Sujeeb Money Market Level 3

Contents
Time
Before you start Money Markets What’s next? Contents
▼
▼
$ $ Instruments
Place Pace
Page i Page 153
▼ ▼
Coupon bearing instruments Discount instruments
Instrument Code page Instrument Code page
Money Market Deposits DEP 1 Treasury Bill (T-Bill) TBL 29

Certificate of Deposit (CD) CD 13 Bills of Exchange/Banker’s Acceptance (BA) BA 39
Repurchase Agreement (Repo) REP 23 Commercial Paper (CP) CP 47
▼
Derivatives
Instrument Code page
Forward Rate Agreement (FRA) FRA 55

Interest Rate futures FUT 71
Interest Rate Swap (IRS) IRS 93
Options on Interest Rate futures OPT 115
Options on FRAs – Interest Rate Guarantee (IRGs) IRG 133
Options on IRSs – Swaptions SWP 147
i
Contents
■ Money Markets and Foreign Exchange Instruments

Contents
Instruments Level 3 code Derivatives Level 3 code
Money Markets Money Markets
Money Market Deposits MMI:DEP Forward Rate Agreement (FRA) MMI:FRA
Certificate of Deposit (CD) MMI:CD Interest Rate futures MMI:FUT
Repurchase Agreement (Repo) MMI:REP Interest Rate Swap (IRS) MMI:IRS
Treasury Bill (T-Bill) MMI:TBL Options on Interest Rate futures MMI:OPT
Bill of Exchange/Banker’s Acceptance (BA) MMI:BA Options on FRAs – Interest Rate Guarantee (IRGs) MMI:IRG
Commercial Paper (CP) MMI:CP Options on IRS – Swaptions MMI:SWP
Foreign Exchange (FX) Foreign Exchange (FX)
Spot transactions – Currencies versus USD FXI:SPT Synthetic Agreements for Foreign Exchange (SAFEs) FXI:SAF
Spot transactions – Cross rates FXI:CRS Currency futures FXI:FUT
Forward outright transactions FXI:OUT Currency swap FXI:CSP
FX Swaps FXI:SWP Currency options – on Cash and on Futures FXI:OPT
ii
Before you start
Time
■ Who is this workbook for? The learning materials for each area of information answer a series of Place Pace
basic questions outlined below:

The learning materials for the Know your Markets open Before you start
learning package integrate both traditional workbooks with What do I need to know
materials on the Reuters internal Web site. about my market so I
can do my job?
The package has a modular structure and is split into three
levels and four market sectors.
Market Product
▼
information information
This Level 3 workbook is primarily aimed at sales, client
training and customer sales staff who need an in-depth
understanding of markets and related Reuters products.
This greater understanding will enable them to discuss • What instruments • How are the
their customers’ problems and needs in the context of the are used? instruments used
markets in which they operate. in practice?
• Who uses the
Both the workbook and Web Level 3 learning materials have been instruments? • How is the
designed to answer questions concerning the latter two of the three Reuters product
fundamental areas of information that the Know your Markets package • How do the used?
is intended to address: instruments work
– calculations? • Who are the
❑ Customer information competition?
❑ Market information
Across the market sectors there are also areas of common
information required. For the Know your Markets package these have
❑ Product information
been divided into three workbooks.
❑ Institutions and Regulation

❑ Introduction to Derivatives
❑ Competition
There are also underlying techniques used in the financial markets,
for example, Technical Analysis, which you may also need to know
something about. You may find the open learning workbook Technical
Analysis: An Introduction useful for the Reuters 3000 products.
iii
Before you start
Time
Place Pace
This workbook is designed to fit into the following series for the To access the Web site use the address below for the Markets Matrix
Money Markets and Foreign Exchange. page.
Before you start
Level 2 workbooks http://www.trn.uki.ime.reuters.com/markets_matrix

Customer information
Money M From here you can select the Market or Product information for the
arkets
& Foreig particular market sector you want by making the appropriate screen
n selection.
Exchang
e
Cross market information
Insitutio Competi Introduc

ns & tion tion to
Regulati Derivativ
on es
Product information – What do you need to know?
❑ What information is needed?
❑ How to get information
❑ Catalogue of information
Level 3 workbooks
Market and Product ➪ Links to Customer profiles/Customer scenarios on
information Money M Foreign Web or Study Guides
arkets Exchang
Instrume e ➪ Links to instruments on Web or Study Guides
nts Instrume
nts
Market information – What instruments are used?

❑ Level 2
• What it is
The Web site accompanying the workbooks provides you with a set of
• Who uses it
quick reference performance materials which may help you if you
❑ Level 3
need a quick reminder of any of the three areas of information –
• Calculations/charts etc
Customer, Market or Product. The Web site materials contains some
• Reuters products
additional multi-media learning materials such as interviews with and • Endcheck
photographs of market players. These materials are cross-referenced • Customer scenarios
to the workbooks which you should use for more in-depth study.
➪ Links to instruments on Web or Study Guides
➪ Links to Reuters products
iv
Before you start
Time
It is worth noting that although each Level 2 workbook has a section ■ What does this workbook contain? Place Pace
on the instruments traded in the particular market, this is a very brief

overview and contains the minimum of information. The first two All the workbooks at Level 3 have the same areas of information and Before you start
sections of this Level 3 workbook are suitable for Level 2 use if all that answer the same basic questions. Each area has an icon to identify it
is required is information concerning the following: which is found in the title to the section. The icons and sections are
as follows:
❑ What is the instrument?
What is the instrument?
❑ Who uses the instrument? This always has a definition of the instrument and a
description of what the instrument is used for.
The later sections of the Level 3 workbook deal with calculations and
more complex details about the instrument.
Who uses the instrument?
This describes the market players and their trading
techniques.
The instrument in the market place

7 8 9
This deals with any formulas, calculations and examples
4 5
1 2
6
3
of the way the instrument is used in the markets.
0
Using Reuters products

This deals with the relevant Reuters 3000 and RT pages,
their contents and how they are used in the markets.
The section may also refer to customer scenarios which
may be relevant.
Endcheck
This section provides an opportunity for you to test your
understanding of the formulas, calculations and
products used.
v
Before you start
Time
Place Pace
Throughout the modules you will find that important terms or ■ How to use this package
concepts are shown in bold, for example, Yield. You will also find that
Before you start at certain points learning activities are included which are designed Before you start using the package you should discuss
to enhance your learning. The various activities use the following with your line manager how he/she will help by giving
icons: time for study and giving you feedback and support.
This means stop and think about the point being made. Although your learning style is unique to you, you will
You may want to jot a few words in the box provided – it find that your learning is much more effective if you
doesn’t matter if you don’t. allocate reasonable sized periods of time for study. The
most effective learning period is about 30 minutes – so
use this as a basis. If you try to fit your learning into odd
This indicates an activity for you to do. It is usually moments in a busy schedule you will not get the best
something written – for example, a calculation. from the materials or yourself. You might like to schedule
learning periods into your day just as you would business
This indicates a reference to an instrument in this or meetings.
MMI:CD another Level 3 workbook. A complete list of the
instruments and their codes is given in the Contents. A Being a successful open learner means more than just reading. Open
cross reference to an instrument will appear like this, learning is interactive – it is designed to enhance your learning by
for example, Certificate of Deposit. getting you to be active. There is an old Chinese saying which may
help:
This indicates that you should use the appropriate
3000 I hear and I forget
Reuters 3000 product or Reuters Terminal (RT) and
I see and I remember
follow the instructions. A screen dump of what you
I do and I understand
should see is usually included as well. It is important to
understand that the activities here assume you have a
RT basic knowledge of the Reuters product software. If The various types of activities and their icons have already been
you do not have this knowledge you may need to start mentioned – even thinking is an activity.
with this first!
Try to make sure your study is uninterrupted. This probably means
that your workplace is not a good environment! You will need to find
This indicates an important item of information worth both the time and place where you can study – you may have access to
i remembering. a quiet room at work, you may have a room at home, you may need to
use a library.
It’s important to remember that learning is not a race – everyone

learns at their own rate. Some people find things easy, some not quite
so easy. So don’t rush your learning – make sure you get the most
from the package. You should now have enough information to plan
the use of your workbook and the Web materials – remember it’s your
learning so it’s over to you...
vi
Before you start
Time
Place Pace
■ Coupon bearing instruments Before you start
Money Market Deposits 1
Certificate of Deposit (CD) 13
Repurchase Agreement (Repo) 23
■ Discount instruments 29
Treasury Bill (T-Bill) 39
Bills of Exchange/Banker’s Acceptance (BA) 47

