Lecture 3: Interest Rate Forwards and Options 01135532: Financial Instrument and Innovation Nattawut Jenwittayaroje, Ph.D., CFA NIDA Business School 1 Forward Rate Agreements (FRAs) Definition A forward contract is an agreement between two parties in which one party, the buyer (long), agrees to buy from the other party, the seller (short), underlying asset at a maturity date at a price agreed upon today (i.e., delivery or forward prices) An FRA is a forward contract in which the underlying is an interest rate. One party agrees to make a payment at a fixed interest rate, while the other agrees to make a payment at a floating interest rate, which is determined at the expiration date. Long FRA pay fixed, receive float Short FRA receive float, pay fixed 2 1
FRAs (continued) The Structure and Use of a Typical FRA Underlying is usually LIBOR Since payoff is made today (contrast with swaps), discounting is required. For FRA on m-day LIBOR, the payoff today is Example: Long an FRA on 90-day LIBOR expiring in 30 days. Notional principal of $20 million. Agreed upon rate is 10 percent. Payoff will be 3 FRAs (continued) For example, if 90-day LIBOR at expiration is 8 percent, So the long has to pay $98,039 to the party who is short. If 90-day LIBOR at expiration is 12 percent, the payoff is So the long receives $97,087 from the party who is short. 4 2
FRAs (continued) Note the terminology of FRAs: A B means FRA expires in A months and the underlying is B-A month LIBOR. For example, a 6 x 9 FRA is an FRA that expires in six months with underlying 90-day LIBOR. For example, a 12 x 18 FRA is an FRA that expires in twelve months and the underlying is 180-day LIBOR. 5 Applications of FRAs FRA users are typically borrowers or lenders with a single future date on which they are exposed to interest rate risk. See Table 13.3 and Figure 13.2 for an example. 6 3
7 Interest Rate Options Definition: an option in which the underlying is an interest rate; it provides the right to make a fixed interest payment and receive a floating interest payment interest rate call option the right to make a floating interest payment and receive a fixed interest payment interest rate put option. The fixed rate is called the exercise rate. 8 4
Interest Rate Options (continued) The Structure and Use of a Typical Interest Rate Option With an exercise rate of X, the payoff of an interest rate call is The payoff of an interest rate put is The payoff occurs m days after expiration (as well as interest rate swap), so no discounting is required. Example: notional principal of $20 million, expiration in 30 days, underlying of 90-day LIBOR, exercise rate of 10 percent. m = 90 days, X = 10% 9 Interest Rate Options (continued) The Structure and Use of a Typical Interest Rate Option (continued) If 90-day LIBOR is 6 percent at expiration, payoff of a call is The payoff of a put is If 90-day LIBOR is 14 percent at expiration, payoff of a call is The payoff of a put is These payoffs are made 90 days after the expiration of the options. 10 5
Interest Rate Options (continued) Interest Rate Option Strategies See Table 13.5 and Figure 13.3 for an example of the use of an interest rate call by a borrower to hedge an anticipated loan. See Table 13.6 and Figure 13.4 for an example of the use of an interest rate put by a lender to hedge an anticipated loan. 11 Interest Rate Option Strategies 12 6
Interest Rate Option Strategies 13 Interest Rate Option Strategies 14 7
Interest Rate Option Strategies 15 Interest Rate Options (continued) Interest Rate Caps, Floors, and Collars A combination of interest rate calls used by a borrower to hedge a floating-rate loan is called an interest rate cap. The component calls are referred to as caplets. A combination of interest rate puts used by a lender to hedge a floating-rate loan is called an interest rate floor. The component puts are referred to as floorlets. A combination of a long cap and short floor at different exercise prices is called an interest rate collar. 16 8
Interest Rate Cap Each component caplet pays off independently of the others. See Table 13.7 for an example of a borrower using an interest rate cap. 17 Interest Rate Floor Each component floorlet pays off independently of the others See Table 13.8 for an example of a lender using an interest rate floor. 18 9
Interest Rate Options (continued) Interest Rate Collars A borrower using a long cap can combine it with a short floor so that the floor premium offsets the cap premium. If the floor premium precisely equals the cap premium, there is no cash cost up front. This is called a zero-cost collar. The exercise rate on the floor is set so that the premium on the floor offsets the premium on the cap. By selling the floor, however, the borrower gives up gains from falling interest rates below the floor exercise rate. The net result is that maximum and minimum rates are established on the loan. See Table 13.9 for example. 19 Interest Rate Collars 20 10