DBA 1754 FINANCIAL DERIVATIVES ASSIGNMENT II

1. Define the terms and option contract. What are the features of option contract?

An option is a contract written by a seller that conveys to the buyer the right but not the obligation to buy (in the case of a ) or to sell (in the case of a ) a particular asset, such as a piece of property, or shares of stock or some other underlying security, such as, among others, a . In return for granting the option, the seller collects a payment (the premium) from the buyer.

For example, buying a call option provides the right to buy a specified quantity of a security at a set at some time on or before , while buying a put option provides the right to sell. Upon the option holder's choice to the option, the party who sold, or wrote, the option must fulfill the terms of the contract.

The theoretical value of an option can be evaluated according to several models. These models, which are developed by quantitative analysts, attempt to predict how the value of the option will change in response to changing conditions. Hence, the risks associated with granting, owning, or trading options may be quantified and managed with a greater degree of precision, perhaps, than with some other investments.

Exchange-traded options form an important class of options which have standardized contract features and trade on public exchanges, facilitating trading among independent parties. Over-the-counter options are traded between private parties, often well-capitalized institutions, that have negotiated separate trading and clearing arrangements with each other. Another important class of options, particularly in the U.S., are employee stock options, which are awarded by a company to their employees as a form of incentive compensation.

Other types of options exist in many financial contracts, for example real estate options are often used to assemble large parcels of land, and prepayment options are usually included in mortgage loans. However, many of the valuation and risk management principles apply across all financial options.

Contract specifications

Every financial option is a contract between the two counterparties with the terms of the option specified in a term sheet. Option contracts may be quite complicated; however, at minimum, they usually contain the following specifications:[3]

• whether the option holder has the right to buy (a call option) or the right to sell (a put option) • the quantity and class of the underlying asset(s) (e.g. 100 shares of XYZ Co. B stock) • the strike price, also known as the exercise price, which is the price at which the underlying transaction will occur upon exercise • the expiration date, or expiry, which is the last date the option can be exercised • the settlement terms, for instance whether the writer must deliver the actual asset on exercise, or may simply tender the equivalent cash amount • the terms by which the option is quoted in the market to convert the quoted price into the actual premium–the total amount paid by the holder to the writer of the option.

Types of options

The primary types of financial options are:

• Exchange traded options (also called "listed options") are a class of exchange traded derivatives. Exchange traded options have standardized contracts, and are settled through a clearing house with fulfillment guaranteed by the credit of the exchange. Since the contracts are standardized, accurate pricing models are often available. Exchange traded options include:[4][5]

1. stock options, 2. commodity options, 3. bond options and other interest rate options 4. index (equity) options, and 5. options on futures contracts

• Over-the-counter options (OTC options, also called "dealer options") are traded between two private parties, and are not listed on an exchange. The terms of an OTC option are unrestricted and may be individually tailored to meet any business need. In general, at least one of the counterparties to an OTC option is a well-capitalized institution. Option types commonly traded over the counter include:

1. interest rate options 2. currency cross rate options, and 3. options on swaps or .

• Employee stock options are issued by a company to its employees as compensation.

Option styles

Naming conventions are used to help identify properties common to many different types of options. These include:

• European option - an option that may only be exercised on expiration. • American option - an option that may be exercised on any trading day on or before expiration. • Bermudan option - an option that may be exercised only on specified dates on or before expiration. • - any option with the general characteristic that the underlying security's price must reach some trigger level before the exercise can occur.

Valuation models The value of an option can be estimated using a variety of quantitative techniques based on the concept of risk neutral pricing and using stochastic calculus. The most basic model is the Black-Scholes model. More sophisticated models are used to model the smile. These models are implemented using a variety of numerical techniques. In general, standard option valuation models depend on the following factors:

• The current market price of the underlying security, • the strike price of the option, particularly in relation to the current market price of the underlier (in the money vs. out of the money), • the cost of holding a position in the underlying security, including interest and dividends, • the time to expiration together with any restrictions on when exercise may occur, and • an estimate of the future volatility of the underlying security's price over the life of the option.

More advanced models can require additional factors, such as an estimate of how volatility changes over time and for various underlying price levels, or the dynamics of stochastic interest rates.