Commercial Paper (CP)
■ Derivatives
Forward Rate Agreement (FRA) 55
Interest rate futures 71
Interest Rate Swap (IRS) 93
Options on Interest rate futures 114
Options on FRAs – Interest Rate 133
Guarantees (IRGs)
Options on IRSs – Swaptions 147
vii
Before you start
Time
Place Pace
You may find the following chart useful for planning your learning
and to decide the order in which you would like to study the
Before you start instruments
Instruments Level 3 code Start date Completion date Comments
Coupon bearing instruments
Money Market Deposits MMI:DEP
Certificate of Deposit (CD) MMI:CD
Repurchase Agreement (Repo) MMI:REP
Discount instruments
Treasury Bill (T-Bill) MMI:TBL
Bill of Exchange/Banker’s Acceptance (BA) MMI:BA
Commercial Paper (CP) MMI:CP
Derivatives
Forward Rate Agreement (FRA) MMI:FRA
Interest Rate futures MMI:FUT
Interest Rate Swap (IRS) MMI:IRS
Options on Interest Rate futures MMI:OPT
Options on FRAs – Interest Rate Guarantee (IRGs) MMI:IRG
Options on IRS – Swaptions MMI:SWP
viii
Money Market Deposits
■ What is it? Before you have a look at the deposit market in more detail you need $ $
to understand some of the terms used for trades in the market place
A Money Market Deposit is an unsecured, fixed rate – some of these have already been introduced. Coupon bearing
investment or loan between financial institutions.
If you are a borrower of funds, you refer to the trade as a taking. The
counterparty to the same trade refers to the deal as a placement.
Within the Money Markets the deposit market is often referred to as The borrower, or taker of the funds pays interest based upon:
the Interbank deposit market. This is because the market operates
essentially between banks. Deposits are fixed-term, non-negotiable ❑ An agreed interest rate
investments or loans which yield interest. The interest rates paid are
used as a basis for other Money Market and FX instruments ❑ A defined amount of loan – the principal
including:
❑ A specified period of the loan – the maturity or tenor
❑ Establishing the price of coupon bearing instruments such
as CDs and Repos, and the price of discount instruments ❑ An end date or maturity date on which the taker pays back
such as CPs and T-Bills the principal and any interest due
❑ Pricing derivative instruments such as FRAs and short A transaction is agreed on its trade date but the start date of the trade
Interest rate futures for the purpose of calculating interest is known as the value or
delivery date. This is the date on which the placer delivers the
❑ Setting the rates on instruments which have a ‘floating’ principal to the taker. The value date is usually taken as spot which is
aspect such as Interest Rate Swaps and Floating Rate Notes usually two working days after the trade date. However, as is described
later, the value date may differ depending on the maturity of the
❑ Pricing Forward FX rates deposit.
Within the Interbank deposit market there are two basic types – fixed At the end date – the maturity date – of the loan the taker pays back
and notice: the principal, plus any owed interest. The lender, or placer of the
deposit, receives the principal and interest from the taker at maturity.
A fixed deposit is one where the rate of interest and the
maturity date are agreed at the time of the transaction. Takers and placers are often referred to as buyers and sellers
respectively, even though the monies are not actually bought or sold.
A notice or call deposit is one where the rate of interest You should note that deposits are generally non-negotiable. This
may be changed or the termination of the deposit means that the deal remains on the books until the maturity date,
requested with effect from a specified number of working even if one of the parties wishes to terminate or ‘break’ the deposit
days. A working day means that the Money Market prior to the maturity date.
financial centre involved with the trade must be open for
business.
1
$ $ Maturity dates Broken dates

The maturity or tenor of a loan is important because its duration is In this OTC market, irregular or broken dates will be quoted for
Coupon bearing used to calculate interest payments. There are three common maturities which do not quite match the short or fixed dates
maturities you will encounter: described previously. The rates for broken dates are calculated by
interpolating between the rates for two known dates. For example, a
Short dates 4-month deposit rate can be calculated by interpolating between the
Maturities that are up to, but not including one month. The table 3- and 6-month rates.
below indicates the short date name and day count conventions:
You must be careful when using the term spot for the value date. In
Overnight O/N Deposit today – return tomorrow most cases for fixed dates spot is two working days but in GBP trades
in London, spot is value today.
Tomorrow/next T/N Deposit tomorrow – return next
business day The examples below illustrate the events for an overnight and 2-
month deposit.
Spot/next S/N Deposit on spot date (two days after
trade date) – return day after
Borrower
Spot/week S/W Deposit on spot date – return 7 Overnight: Borrow Return
calendar days later Short date principal principal+
Interest
10th July 10th July 11th July
Trade date Today Next day
Fixed dates
Maturities that run from one to twelve months out of spot. Fixed
dates are often referred to as the periods. The most active periods are
indicated in the table below:
Fixed periods Months

Investor
Period or tenor 1 2 3 6 12
2 month: Deposit Receive
principal+
Fixed date principal
Interest
The value date for most Eurocurrency fixed date transactions is spot.
i Some domestic deposits tarde value date as today.
10th July
Trade date
12th July 12th Sept
Spot 2 Months
Money Markets maturities do not normally extend longer than one

year. Because of the credit risks recognised by trading institutions for
deals longer than one year in duration, these maturities are not very
liquid.
2
Components of a trade As in the FX Markets, the Deposit Markets have a bid side – taker, and $ $
The principal particulars of a deposit trade are: an offered side – placer. The table below compares some of the
terminology and components of FX and Deposit deals. Coupon bearing
Trade Date The date on which the trade takes place.
Value Date The start date of a deposit. On this date, the lender Term or component Spot FX contract MM Deposit contract
delivers the principal of the trade to the borrower.
Interest on the deposit begins to accrue on this date. No. of currencies 2 1
Maturity The end date of the deposit. On this date, the Value date Date on which the Date on which the
Date borrower repays the lender the principal of the currencies are placer delivers the
trade, plus all interest due. The last day for interest exchanged principal to the
accrual on a deposit is the day before the maturity taker. This is the start
date. date of the deposit
Rate The agreed upon interest rate expressed as a Maturity date Not applicable Date on which the
percentage on a per annum basis. This may also be taker repays the
called a yield. principal plus
interest to the placer.
Basis The number of days in a year used to calculate This is the end of the
interest. Most of the world uses a 360 day basis, deposit
meaning that a year is said to contain 360 days.
Countries such as Canada, Ireland, Singapore, Hong Price/rate The agreed upon The agreed upon
Kong, Belgium and the U.K. use a 365 day basis. rate expressed as an rate expressed as a
amount of the quote percentage per
Currency The currency of the deposit. currency per single annum
unit of the base
Amount The amount of the deposit. currency
Taking bank The bank that borrows the money. The deposit is Bid means Expression of an Expression of an
recorded as a liability on this bank’s books. intent to buy the intent to borrow the
base currency specified currency
Placing bank The bank that lends the money. The deposit is
recorded as an asset on this bank’s books. Offer means Expression of an Expression of an
intent to sell the intent to lend the
Payment Precise instructions advising each bank as to the base currency specified currency
Instructions appropriate details for the delivery of principal on
the value date to the taking bank, and subsequent Hit the bid means To sell the base To lend the specified
repayment of principal plus interest to the placing currency at the bid currency at the bid
bank on the maturity date. price price
Method/via The method used to transact the trade. (Direct, via a Take the offer means To buy the base To borrow the
broker, etc.) currency at the specified currency
offered price at the offered price
Confirmation Printed verification of all the terms of the trade.
Each counterparty sends the other a confirmation.
3
$ $ How are interest rates expressed?

