%
18 months Spot Rate:
60/(1.04) + 60/(1.05025)2+ 1060/(1+S/2)3 = 1000; S = 12.17%

Cap: It is a series of interest rate call options.


It is used by floating rate borrowers to hedge the risk of increase in
interest rate.
When interest rate increases. On one hand borrower has to pay higher
interest but on other hand it gain by exercising the call
Each option in cap is called the caplet.

Borrowed amount $1 million @Libor, payable quarterly.


Cap @ 6%.

Quarter

Libor

Interest

Cap

Net

7%

-17500

+2500

-15000

5%

-12500

-12500

8%

-20000

+5000

-15000

4%

-10000

-10000

After hedging with cap interest outflow is never more than $15000

Floor: It is a series of interest rate put options.


Used by floating rate lender to hedge the risk of
downfall in interest rate. Or
Floating rate borrowers also use it to defray some of
the cost of a cap by taking a short position in floor.
When interest rate decreases below strike price then
the short floor will have to make a payment
Each option in a floor is called the floorlet.

Interest rate Collar is combination of the long cap & short floor.
It is created by floating rate borrower to make cost effective hedging.
Long cap gives protection against rise in interest rate &
Short floor reduces cost of hedging (by sacrificing benefit of lower
interest rate)

Interest rate can also be used as an


underlying for derivatives
IRS can be used to convert fixed to
floating rate and vice versa
Swaption are option on swap
Spot rate is geometric mean of
forward rates
Collar is cost free hedging option

CA. Tarun Mahajan


tarunmahajanca@gmail.com