The following are some of the principal valuation techniques used in practice to evaluate option contracts.

Risks

As with all securities, trading options entails the risk of the option's value changing over time. However, unlike traditional securities, the return from holding an option varies non-linearly with the value of the underlier and other factors. Therefore, the risks associated with holding options are more complicated to understand and predict.

In general, the change in the value of an option can be derived from Ito's lemma as:

where the Δ, Γ, κ and θ are the standard hedge parameters calculated from an option valuation model, such as Black-Schooled, and dS, dσ and dt are unit changes in the underlier price, the underlier volatility and time, respectively.

Thus, at any point in time, one can estimate the risk inherent in holding an option by calculating its hedge parameters and then estimating the expected change in the model inputs, dS, dσ and dt, provided the changes in these values are small. This technique can be used effectively to understand and manage the risks associated with standard options. For instance, by offsetting a holding in an option with the quantity − Δ of shares in the underlier, a trader can form a portfolio that is hedged from loss for small changes in the underlier price. The corresponding price sensitivity formula for this portfolio Π is:

Example

A call option expiring in 99 days on 100 shares of XYZ stock is struck at $50, with XYZ currently trading at $48. With future realized volatility over the life of the option estimated at 25%, the theoretical value of the option is $1.89. The hedge parameters Δ, Γ, κ, θ are (0.439, 0.0631, 9.6, and -0.022), respectively. Assume that on the following day, XYZ stock rises to $48.5 and volatility falls to 23.5%. We can calculate the estimated value of the call option by applying the hedge parameters to the new model inputs as:

Under this scenario, the value of the option increases by $0.0614 to $1.9514, realizing a profit of $6.14. Note that for a delta neutral portfolio, where by the trader had also sold 44 shares of XYZ stock as a hedge, the net loss under the same scenario would be ($15.81).

Pin risk

A special situation called pin risk can arise when the underlier closes at or very close to the option's strike value on the last day the option is traded prior to expiration. The option writer (seller) may not know with certainty whether or not the option will actually be exercised or be allowed to expire worthless. Therefore, the option writer may end up with a large, unwanted residual position in the underlier when the markets open on the next trading day after expiration, regardless of their best efforts to avoid such a residual.

Counterparty risk

A further, often ignored, risk in derivatives such as options is counterparty risk. In an option contract this risk is that the seller won't sell or buy the underlying asset as agreed. The risk can be minimized by using a financially strong intermediary able to make good on the trade, but in a major panic or crash the number of defaults can overwhelm even the strongest intermediaries.

Trading

The most common way to trade options is via standardized options contracts that are listed by various futures and options exchanges. Listings and prices are tracked and can be looked up by ticker symbol. By publishing continuous, live markets for option prices, an exchange enables independent parties to engage in price discovery and execute transactions. As an intermediary to both sides of the transaction, the benefits the exchange provides to the transaction include:

• fulfillment of the contract is backed by the credit of the exchange, which typically has the highest rating (AAA), • counterparties remain anonymous, • enforcement of market regulation to ensure fairness and transparency, and • maintenance of orderly markets, especially during fast trading conditions.

Over-the-counter options contracts are not traded on exchanges, but instead between two independent parties. Ordinarily, at least one of the counterparties is a well-capitalized institution. By avoiding an exchange, users of OTC options can narrowly tailor the terms of the option contract to suit individual business requirements. In addition, OTC option transactions generally do not need to be advertised to the market and face little or no regulatory requirements. However, OTC counterparties must establish credit lines with each other, and conform to each others clearing and settlement procedures.

With few exceptions, there are no secondary markets for employee stock options. These must either be exercised by the original grantee or allowed to expire worthless.

The basic trades of traded stock options (American style)

These trades are described from the point of view of a speculator. If they are combined with other positions, they can also be used in hedging. An option contract in US markets usually represents 100 shares of the underlying security.[14]

Payoffs and profits from a long call.