There are two ways you will see interest rates expressed: The bid/offer rates from this
Coupon bearing bank are quoted in decimals
❑ Fractions. Until the early 1990s, interest rates were
expressed as a combination of a whole number, when
applicable, and a fraction. Fractions are quoted as a
denominator divisible by two or four producing halves,
quarters, eighths, sixteenths, thirty-seconds and, rarely,
sixty-fourths. Quotes between market-makers generally
have a spread of 1/8 % or 1/4 % , for example 6 – 6 1/8 % .
❑ Decimals. Now it is much more common to see decimals

used which allows for narrower spreads. A movement of
1/100 of a percent is referred to as a basis point (BP) so
from 6.03% to 6.04% represents a move of 1 BP. A typical
market-maker quote in decimal form usually has a 10 BP
spread, for example 6.00 - 6.10%.
Before moving on use the RT to have a look at some rates... These are
the maturities
The bid/offer rates from this bank
To see the rates from a typical bank type in BPNC are quoted in fractions
RT and BADD and press Enter after each entry.
These are Note: London quotes offer/bid style

the maturities Offer = 53/4% , Bid = 51/2% .
4
Offered and Bid rates ■ Who uses Money Market Deposits? $ $

The only official benchmark that exists for interest rates is that
provided by a Central Bank for overnight funding. The rates for the Borrowers/Lenders Coupon bearing
other maturities are generated by the market. However, nearly every In the Interbank Deposit markets banks borrow and lend
institution has a slightly different opinion of what the rate is for a in response to their customers’ requirements. The banks
given maturity. To cope with this situation the market needs a also accept and relend deposits on their own account in
mechanism that provides a semi-official benchmark rate for the fixed order to profit from movements in interest rates. If a Money Market
date maturities. transaction involves different currencies on the two sides of the trade,
then the transaction has a FX aspect and gives rise to a deposit swap.
LIBOR London Interbank Offered Rate. This is the rate a bank
offers or charges for lending money. A long position means you have bought a currency.
i A short position means you have sold a currency.
LIBID London Interbank Bid Rate. This is the rate the bank
bids for money or pays for deposited funds.
Banks trading on their own account will also be seeking to maximise
LIMEAN This is the average of the LIBOR and LIBID rates which profits from interest arbitrage. This means the banks are constantly
you may sometimes see used looking for the greatest spread between the rates for accepting and
relending deposits.
The banks in London use a system that has been imitated by other
Brokers
financial centres. Each day, at around 11:00 am London time, a
Brokers are active in the Money Markets where they act as
survey of up to 16 British Banking Association (BBA) selected banks
intermediaries between counterparties – they try to match a
is undertaken for their fixed rate maturity lending (offer) rates to
borrower with a lender. Brokers do not take positions on their own
each other for the major Eurocurrencies. A single rate is established
account but receive fees for arranging transactions.
per currency and maturity which is known as a BBA LIBOR or
LIBOR fixing. These LIBOR fixings are used for setting rates on
The following criteria must be satisfied before a trade can be
loans, FRNs and interest rate derivatives. It is important to note the
completed:
following about LIBOR information:
❑ The two parties must have opposite interests – one must
❑ The term LIBOR is always qualified with a currency and a
be a lender, the other a borrower.
maturity, for example, 3-month Deutschemark LIBOR
❑ LIBOR is a reference rate and a t best can be used to fix rates
❑ They must agree on currency, rate, tenor (which must
for negotiated deals
have the same start and maturity dates for the deposit),
❑ Contributing banks cannot be held to LIBOR prices
amount and that enough credit is available between them.
❑ LIBOR refers only to Eurocurrencies – not domestic markets
It is often the case that the amount is negotiated
downward to reflect the credit availability of one or both
Other countries have a similar fixing procedure to LIBOR, for
parties.
example PIBOR is the Paris Interbank Offered Rate and FIBOR is the
Frankfurt Interbank Offered Rate. However, London LIBOR is used
for most transactions in the Money Markets.
5
$ $ ■ Money Market Deposits in the market place Example 1

The interest due on a three month deposit of 10,000,000 USD at
Coupon bearing Interest (I) is calculated by taking into account the Principal 6 1/2 % that has a tenor of 92 days would be calculated as follows:
7 8 9 amount of the deposit (P), the agreed upon interest Rate (R)
4 5 6
expressed in its decimal form, the year Basis (B) of the 10,000,000 (P) x 6.5 (R) x 92(N)
1 2 3 Interest due (I) =
0
currency, either 360 or 365, and the Amount of days (N) that 360 (B) x 100
the deposit lasts. The formula looks like this:
= 166,111.11 USD
Principal (P) x Rate (R) x Amount of days (N) The Basis for USD is 360. The basis is seen as A/360 which means
Interest due (I) =
Basis (B) x 100 the actual number of days (92) over a 360-day year. Actual days
...Equation 1 include weekends and holidays.
It is important to recognise that the interest paid at the maturity of
Interest on deposits maturing within 12 months is paid at maturity
the deposit is simple interest. Compound interest is interest paid on
only.
accumulated interest which you may encounter in the capital
Coupon bearing instruments have two values: markets.
❑ Present Value (PV) – the fair market value today Suppose now that the deposit had been 10,000,000 GBP. Using the
same tenor and rate the interest due is now:
❑ Future Value (FV) – the total repayment value, including 10,000,000 (P) x 6.5(R) x 92(N)
interest, on maturity Interest due (I) =
365 (B) x 100
Future Value = Principal + Interest due ...Equation 2

= 163,835.62 GBP
( )
= P+ P x R x N
B x 100
The Basis for GBP is 365, seen as A/365. Note the difference in
interest amounts due to the different day bases.
Year day basis conventions Except GBP, CAD, BEF, ECU where:
Future Value
[ ( )]
= P x 1 +
R x N
B x 100
...Equation 3 i
Domestic 360 Domestic
Euro
365
365
Euro 360
Depending on the calculations you need to perform concerning

interest, Present Values and Future Values, a knowledge and
understanding of Equations 1 – 3 will be useful.
6
The difference in Basis can be important if you are comparing the ■ Summary $ $
Money Market Yields, MMY – interest paid – between different
instruments. To compare rates between instruments you have to Coupon bearing
compare like with like. To do this you need to calculate the true
annual yield for both deposits.
Example 2 ❑ Fixed term, non-negotiable

You wish to compare a GBP deposit which uses Actual/365 (A/365) to
calculate interest with a Eurodeposit which uses Actual/360 (A/360) ❑ Domestic and Euro Markets
for interest calculations. To compare like with like you need to add
interest for 5 more days for the Eurodeposit. To do this simply ❑ Maturities or tenors one day to 12 months
multiply the Rate by 365/360.
• Short dates – up to one month
For example, a Euromark deposit for DEM 100 million has a quoted • Fixed dates – 1, 2, 3, 6, and 12 months from spot
rate of 10%. What is the true annual yield for this deposit on a 365 • Broken dates – dates not matching short or fixed dates
day year basis?
❑ Interbank rates
True annual yield = 10 x 365
360 • Bid/Offer
• Offer/Bid – London
= 10.14%
❑ Interest rate quoted as a % per annum
Similarly if you need to compare an A/360 quoted instrument with
one using A/365, the Rate will need to be multiplied by 360/365 –
❑ Simple interest calculations
the interest is less because only 360 days are used to calculate the true
annual yield.
• A/360
• A/365
This means that you must be careful when comparing the data for
instruments onscreen! ❑ LIBOR
7
$ $ ■ Using Reuters products
Coupon bearing The following exercises using Reuters products and the
RT may help your understanding of Money Market
Deposits and how they are used.
RT Type in MONEY and press Enter to display the

Speed Guide. From this page double-click in
<DEPO/1> to display the DEPOSITS Speed Guide.
From here double-click in any currency you require
rates for. You may also find it useful to display LIBOR rates for
Eurocurrencies by typing in ISDA and pressing Enter – for
Eurodollar LIBOR rates from different banks type in LIBO and
press Enter.
8
$ $
3000 Exercise 1. Using the MMMW page in Money 3000 3000 You can also use the MMMW page to calculate Coupon bearing
can be useful as you can display Bid and Ask prices broken dates for deposits. But before you look at
for a number of currencies from different the page try the following:
contributors simultaneously. For example you want
to lend £5 million for 3 months and at the same time you need to
borrow 2 million DEM. You use MMMW to display GBP Bid rates
and DEM Ask rates from different contributors to select who you To calculate broken dates carry out the following:
want to trade with. Assume 3 months is 90 days in both cases.
1. Select maturity rates for either side of the broken date.
2. Calculate the rate change for each day between the maturities
selected.
3. Multiply the result from 2) by the number of days for the broken
date.
4. Add the result from 3) to the rate for the near deposit and this is
the broken date rate.
Exercise 2
It is 30th June 1997 and you need the GBP rate for a broken date of
15th August 1997 using TTKL Bid prices opposite. Value is 2nd July.
The 1 month deposit maturity date is 4th August and the maturity
1) Which GBP contributor would you deposit funds with for the best
date for 2 months is 2nd September. There are 29 days from 4th
rate of return and what interest would you expect to receive?
August until 2nd September, and 11 days to the broken date.
Answer:
Calculate the broken date rate for the bid.
Answer:
2) Which DEM contributor would you borrow funds from and what
interest would you pay?
Answer:
Before you check your answers on page 12, why not complete the following End
check?
9
$ $ ■ End check 5. You are the Treasurer of a large corporation in London and at
times you need to deposit and borrow dollars. There are four
Coupon bearing banks you could deal with quoting the following Eurodollar rates
1. Which of the following Money Market instruments is not for one month (31 days) on a 360-day year basis.
negotiable?
Bank A Bank B Bank C Bank D
❑ a) Cash deposit
6 /16 – 69/16
11
63/4 – 65/8 67/8 – 611/16 613/16 – 63/4
❑ b) Certificate of Deposit
❑ c) Eligible Bill a) From which bank would you borrow Eurodollars and at what
❑ d) Commercial Paper rate?
b) From your answer in a), if you borrowed $5 million what is the
2. Which of the following Eurocurrency deposits is quoted on the total amount payable at maturity?
basis of Actual/365 days? c) With which bank would you deposit funds and at what rate?
❑ a) Euromarks Answer a)
❑ b) Euroyen
❑ c) Eurosterling
❑ d) Eurodollars
3. What is the true annual yield of a 12 month Euromark deposit

quoted at 3.00%?
❑ a) 3.00% Answer b)
❑ b) 3.02%
❑ c) 3.04%
❑ d) 3.05%
4. A market-maker quotes a 6-month (180 days) Eurodollar rate of

53/4 – 515/32% . A market-taker takes $20 millions at 515/32% . Calculate
the interest due for the deposit.
Answer c)
Answer:
You can now check your answers on page 12.
10
Your notes $ $
Coupon bearing
11
$ $ Answers to exercises End check answers to questions
Coupon bearing Exercise 1 ✔ or ✖

1) The highest Bid rate is from TTKL at 6.84 %. The interest for 1. a) ❑
90 days is £84328.70.
2. c) ❑
Use Equation 1.
Interest = 5,000,000 x 90 x 6.84 3. c) ❑
365 100
4. $546,875.00 ❑
2) The lowest Ask rate is from TRDL at 3.10%. The interest due
for 90 days is 15500 DEM. Use Equation 1.
Interest = 20,000,000 x 180 x 5.46875
Use Equation 1.
360 100
Interest = 2,000,000 x 90 x 3.10
360 100
Exercise 2 5. a) Bank A – This has lowest offer rate of 611/16% . ❑

1) 1 month rate is 6.5938%, 2 month rate is 6.7500%
2) Number of days between maturities is 29 days. b) $5,028,793.00 ❑
Rate change per day is 6.7500 – 6.5938/29 = 0.1562/29
3) Rate change for broken Use Equation 3.
date period is 11 x
0.1562/29 = 0.0592
4) Broken date rate is
Total amount= 5,000,000 x
[ (
1 + 6.6875 x 31
100 x 360 )]
therefore 6.5938 + = 5,000,000 x (1.0057586)
0.0592 = 6.6530
Using the Deposit

c) Bank D – This has the highest bid rate of 63/4% . ❑
Calculator things are much
simpler! Make sure you
enter the correct data in
the fields and Money 3000
performs the calculation
for you. Check your answer
How well did you score? You should have managed to get most of
here.
these questions correct.
12
Certificate of Deposit (CD)
■ What is it? US Domestic CDs $ $

In order to issue a CD in the US domestic market a bank must have a
A Certificate of Deposit is a negotiable receipt for funds good or acceptable credit rating in the market place. Most US bank Coupon bearing
deposited at a bank or other financial institution for a CDs are issued with maturities of 1 to 6 months, in $1 million units –
specified time period and at a specified interest rate. pieces – at face value. The majority of US domestic CDs are payable
at maturity in New York.
In other words it is an IOU with a fixed coupon. Most CDs issued by
banks are negotiable instruments and are bearer certificates which Many US banks issuing CDs also prefer to place the instruments
means that ownership belongs to whoever possesses the certificate. directly with their clients. This technique has two advantages:
What then is the difference between 1. The bank’s borrowing is less visible which influences their
an interbank deposit and a CD? The credit rating
Certificate of Deposit problem with a simple deposit is that
MegaBank
is for a fixed term and is non- 2. CDs issued through dealers may reappear in competition
$1,000,000 negotiable. By buying a negotiable to any new issue the bank may seek to launch
Maturity 3 months CD for a fixed period, if it becomes
Interest 6.75%
necessary to raise funds before the However, US banks do issue CDs on a commission basis through a
maturity date, then the buyer can sell number of Securities Houses who make a market in CDs. These
the CD in the secondary market. houses have distribution networks for the world-wide retail of new
issues.
The rate of interest paid on a CD depends on factors such as current
market conditions, the denomination of the CD and the standing of
the bank offering the instrument.
This section of
screen is
The depositor can retain the CD until maturity and receive the
taken from
guaranteed interest or if funds are required urgently the CD can be
Money 3000
sold in the money markets. The CD will be sold at the going market
page MMBW
price which reflects the current interest rates. CDs are issued at a
for USD
lower rate than LIBOR because they may not be held to maturity.
Domestic CDs
CDs were first issued in the US in 1961, in the Euromarkets in 1966
and in London in 1968.
USD denominated CDs issued by Foreign banks in the US are often called
i Yankee CDs
13
$ $ Euro CDs In addition to the fixed rate coupon CDs, there are also two
A Euro CD is a receipt for a Eurocurrency fixed term deposit typically variations which may be encountered:
Coupon bearing with a London-based bank. Euro CDs are mainly USD denominated
bearer instruments issued in $1 million units. It is common to see ❑ Discount CDs. In this case a CD offered at £1 million face
early and late prices quoted for CDs which reflects whether the CD value and a yield of 10% would be bought for, say, £900,000.
matures in the first or second half of the month respectively. On maturity the loan would be repaid at £1 million earning
£100,000 interest on an investment of £900,000. This
The main issuers of Euro CDs are branches of major US banks, represents a true yield of 11.11%.
British clearing banks, branches of major continental Europe banks
and Japanese banks. There is a secondary market in Euro CDs ❑ Floating Rate CDs. These are based on a benchmark –
although as much as 50% of current issues are lock-ups – the CDs are usually LIBOR and are similar in principal to Floating
bought and held to maturity, often in the safe custody of the issuing Rate Notes, FRNs, used in the debt markets. You may find
bank. it useful to compare these instruments with FRNs in the
Debt Markets section. Although not very common the two
types which may be encountered are 6-month instruments
with a 30-day roll and a 1-year paper with a 3-month roll.
The buyer of a Floating Rate CD has some protection
against rising interest rates but this is offset to some extent
This section of because this type of CD is less liquid than the normal fixed
screen is rate type.
taken from
Money 3000 On each roll date accrued interest is paid and a new coupon is set.
page MMBW i
for USD
Domestic
Euro CDs
14
■ Who uses CDs? Your notes $ $

Investors Coupon bearing
The advantage of CDs for investors is that the instruments
are negotiable in the secondary market should they wish
to raise cash quickly. However, this means that issuers of
CDs will pay some 10 - 15 basis points below comparable fixed deposit
rates for such negotiable instruments.
Corporate treasurers are large buyers of CDs but increasingly the

bulk of demand has come from specialist money market funds. These
funds are required to maintain short average maturity on their
portfolios which makes CDs attractive instruments.
Dealers and brokers

As well as buying and selling CDs to clients, dealers create a
secondary market by quoting bid and offer prices to other dealers.
The normal settlement date for CDs denominated in a foreign
currency is 2 business days. Domestic CDs settle the following day –
the same for domestic currency deposits.
InterDealer Brokers also operate in the secondary market providing

anonymous trading facilities between dealers. Typical brokerage is 1
basis point per annum on the amount traded which is paid by the
party initiating the trade.
Brokerage of 1 basis point per annum is sometimes called an 01.

i
Brokers typically quote price runs in the 3 to 6-month maturities.