Long call

A trader who believes that a stock's price will increase might buy the right to purchase the stock (a call option) rather than just buy the stock. He would have no obligation to buy the stock, only the right to do so until the expiration date. If the stock price at expiration is above the exercise price by more than the premium (price) paid, he will profit. If the stock price at expiration is lower than the exercise price, he will let the call contract expire worthless, and only lose the amount of the premium. A trader might buy the option instead of shares, because for the same amount of money, he can obtain a much larger number of options than shares. If the stock rises, he will thus realize a larger gain than if he had purchased shares.

Long put

Payoffs and profits from a long put.

A trader who believes that a stock's price will decrease can buy the right to sell the stock at a fixed price (a put option). He will be under no obligation to sell the stock, but has the right to do so until the expiration date. If the stock price at expiration is below the exercise price by more than the premium paid, he will profit. If the stock price at expiration is above the exercise price, he will let the put contract expire worthless and only lose the premium paid.

Short call

Payoffs and profits from a naked short call.

A trader who believes that a stock price will decrease, can sell the stock short or instead sell, or "write," a call. The trader selling a call has an obligation to sell the stock to the call buyer at the buyer's option. If the stock price decreases, the short call position will make a profit in the amount of the premium. If the stock price increases over the exercise price by more than the amount of the premium, the short will lose money, with the potential loss unlimited.

Short put Payoffs and profits from a naked short put.

A trader who believes that a stock price will increase can buy the stock or instead sell a put. The trader selling a put has an obligation to buy the stock from the put buyer at the put buyer's option. If the stock price at expiration is above the exercise price, the short put position will make a profit in the amount of the premium. If the stock price at expiration is below the exercise price by more than the amount of the premium, the trader will lose money, with the potential loss being up to the full value of the stock.

Option strategies

Payoffs from buying a spread.

Payoffs from selling a .

Payoffs from a .

Combining any of the four basic kinds of option trades (possibly with different exercise prices and maturities) and the two basic kinds of stock trades (long and short) allows a variety of options strategies. Simple strategies usually combine only a few trades, while more complicated strategies can combine several.

Strategies are often used to engineer a particular risk profile to movements in the underlying security. For example, buying a butterfly spread (long one X1 call, short two X2 calls, and long one X3 call) allows a trader to profit if the stock price on the expiration date is near the middle exercise price, X2, and does not expose the trader to a large loss.

An is a strategy that is similar to a butterfly spread, but with different strikes for the short options - offering a larger likelihood of profit but with a lower net credit compared to the butterfly spread.

Selling a straddle (selling both a put and a call at the same exercise price) would give a trader a greater profit than a butterfly if the final stock price is near the exercise price, but might result in a large loss.

Similar to the straddle is the which is also constructed by a call and a put, but whose strikes are different, reducing the net debit of the trade, but also reducing the likelihood of profit in the trade.

One well-known strategy is the covered call, in which a trader buys a stock (or holds a previously-purchased long stock position), and sells a call. If the stock price rises above the exercise price, the call will be exercised and the trader will get a fixed profit. If the stock price falls, the trader will lose money on his stock position, but this will be partially offset by the premium received from selling the call. Overall, the payoffs match the payoffs from selling a put.

Vanilla Vs. Exotic Options

A "Vanilla Option" is an informal term used to refer a standard Option on any financial instrument.[16] The "vanilla" or "plain vanilla" term is attached infront of a Option to indicate that it is a simple and standard Option with terms like Strike price and Expiry, and has no complex structure. As Options may get very complex with custom features, this term helps distinguish simple option from a complex option. On the contrary, complex option is referred to as "". You can use "Exotic" term to refer to OTC Options. Otherwise there are no clear rules defined to distinguish these two. 2. Explain he mechanism of interest rate swaps and rises inherent therein

(i) An interest rate is a contractual agreement entered into between two counterparties under which each agrees to make periodic payment to the other for an agreed period of time based upon a notional amount of principal. The principal amount is notional because there is no need to exchange actual amounts of principal in a single currency transaction: there is no foreign exchange component to be taken account of. Equally, however, a notional amount of principal is required in order to compute the actual cash amounts that will be periodically exchanged.