However, these quoted prices are more varied than for instruments
such as government securities as the credit rating of banks issuing
CDs varies which affects the quoted prices.
15
$ $ ■ CDs in the market place Year day basis conventions Except GBP, CAD, BEF, ECU etc. where:
i
Coupon bearing Interest on short-term CDs is normally payable at maturity Domestic 360 Domestic 365
Euro 360 Euro 365
7 8 9 which in the US is termed a bullet security. For CDs issued
4 5 6
1 2 3 with maturities of 12 months and greater, interest is typically
0
paid semi-annually. The CD has an original maturity of 366 days – a leap year! The
interest due is simply calculated from the formula:
A bullet security is one where the principal of a loan is paid in whole on
i maturity
Principal (P) x Rate (R) x Amount of days (N)
On maturity the bearer of a CD will receive the instrument’s Interest due (I) =
Basis (B) x 100
principal plus the agreed interest which is due. But supposing the ...Equation 2
bearer requires cash for a project and decides to sell the CD. What is
a fair market value for the CD? What is its Present Value, (PV)? = 1,000,000 x 8.5 x 366
360 x 100
A dollar received in the future is worth less than a dollar today
because there is no opportunity to invest the dollar and earn interest.
The Future Value (FV) – the repayment amount – is the amount of = $86,416.67
money you would have if you invested a sum today, PV, for a period of
time at a given rate of interest. So the Future Value of the CD = $1,086,416.67
Future Value = Principal + Interest due ...Equation 1 You now decide that you must sell the CD for settlement on the 1st
November 1996 when there are only 61 days left to maturity.
The fair value, or settlement amount, of the CD should be that
amount of money (PV) which when placed on deposit today for the Suppose the current 2-month deposit rate is 9.75%. The fair value of
number of days left to maturity would result in the same FV if the CD the CD should be that amount of money, PV, which if placed on
were left to mature. So the return on the CD should equal the return deposit today at 9.75% for 61 days would also result in a FV of
currently available on a deposit for the same maturity. $1,086,416.67.
Example 1 Using Equations 1 and 2:

Consider the following CD:
Future Value = Principal + Interest due
CD face value: $1,000,000

Issue date: 1st January 1996 ( )
= P+ P x R x N
B x 100
Maturity date: 1st January 1997
Coupon:
Year basis:
8.5% pa
360 days
Future Value
[ ( )]
= P x 1 +
R x N
B x 100
...Equation 3
16
In this case the Principal is the Present Value: You may or may not be offered a fair price if you want to sell your CD. $ $
What is required is a measure of how good or bad the price you are
Present value = Future value ÷ Interest due offered is. The important factor for the value of a CD in the Coupon bearing
1086416.67 secondary market is its Yield To Maturity, YTM which is also known
= 1 + 9.75 x 61
[ 360 x 100 ] as the Money Market Yield, MMY. The YTM is:
The rate of return on a fixed income instrument, such as a CD, if

it is held to maturity.
Present Value = $1,068,759.87
So the fair value for this CD, 2-months from maturity, discounted at In order to compare the value of a CD with interest rates on deposits
9.75% is $1,068,759.87. and other instruments, market-makers quote a yield basis rather than
cash values.
The general equation for calculating the Present Value for a CD
CDs are quoted on a YTM (MMY) basis rather than in cash terms.
which has not reached maturity is given in Equation 4. i
Present Value
[ ( )]
= P x 1 +
R x N
B x 100
Future Value
Although YTM is the rate of return if an instrument is held to
maturity, short-term investors often liquidate their position before
maturity. These investors are therefore concerned with the horizon
Interest due
[ ( )]
1 +
r x n
B x 100
return on the instrument which has two components:
Horizon return = Accrued interest + Capital gains

...Equation 4
Where P = Principal or the CD face value This means the horizon return is the rate of return achieved on an
R = Quoted coupon rate for the CD investment, from purchase to sale, expressed as a percentage per
N = Number of days to maturity annum taking into account both components.
B = Year basis – 365 or 360
r = Current market interest rate If an investment is held to maturity, then its horizon return equals the YTM.
n = Current number of days to maturity
i
17
$ $ Example 2 ■ Summary
Using the CD details from Example 1 you are offered $1,065,000.00
Coupon bearing by a market-maker for its purchase with 61 days left to maturity. What
YTM does this represent? Should you sell to the market-maker?
Using Equation 3 and rearranging for R, where P is taken as the PV:
❑ A Certificate of Deposit is an IOU with a fixed coupon
R% = ( B x 100
N
)( x
FV – PV
PV
) ... Equation 5
and which is a negotiable instrument
❑ Many commercial banks issue Domestic CDs which are

= 360 x 100 x 1086416.67 – 1065000.00
normally payable at maturity
61 1065000.00
= 11.87% ❑ A Euro CD is a receipt for a Eurocurrency fixed term

deposit typically with a London-based bank
At the price offered the CD yields over 2% more than the
comparable deposit rate of 9.75% – this is an excellent deal!
❑ CDs are often quoted as early or late prices which reflects
The market-maker is unlikely to quote the price of $1,065,000.00 for whether the instrument matures in the first or second half
the CD, which is the settlement amount. What the market-maker will of the month
quote is a two-way price, for example, 11.92/11.87.
This means that the market-maker will buy a CD from you (bid) for a
cash amount that produces a yield of 11.92% for him, or that the
market-maker will sell you (offer) a CD for a sum that will yield you
11.87%.
It is important to remember that the yields here are Money Market

Yields and not true annual yields. Using this method of quotes makes
the true value of CDs very transparent and easy to compare with
interest rates on fixed deposits. When trading CDs the yield price is
agreed and then the cash settlement is calculated for the purchase/
sale of the CD.
The higher the quoted price, the lower the value of the asset.
i
If you hold a CD you want broker prices to go down – the lower the price, the
greater the yield.
18
■ Using Reuters products $ $

The following exercises using Reuters products and the Coupon bearing
RT may help your understanding of CDs and how they
are used.
RT From the MONEY Speed guide double-click in the

Money Market field <MMKT/>. You can display the
GBP CD prices from the broker Harlow Butler by
double-clicking in the field <CD=HBEL>. You may
also find it useful to type in US/MMKT and press Enter. If you
double-click in the Certificate of Deposits field <USCD1> you will
see a variety of CD prices from different US Commercial Banks.
19
$ $
Coupon bearing 3000 Using Money 3000 CD prices can be displayed for
any currency of your choice using the MMCB page.
In the screen below prices for Domestic CDs from
Garvin Guy Butler are shown. You may find the
Calculator useful if you need to calculate the Horizon return for a
CD for a date before maturity. Simply make sure you have the
correct details for the CD required and change the Horizon Date
and press Enter – the new Horizon Return will be displayed.
Enter the new Horizon