Under the commonest form of , a series of payments calculated by applying a fixed rate of interest to a notional principal amount is exchanged for a stream of payments similarly calculated but using a floating rate of interest. This is a fixed-for-floating interest rate swap. Alternatively, both series of cashflows to be exchanged could be calculated using floating rates of interest but floating rates that are based upon different underlying indices. Examples might be Libor and commercial paper or Treasury bills and Libor and this form of interest rate swap is known as a basis or money market swap.

(ii) Pricing Interest Rate Swaps

If we consider the generic fixed-to-floating interest rate swap, the most obvious difficulty to be overcome in pricing such a swap would seem to be the fact that the future stream of floating rate payments to be made by one counterparty is unknown at the time the swap is being priced. This must be literally true: no one can know with absolute certainty what the 6 month US dollar Libor rate will be in 12 months time or 18 months time. However, if the capital markets do not possess an infallible crystal ball in which the precise trend of future interest rates can be observed, the markets do possess a considerable body of information about the relationship between interest rates and future periods of time.

In many countries, for example, there is a deep and liquid market in interest bearing securities issued by the government. These securities pay interest on a periodic basis, they are issued with a wide range of maturities, principal is repaid only at maturity and at any given point in time the market values these securities to yield whatever rate of interest is necessary to make the securities trade at their par value.

It is possible, therefore, to plot a graph of the yields of such securities having regard to their varying maturities. This graph is known generally as a yield curve -- i.e.: the relationship between future interest rates and time -- and a graph showing the yield of securities displaying the same characteristics as government securities is known as the par coupon yield curve. The classic example of a par coupon yield curve is the US Treasury yield curve. A different kind of security to a government security or similar interest bearing note is the zero-coupon bond. The zero-coupon bond does not pay interest at periodic intervals. Instead it is issued at a discount from its par or face value but is redeemed at par, the accumulated discount which is then repaid representing compounded or "rolled-up" interest. A graph of the internal rate of return (IRR) of zero-coupon bonds over a range of maturities is known as the zero-coupon yield curve.

Finally, at any time the market is prepared to quote an investor forward interest rates. If, for example, an investor wishes to place a sum of money on deposit for six months and then reinvest that deposit once it has matured for a further six months, then the market will quote today a rate at which the investor can re-invest his deposit in six months time. This is not an exercise in "crystal ball gazing" by the market. On the contrary, the six month forward deposit rate is a mathematically derived rate which reflects an arbitrage relationship between current (or spot) interest rates and forward interest rates. In other words, the six month forward interest rate will always be the precise rate of interest which eliminates any arbitrage profit. The forward interest rate will leave the investor indifferent as to whether he invests for six months and then re- invests for a further six months at the six month forward interest rate or whether he invests for a twelve month period at today's twelve month deposit rate.

The graphical relationship of forward interest rates is known as the forward yield curve. One must conclude, therefore, that even if -- literally -- future interest rates cannot be known in advance, the market does possess a great deal of information concerning the yield generated by existing instruments over future periods of time and it does have the ability to calculate forward interest rates which will always be at such a level as to eliminate any arbitrage profit with spot interest rates. Future floating rates of interest can be calculated, therefore, using the forward yield curve but this in itself is not sufficient to let us calculate the fixed rate payments due under the swap. A further piece of the puzzle is missing and this relates to the fact that the net present value of the aggregate set of cashflows due under any swap is -- at inception -- zero. The truth of this statement will become clear if we reflect on the fact that the net present value of any fixed rate or floating rate loan must be zero when that loan is granted, provided, of course, that the loan has been priced according to prevailing market terms. This must be true, since otherwise it would be possible to make money simply by borrowing money, a nonsensical result However, we have already seen that a fixed to floating interest rate swap is no more than the combination of a fixed rate loan and a floating rate loan without the initial borrowing and subsequent repayment of a principal amount. The net present value of both the fixed rate stream of payments and the floating rate stream of payments in a fixed to floating interest rate swap is zero, therefore, and the net present value of the complete swap must be zero, since it involves the exchange of one zero net present value stream of payments for a second net present value stream of payments.