Date here and press Enter
The new Horizon Return is calculated and shown

here – it has changed from 5.670% to 5.616% by
moving the date forward to 15th August 1997
20
■ End check 5. On 19th February you buy a 6-month (180 days) Euro CD at $ $
8.40% with the following details and which has 90 days to
maturity: Coupon bearing
1. When do Eurodollar CDs issued for 12 months generally pay
interest? CD face value: $100,000
Issue date: 20th November
❑ a) On the issue date Maturity date: 20th May
❑ b) At maturity
❑ c) Quarterly Coupon: 9.5% pa
❑ d) Semi-annually Year basis: 360 days
2. XYZ Bank wishes to invest in a very liquid instrument. Which of Calculate the following:
the following are they most likely to do? a) The purchase cost of the CD
b) The interest actually paid
❑ a) Buy a A2/P2 Commercial Paper c) If the CD was sold on 29th February at 8.30% how much profit
❑ b) Buy a CD rated AAA is made and what is the Horizon return?
❑ c) Buy a CD rated BBB
❑ d) Deposit funds in the Money Market Answer a)
3. What is the main advantage of a CD over other Money Market

instruments? A CD:
❑ a) Pays a higher rate of interest

❑ b) Can be resold in the secondary market
❑ c) Is the safest form of investment
Answer b)
4. You have bought a Sterling CD in the secondary market with a
nominal value of £1,000,000. There are 87 days left to maturity
and a yield of 6.5%. The CD was issued for 90 days with a coupon
of 6.75%. How much do you receive at maturity?
Answer c)
❑ a) £1,015493.10
❑ b) £1,015,631.65
❑ c) £1,016,643.80
❑ d) £1,018,643.60
21
$ $ End check answers to questions
Coupon bearing ✔ or ✖ ✔ or ✖
1. b) ❑ 5. c) Profit = $257.51 ❑
Horizon rate = 9.159% ❑
2. b) ❑
3. b) ❑
Selling cost = 100,000 x
[ (
1+ 9.50 x 181
100 x 360 )]
4. c) ❑
[ (
1+ 8.30 x 80
100 x 360 )]
Use Equation 3.
Sum at maturity = 1,000,000 x
[ (
1+ 6.75 x 90
100 x 365 )] = 1.0477638
1.0184444
= $102,878.84
5. a) Purchase cost = $102,621.33 ❑
Profit = Selling – Purchase price
Use Equation 4.
= 102,878.84 – 102,621.33
Purchase cost = 100,000 x
[ (
1+ 9.50 x 181
100 x 360 )]
[ (
1+ 8.40 x 90
100 x 360 )] Horizon return = 257.51 x 360 x 100 x 365
102,621.33 10 360
= 1.0477638
1.0210
b) Actual interest = $9631.94 ❑
Annually = 9.50 x 100,000 x 365

100 x 360
22
Repurchase Agreement (Repo)
■ What is it? The following diagrams illustrate the process of using a Repo. $ $
A Repurchase Agreement (Repo) is an agreement for the First leg – the sale Coupon bearing
,,
sale of an instrument with the simultaneous agreement by
the seller to repurchase the instrument at an agreed
,,
future date and agreed price.
,,
Dealer A sells instruments
A Reverse Repurchase Agreement – Reverse Repo – is an
worth $1 million
agreement for the purchase of an instrument with the
▼
simultaneous agreement by the seller to resell the
▼
instrument at an agreed future date and agreed price.
Dealer B pays A $1 million
Within the Capital Markets, market players need to finance their

activities using loans. As in most financial loans, lenders require Dealer A Dealer B
collateral – security – for the loan. A Repo is a sale and repurchase (Seller) (Buyer)
agreement which can use almost any asset as collateral. However,
government issued instruments such as T-Bonds and T-Bills are most Dealer A now has $1 million for delivering the instruments worth $1
often used because of the credit worthiness of the issues. FRNs, CDs million to Dealer B.
and CPs are also used for Repos. Second leg – the repurchase
In a Repo, Dealer A sells instruments to Dealer B with an obligation

to repurchase equivalent instruments from B at an agreed future ,,
,,
,,
date. Dealer B now holds the instruments and can use them for Dealer A pays $1 million
whatever purpose but has the obligation to deliver equivalent plus a repo rate of 6.5%
instruments to A at the agreed future date.
▼
▼
The interest rate implied by the difference between the sale and Dealer B sells instruments
purchase price is known as the repo rate. worth $1 million
If Dealer A uses a Repo as a means to raise capital, the repo rate is in

Dealer A Dealer B
effect the cost of the loan.
(Seller) (Buyer)
Dealer B has earned 6.5% interest on the Repo.
In a Reverse Repo Dealer A agrees to buy the instruments and re-sell

them back to Dealer B at an agreed price at an agreed future date.
23
$ $ ■ Who uses Repos? Dealers

Dealers now run books in Repos and Reverse Repos hoping to match
Coupon bearing Central Banks counterparties and make a profitable spread in the middle. In effect
Repo transactions are often used by Central Banks as a this means the dealer is acting in a similar way to a bank – lending
means of monetary control. For example, in the US the money for instruments on one side and taking deposits on the other
largest Repo market involves trading T-Bills overnight side.
which spans the closing and opening times of the Money Markets.
When the Fed uses a Repo it is initially buying T-Bills to temporarily Counterparties to Repos are typically:
add cash to the Money Markets. A Reverse Repo is where the Fed sells
T-Bills to the Money Markets to drain money from the system. You ❑ Central Banks
may think that these explanations are the wrong way round but if you
consider the Fed as Dealer B in the previous diagrams, then all is ❑ Pension funds
well.
❑ Insurance funds
In the UK the Gilt Repo market is relatively new and the global
Master Repurchase Agreement (GMRA) establishes what type of ❑ Large corporations
interest bearing instrument can be used for Repos and allows dealers
to substitute eligible instruments. In many cases government bonds are used for Repos and Repo
Dealers often use Currency Swaps to eliminate FX exposure which
Corporations may arise on interest rate differentials between bonds denominated
Repos may be used by corporations who are trying to match funds in different currencies.
with their available cash which is needed at a future date. In effect
they buy cash instruments – usually T-Bills – to hedge a future
position. Using a Repo means the T-Bills are immediately sold but
their repurchase is agreed for a future date.
24
■ Repos in the market place

Term Description
$ $
The Repo market formalises to some extent the use of Coupon bearing
Margin Where the Repo transaction is covered by a bilateral
7 8 9 interest bearing instruments – particularly Government
4 5 6 (cont.) margining agreement between counterparties, a third
1 2 3 bonds – as collateral for loans. In some cases dealers use the
party such as a Custodian Bank or Clearing House is
0
cash raised on existing bonds to buy more bonds. In other
used to revalue the collateral and manage the transfer
cases dealers may have sold bonds they do not actually
of cash and instruments involved.
possess and use the Repo markets to borrow the bonds they require
for cash. Repos can resemble futures contracts in that dealers can
Haircut This is the margin a Repo dealer puts up and is the
open and close large financial positions without involving too much
amount by which the value of the instruments involved
of their capital. Within the Repo markets it is useful to understand
exceeds the cash invested in the Repo transaction.
the following terms:
Buy/ A simultaneous spot purchase and forward sale of
Term Description sellback instruments with the agreed repo rate being used to
Repo derive the forward purchase price. The buyer receives
Ask The interest rate at which a dealer will pay for a Repo to the accrued interest and any coupon payments during
obtain cash. the Repo period. This type of Repo requires no
collateral monitoring or margining provisions.
Bid The interest rate at which a dealer will pay for a Repo to
obtain instruments.
Buyer Cash provider. The buyer provides cash through the

temporary purchase of instruments.
Seller Cash taker or instrument lender. The seller provides the

instruments in the Repo transaction.
Repo rate Annual interest rate.
Margin This refers to the revaluation of the collateral that has

been provided by the instrument lender. If the price of
the collateral moves in the markets then this will give
rise to a change in value.
Any deficits or surpluses will need to be adjusted

between the counterparties. Revaluation is usually
carried out daily.
25
$ $ ■ Summary Your notes
Coupon bearing
❑ A Repo is an agreement for the sale of an instrument with

the simultaneous agreement by the seller to repurchase
the instrument at an agreed future date and agreed price
❑ A Reverse Repo is an agreement for the purchase of an

instrument with the simultaneous agreement by the seller
to resell the instrument at an agreed future date and
agreed price
❑ A repo rate is the interest rate implied by the difference

between the sale and purchase prices
❑ The Repo markets for government treasury instruments

are important as the bills and bonds involved are
considered to be the most creditworthy collateral
26