The pricing picture is now complete. Since the floating rate payments due under the swap can be calculated as explained above, the fixed rate payments will be of such an amount that when they are deducted from the floating rate payments and the net cash flow for each period is discounted at the appropriate rate given by the zero coupon yield curve, the net present value of the swap will be zero. It might also be noted that the actual fixed rate produced by the above calculation represents the par coupon rate payable for that maturity if the stream of fixed rate payments due under the swap are viewed as being a hypothetical fixed rate security. This could be proved by using standard fixed rate bond valuation techniques. (iii) Financial Benefits Created By Swap Transactions

Consider the following statements:

(a) A company with the highest credit rating, AAA, will pay less to raise funds under identical terms and conditions than a less creditworthy company with a lower rating, say BBB. The incremental borrowing premium paid by a BBB company, which it will be convenient to refer to as a "credit quality spread", is greater in relation to fixed interest rate borrowings than it is for floating rate borrowings and this spread increases with maturity.

(b) The counterparty making fixed rate payments in a swap is predominantly the less creditworthy participant.

(c) Companies have been able to lower their nominal funding costs by using swaps in conjunction with credit quality spreads.

These statements are, I submit, fully consistent with the objective data provided by swap transactions and they help to explain the "too good to be true" feeling that is sometimes expressed regarding swaps. Can it really be true, outside of "Alice in Wonderland", that everyone can be a winner and that no one is a loser? If so, why does this happy state of affairs exist?

(a) The Theory of Comparative Advantage

When we begin to seek an answer to the questions raised above, the response we are most likely to meet from both market participants and commentators alike is that each of the counterparties in a swap has a "comparative advantage" in a particular and different credit market and that an advantage in one market is used to obtain an equivalent advantage in a different market to which access was otherwise denied. The AAA company therefore raises funds in the floating rate market where it has an advantage, an advantage which is also possessed by company BBB in the fixed rate market.

The mechanism of an interest rate swap allows each company to exploit their privileged access to one market in order to produce interest rate savings in a different market. This argument is an attractive one because of its relative simplicity and because it is fully consistent with data provided by the swap market itself. However, as Clifford Smith, Charles Smithson and Sykes Wilford point out in their book MANAGING FINANCIAL RISK, it ignores the fact that the concept of comparative advantage is used in international trade theory, the discipline from which it is derived, to explain why a natural or other immobile benefit is a stimulus to international trade flows. As the authors point out: The United States has a comparative advantage in wheat because the United States has wheat producing acreage not available in Japan. If land could be moved -- if land in Kansas could be relocated outside Tokyo -- the comparative advantage would disappear. The international capital markets are, however, fully mobile. In the absence of barriers to capital flows, arbitrage will eliminate any comparative advantage that exists within such markets and this rationale for the creation of the swap transactions would be eliminated over time leading to the disappearance of the swap as a financial instrument. This conclusion clearly conflicts with the continued and expanding existence of the swap market.

It would seem, therefore, that even if the theory of comparative advantage does retain some force -- not withstanding the effect of arbitrage -- which it almost certainly does, it cannot constitute the sole explanation for the value created by swap transactions. The source of that value may lie in part in at least two other areas.

(b) Information Asymmetries

The much- vaunted economic efficiency of the capital markets may nevertheless co- exist with certain information asymmetries. Four authors from a major US money centre bank have argued that a company will -- and should -- choose to issue short term floating rate debt and swap this debt into fixed rate funding as compared with its other financing options if:

(1) It had information -- not available to the market generally -- which would suggest that its own credit quality spread (the difference, you will recall, between the cost of fixed and floating rate debt) would be lower in the future than the market expectation.

(2) It anticipates higher risk- free interest rates in the future than does the market and is more sensitive (i.e. averse) to such changes than the market generally.

In this situation a company is able to exploit its information asymmetry by issuing short term floating rate debt and to protect itself against future interest rate risk by swapping such floating rate debt into fixed rate debt.

(c) Fixed Rate Debt and Embedded Options

Fixed rate debt typically includes either a prepayment option or, in the case of publicly traded debt, a call provision. In substance this right is no more and no less than a put option on interest rates and a right which becomes more valuable the further interest rates fall. By way of contrast, swap agreements do not contain a prepayment option. The early termination of a swap contract will involve the payment, in some form or other, of the value of the remaining contract period to maturity.

Returning, therefore, to our initial question as to why an interest rate swap can produce apparent financial benefits for both counterparties the true explanation is, I would suggest, a more complicated one than can be provided by the concept of comparative advantage alone. Information asymmetries may well be a factor, together with the fact that the fixed rate payer in an interest rate swap -- reflecting the fact that he has no early termination right -- is not paying a premium for the implicit embedded within a fixed rate loan that does contain a pre- payment rights. This saving is divided between both counterparties to the swap.

(iv) Reversing or Terminating Interest Rate Swaps

The point has been made above that at inception the net present value of the aggregate cashflows that comprise an interest rate swap will be zero. As time passes, however, this will cease to be the case, the reason for this being that the shape of the yield curves used to price the swap initially will change over time. Assume, for example, that shortly after an interest rate swap has been completed there is an increase in forward interest rates: the forward yield curve steepens. Since the fixed rate payments due under the swap are, by definition, fixed, this change in the prevailing interest rate environment will affect future floating rate payments only: current market expectations are that the future floating rate payments due under the swap will be higher than those originally expected when the swap was priced. This benefit will accrue to the fixed rate payer under the swap and will represent a cost to the floating rate payer. If the new net cashflows due under the swap are computed and if these are discounted at the appropriate new zero coupon rate for each future period (i.e. reflecting the current zero coupon yield curve and not the original zero coupon yield curve), the positive net present value result reflects how the value of the swap to the fixed rate payer has risen from zero at inception. Correspondingly, it demonstrates how the value of the swap to the floating rate payer has declined from zero to a negative amount.

What we have done in the above example is mark the interest rate swap to market. If, having done this, the floating rate payer wishes to terminate the swap with the fixed rate payer's agreement, then the positive net present value figure we have calculated represents the termination payment that will have to be paid to the fixed rate payer. Alternatively, if the floating rate payer wishes to cancel the swap by entering into a reverse swap with a new counterparty for the remaining term of the original swap, the net present value figure represents the payment that the floating rate payer will have to make to the new counterparty in order for him to enter into a swap which precisely mirrors the terms and conditions of the original swap.

(v) Credit Risk Implicit in Interest Rate Swaps

To the extent that any interest rate swap involves mutual obligations to exchange cashflows, a degree of credit risk must be implicit in the swap. Note however, that because a swap is a notional principal contract, no credit risk arises in respect of an amount of principal advanced by a lender to a borrower which would be the case with a loan. Further, because the cashflows to be exchanged under an interest rate swap on each settlement date are typically "netted" (or offset) what is paid or received represents simply the difference between fixed and floating rates of interest. Contrast this again with a loan where what is due is an absolute amount of interest representing either a fixed or a floating rate of interest applied to the outstanding principal balance. The periodic cashflows under a swap will, by definition, be smaller therefore than the periodic cashflows due under a comparable loan.

An interest rate swap is in essence a series of forward contracts on interest rates.. In distinction to a , the periodic exchange of payment flows provided for under an interest rate swap does provide for a partial periodic settlement of the contract but it is important to appreciate that the net present value of the swap does not reduce to zero once a periodic exchange has taken place. This will not be the case because -- as discussed in the context of reversing or terminating interest rate swaps -- the shape of the yield curve used to price the swap initially will change over time giving the swap a positive net present value for either the fixed rate payer or the floating rate payer notwithstanding that a periodic exchange of payments is being made. (vi) Users and Uses of Interest Rate Swaps

Interest rate swaps are used by a wide range of commercial banks, investment banks, non-financial operating companies, insurance companies, mortgage companies, investment vehicles and trusts, government agencies and sovereign states for one or more of the following reasons:

1. To obtain lower cost funding

2. To hedge interest rate exposure

3. To obtain higher yielding investment assets

4. To create types of investment asset not otherwise obtainable

5. To implement overall asset or liability management strategies

6. To take speculative positions in relation to future movements in interest rates.

The advantages of interest rate swaps include the following:

1. A floating-to-fixed swap increases the certainty of an issuer's future obligations.

2. Swapping from fixed-to-floating rate may save the issuer money if interest rates decline.

3. Swapping allows issuers to revise their debt profile to take advantage of current or expected future market conditions.

4. Interest rate swaps are a financial tool that potentially can help issuers lower the amount of debt service.

Typical transactions would certainly include the following, although the range of possible permutations is almost endless.

(a) Reduce Funding Costs. A US industrial corporation with a single A credit rating wants to raise US$100 million of seven year fixed rate debt that would be callable at par after three years. In order to reduce its funding cost it actually issues six month commercial paper and simultaneously enters into a seven year, nonamortising swap under which it receives a six month floating rate of interest (Libor Flat) and pays a series of fixed semi- annual swap payments. The cost saving is 110 basis points.

(b) Liability Management. A company actually issues seven year fixed rate debt which is callable after three years and which carries a coupon of 7%. It enters into a fixed- to- floating interest rate swap for three years only under the terms of which it pays a floating rate of Libor + 185 bps and receives a fixed rate of 7%. At the end of three years the company has the flexibility of calling its fixed rate loan -- in which case it will have actually borrowed on a synthetic floating rate basis for three years -- or it can keep its loan obligation outstanding and pay a 7% fixed rate for a further four years. As a further variation, the company's fixed- to- floating interest rate swap could be an "arrears reset swap" in which -- unlike a conventional swap -- the swap rate is set at the end and not at the beginning of each period. This effectively extends the company's exposure to Libor by one additional interest period which will improve the economics of the transaction.

(c) Speculative Position. The same company described in (b) above may be willing to take a position on short term interest rates and lower its cost of borrowing even further (provided that its judgment as to the level of future interest rates is correct). The company enters into a three year "yield curve arbitrage swap" in which the floating rate payments it makes under the swap are calculated by reference to a formula. For each basis point that Libor rises, the company's floating rate swap payments rise by two basis points. The company's spread over Libor, however, falls from 185 bps to 144 bps. In exchange, therefore, for significantly increasing its exposure to short term rates, the company can generate powerful savings.

(d) Hedging Interest Rate Exposure. A financial institution providing fixed rate mortgages is exposed in a period of falling interest rates if homeowners choose to pre- pay their mortgages and re- finance at a lower rate. It protects against this risk by entering into an "index-amortising rate swap" with, for example, a US regional bank. Under the terms of this swap the US regional bank will receive fixed rate payments of 100 bps to as much as 150 bps above the fixed rate payable under a straightforward interest rate swap. In exchange, the bank accepts that the notional principal amount of the swap will amortize as rates fall and that the faster rates fall, the faster the notional principal will be amortized.

A less aggressive version of the same structure is the "indexed principal swap". Here the notional principal amount continually amortizes in line with a mortgage pre- payment index such as PSA but the amortization rate increases when interest rates fall and the rate decreases when interest rates rise.

(e) Creation of New Investment Assets. A UK corporate treasurer whose company has substantial business in Spain feels that the current short term yield curves for sterling and the peseta which show absolute interest rates converging in the two countries is exaggerated. Consequently he takes cash currently invested in the short term sterling money markets and invests this cash in a "differential swap". A differential swap is a swap under which the UK company will pay a floating rate of interest in sterling (6 mth. Libor) and receive, also in sterling, a stream of floating rate payments reflecting Spanish interest rates plus or minus a spread. The flows might be: UK corporation pays six month sterling Libor flat and receives six month Peseta Mibor less 210 bps paid in sterling. Assuming a two year transaction and assuming sterling interest rates remained at their initial level of 5.25%, peseta Mibor would have to fall by 80 bps every six months in order for the treasurer to earn a lower return on his investment than would have been received from a conventional sterling money market deposit.

(f) Asset Management. A German based fund manager has a view that the sterling yield curve will steepen (i.e. rates will increase) in the range two to five years during the next three years he enters into a "yield curve swap "with a German bank whereby the fund manager pays semi- annual fixed rate payments in DM based on the two year sterling swap rate plus 50 bps. Every six months the rate is re- set to reflect the new two year sterling swap rate. He receives six monthly fixed rate payments calculated by reference to the five year sterling swap rate and re- priced every six months. The fund manager will profit if the yield curve steepens more than 50 bps between two and five years.