The following exercises using Reuters products and the Coupon bearing
RT may help your understanding of Repos and how they
are used.
RT To see Reuters Repurchase Agreement Rates type in

REPO and press Enter. This screen displays the
Overnight to 3-month rates for US Treasury Repos.
You will see a screen similar to that shown here.
27
$ $
Coupon bearing 3000 US Treasury repo rates from Garvin Guy Butler can
be displayed from the MMDI page for USD.
28
Treasury Bill (T-Bill)
■ What is it? The results of the auction are published in The Wall Street Journal and $ $
look something like this:
A Treasury Bill is a short-term negotiable Bill of Discount
Exchange issued by a government to help finance 13 week 26 week
national debt.
Applications $55,735,696 $48,878,949
Accepted bills $13,073,966 $13,080,408
T-Bills are short-term government instruments issued in both the US
Accepted non-compet. $1.118,192 $861,519
and UK. Normally T-Bill prices are quoted at a discount which
Average price rate 99.227 98.352
reflects the prevailing short-term interest rate. If you buy T-Bills you
3.06% 3.26%
are effectively lending money to the government and as such there is
little risk attached. However, the main purpose of T-Bills is not to Yield
finance government spending but to help control monetary policy.
Yields on T-Bills are therefore lower than other short-term money UK T-Bills
market instruments because the loan is guaranteed by the On the last business day of each week the Bank of England issues 91-
government – less risk, less reward. As a result of their reliability these day bills usually for amounts £5000 – 250,000. Tenders are invited
instruments are used as benchmarks for other investments to be each Friday with bills being issued the following week.
compared with.
The results of the tenders are published in the Financial Times and
In the US and UK T-Bills are recorded centrally so there are no they look something like this:
physical certificates of ownership.
BANK OF ENGLAND TREASURY BILL TENDER
US T-Bills
In the US the Fed typically auctions 13- and 26-week T-Bills on behalf Friday 2 Friday 1
of the government every Monday for delivery on Thursday. It also
auctions 52-week bills every month. Bids can either be competitive or Bills on offer £700m £700m
non-competitive. Competitive bids state the actual price the investor Total of applications £2900m £2246m
is willing to pay whereas for non-competitive bids the investor is Total allocated £700m £700m
willing to pay the average of all bids accepted. Minimum accepted bid £98.475 £98.495
Allotment at minimum level 59% 83%
29
$ $ ■ Who uses T-Bills? In contrast to the primary market, settlement in the secondary
market takes place on the following business day at the latest – T+1
Discount US T-Bill investors or Trade + 1.
In the primary market, market-players such as primary
dealers, large institutional investors, money-centre banks Bills are traded traditionally by large investors in minimum lots of $5
and non-professional investors buy T-Bills in competitive million. The US T-Bill is a very liquid market and with the easy
bids on a discounted basis. For example, a bill with a face value of availability of Repurchase Agreements (Repos) dealers build up
$100,000 may be bought for $97,000. The discount is $3000 which substantial long or short T-Bill positions running into many $100
represents the interest on the loan to the government if the bill is millions.
held to maturity. The professional market-players bid for the bills in
a competitive auction whereas non-professional investors can make UK T-Bill investors
non-competitive bids with no price. If successful the professional The main holders of UK T-Bills are the Discount Houses who
market-players pay their bid price; non-competitive bids are priced as dominate the secondary market and act as intermediaries between
an average of the professional market-players bid prices. the Bank of England and investors. The Bank of England can also
invite Discount Houses and Clearing banks to absorb surplus Money
Between the auction and settlement of new issues, primary dealers Market supplies on a particular day and issue T-Bills by allotment.
make a market in when issued (W/I) bills. This is attractive for
dealers who want to run positions as there is no immediate delivery Market prices
or costs involved. T-Bills are guaranteed instruments carrying no risk and as such the
yield is lower than on Money Market deposits and CDs. T-Bills are
The US T-Bill secondary market is the most active US Money Market. quoted on a discount to par basis not on a yield basis. The practice of
The Fed will only deal with primary dealers who must have adequate: discounting to par dates back to the issue of Bills of Exchange from
Merchant Banks.
• Capital
• Market turnover In the secondary market traders deal with each other using quoted
• Experience and knowledge of government markets bid and offer discount rates. A broker’s price run might look like
this:
Virtually all secondary T-Bill trading in the US is carried out using
InterDealer Brokers (IDBs). The 40 or so primary dealers use the US T-Bill
IDBs on a no-names basis. This means trades are settled with an IDB 13 week 6.50 – 49 2 x 5
directly rather than between counterparties which makes it difficult 26 week 6.70 – 69+ 10 x 12
to assess who is in the market and the size of their position.
52 week 6.96 – 95 1 x 10
Because T-Bills carry virtually no risk of default, brokers quote price
runs for different maturities. This is possible because all bills
maturing on the same date should have the same price, irrespective But what do these quotes mean?
of their issue date.
30
Take the rates for 26 weeks: ■ T-Bills in the market place $ $

The Big Figure of 6% is also The relationship between discount rate and yield is Discount
known as the handle and is rarely This means there are important, particularly if you need to compare instruments
7 8 9
referred to in conversations. This 10 million Bid lots 4 5 6
which are quoted in different ways. To illustrate the
1 2 3
quote would be 70 – 69+ and 12 million Offer 0
relationship consider the following simple case. Suppose an
lots available exporter sells a $100 instrument which is discounted by 10%
so receiving $90. What is the equivalent interest rate for this loan? It
Bid Offer is not 10%. If the exporter placed the $90 on deposit for a year at a
rate of 10%, then the interest would be $9. The most the exporter
6.70 – 69+ 10 x 12 could receive in interest and from the sale of the instrument is $99,
not $100. So the effective rate of interest to the exporter for issuing
the instrument is greater than 10%
The bid discount rate The offer discount rate is
is the rate you pay to the rate you receive if you The discount rate quoted is always less than the true yield to maturity on an
buy the bill from the i instrument or the effective rate of interest paid.
sell the bill to the broker–
broker – 6.70%. 6.695%. The 69+ means 69.5
basis points. Within the discount markets, instruments have two values which you
need to understand:
As for CDs once a rate has been agreed the settlement amounts are
❑ Present value (PV) – the settlement amount payable
calculated.
today
❑ Future value (FV) – the redemption amount

payable on maturity
The settlement amount payable on a discount instrument is

calculated using Equation 1.
Settlement amount , S = P x 1 –
[ ( R x N
B x 100 )] ...Equation 1
Where P = Redemption value, FV

R = Discount rate as a decimal
N = Number of days to maturity
31
$ $ By rearranging Equation 1 the Discount rate can be calculated using Example 2 – A UK T-Bill
Equation 2. Calculate the discount rate for the following UK T-Bill which has 91
Discount days to maturity.
R% =
( P – S
P ) (
x
B x 100
N ) ...Equation 2
T-Bill face value:
Settlement date:
£100,000
9th May
Maturity date: 8th August
Settlement value: £98,485
Example 1 – A US T-Bill Year basis: 365 days
Calculate the settlement amount for the following US T-Bill which
has 50 days to maturity. Using Equation 2:
T-Bill face value: $100,000
Settlement date: 9th May Discount rate = 100,000 – 98,485 x 365 x 100
Maturity date: 28th June 100,000 91
Discount rate: 8.12%
Year basis: 360 days = 6.0766%
Using Equation 1:
S = 100,000 x 1 –
[ ( 8.12 x 50
360 x 100 )]
Therefore the settlement value = $98,872.22. This is also written as
98.87% of face value.
If the discount rate remains constant, then as the instrument

approaches maturity N becomes smaller and the settlement price for
the T-Bill rises to converge with its face value.
32
As in the case of other Money Market instruments, quoting a rate Example 3 – A US T-Bill $ $
may not be that useful if you need to compare rates of return from Using the same information from Example 1 calculate the MMY for
different instruments. Rates of return for instruments held to the US T-Bill which has 50 days to maturity. Discount
maturity are compared by calculating the Money Market Yield, MMY
for each instrument. T-Bill face value: $100,000
Settlement date: 9th May
The MMY for an instrument can be calculated as follows: Maturity date: 28th June
Discount rate: 8.12%
1. Calculate the profit to maturity on the instrument.
This is equal to (P – S). Year basis: 360 days
2. Express 1. as a proportion of the amount invested. Using Equation 4:

This is equal to (P – S) ÷ S
8.12/100
3. Express 2. on a percentage annual basis MMY =
Therefore: [ (
1 –
8.12 x 50
360 x 100 )]
MMY =
( P – S
S ) (x
B x 100
N ) ...Equation 3
Therefore the MMY = 8.21%
To convert this yield into a true annual yield you would need to
multiply MMY by 365/360.
Equation 3 is very similar to Equation 2 which can be used to express
MMY in terms of the Discount rate as in Equation 4.
True annual yield = 8.21 x 365
360
R/100
MMY = ...Equation 4 = 8.32%
[ (
1 –
R x N
B x 100 )]
33
$ $ Although the MMY is useful for comparing short-term Money Market ■ Summary
instruments a different yield basis is used for comparisons with
Discount coupon bearing instruments which are nearing maturity.
The Bond Equivalent Yield, BEY allows such a comparison to be
made and is particularly useful for comparing T-Bills with Treasury
Bonds and Notes with only a short time to maturity. ❑ Treasury Bills are short-term, negotiable, government
instruments which are issued at a discount. In the US they
BEY takes into account compounding of interest for coupon are known as T-Bills and in the UK they are commonly
payments and adjusts for a coupon period of 365 days. A complicated called Gilts.
formula is used for calculations which will not be discussed here.
However, a good approximation for US T-Bills with a maturity of 6 ❑ T-Bills are used as benchmarks for other instruments to be
months or less is given by the following equation: compared with
❑ US T-Bills are auctioned and investors buy either

BEY = MMY x 365 competitively or non-competitively on a discount basis
... Equation 5
360
❑ UK Gilts are allocated by invitation to tender from the
Bank of England, mainly to Discount Houses and
In the case of UK T-Bills, as both bills and Gilts are priced on a 365 Clearing banks. The Discount Houses dominate the
basis using Equation 5 means that MMY equals BEY. secondary market by acting as intermediaries between the
Bank of England and investors.
34

The following exercises using Reuters products and the Discount
RT may help your understanding of T-Bills and how they
are used.
RT For US T-Bills type in US/GOVT1 and press Enter

to display the US Government Debt Speed Guide.
To see the end of the day prices for T-Bills from
GOVPX double-click in the < 0#USBILLS3PM>
field – the weekly issues for each month are listed here. You can
also obtain chains of GOVPX prices from the GPXINDEX page.
You will see screens similar to those shown here.
This chain has been accessed from

the GPXINDEX page
35
$ $
Discount RT For UK T-Bills you can display the latest T-Bill
tender results by typing in BOE/MONEYOPS5 and
pressing Enter. To see the UK Government Debt
Speed Guide type in GB/GOVT1 and press Enter.
To display OTC prices for Treasury Bills double click in the
<GB/TBIL> field. Then double-click in the fields for prices – in
this case <BASD> and <3CLIVE> for Barclays Bank PLC and
Clive Discount Co Ltd respectively.
Compare T-
Bill prices
36
■ End check $ $
Discount
1. You want to buy a UK T-Bill with a face value of £100,000 maturing 2. You check on the RT and find the latest price for a US T-Bill with
in 3-months (91 days). Barclays Bank is quoting 65/8% whilst Clive a face value of $100,000 with a 3-month maturity (90 days) is
Discount House is quoting 611/16% . 5.05%.
a) Which Bank would you buy the T-Bill from? a) What is the settlement rate for the bill?
b) What is the settlement rate for the bill?
b) What is the Money Market Yield for the bill?
c) What is the Money Market Yield for the bill?
c) What is the true annual yield for the bill?
37
Discount ✔ or ✖ ✔ or ✖
1. a) Barclays Bank – the lowest discount rate ❑ 2. a) $98,735.50 ❑
b) £98,348.29 ❑ Use Equation 1.
Use Equation 1.
Settlement = 100,000 x
[ (
1– 5.05 x 90
100 x 360 )]
Settlement = 100,000 x
[ (
1– 6.625 x 91
100 x 365 )] = 100,000 x [(1 – (0.012625)]
= 100,000 x [(1 – (0.0165171)] b) 5.115% ❑
c) 6.74% ❑ Use Equation 4.

MMY = 5.05/100
Use Equation 4.
[(1 – (0.012625)]
MMY = 6.625/100
[(1 – (0.0165171)]
c) 5.186% ❑
= 0.06625
360
0.98348
38
Bill of Exchange/Banker’s Acceptance (BA)
■ What is it? the bank issuing the L/C with the necessary documentation such as $ $
Bill of Lading, invoices, warehouse receipts etc the bank accepts the
A commercial Bill of Exchange, or Trade Bill, is an order draft and stamps it ACCEPTED. The resulting Banker’s Acceptance Discount
to pay a specified amount of money to the holder either means the importer’s bank will pay the full amount at the due date.
at a specified future date – Time draft – or on The actual instrument issued is simply a note specifying:
presentation – Sight draft. It is a short-term IOU in
support of a commercial transaction. ❑ The name of the accepting bank
A Banker’s Acceptance, or Banker’s Bill, is a Bill of ❑ A brief description of the underlying transaction
Exchange drawn or accepted by a commercial bank.
Once accepted the instrument becomes negotiable. The exporter can now keep the BA until maturity or if necessary sell
it in the secondary market to raise cash. The BA is now a negotiable
instrument which carries the bank’s obligation to pay.
These instruments have been used in financing international trade
for hundreds of years. A Bill of Exchange in the UK is essentially the If the exporter does sell the BA in the secondary market, then the
same as a BA in the US. These discount instruments are basically buyer pays less than the face value of the bill. In other words the bill
short-term IOUs issued to support a commercial transaction. trades at a discount which has a value determined by the difference
between purchase and face values. The buyer of the BA is effectively
Originally a Bill of Exchange was where an importer agreed to pay an lending money to the original holder and the discount is the interest.
exporter a specific sum of money at a definite future date for goods
or services. The exporter – the drawer – draws a Bill of Exchange on On maturity, the importer has to pay the accepting bank the face
the importer – the drawee. The bill can be drawn as a Sight draft value of the bill. If the importer fails to pay, then the accepting bank
which means that it must be paid immediately on presentation or it still has the obligation to pay the bearer. In consequence accepting
can be a Time draft which means payment is due a number of days banks need to be assured of the credit worthiness of the importer.
after it has been presented.
Typically the exporter sells the BA to his own bank. The bank can
Once the importer acknowledges his obligation to honour the bill he either hold the BA to maturity or re-discount it in the secondary
writes ACCEPTED across the bill which now becomes an acceptance. market.
If the acceptance is between the importer and exporter directly it is Most BAs are now issued to support international trade and are
known as a Trade Bill. If the bill is accepted by the drawer’s/drawee’s bearer instruments drawn on banks having the best credit ratings.
bank then it is known as a Bank Bill. Once a bill has been accepted BAs are drawn for various maturities and face value amounts reflects
then it must be paid at maturity. the nature of the business transaction. BAs are usually created and
traded in lots of USD 1 million or equivalent in other currencies,
In many cases a Time draft is drawn by an exporter under a Letter of although some accepting banks issue smaller lots to attract smaller
Credit, L/C from the importer’s bank. The L/C is a non-negotiable investors.
order from a bank which is required by the exporter who wishes to
have proof that he or she will be paid. Once the exporter provides
39
$ $ The following diagram summarises the processes described in issuing ■ Who uses BAs?
and trading a typical BA.
Discount Banks
Sight or Time draft In London Bills of Exchange and Banker’s Acceptances
Importer Exporter have been issued by Merchant Banks or Accepting House
▼
Drawee Drawer for centuries. In taking on the credit risk for the original
▼
Accepted/Trade Bill drawee, the bank charges a fee to guarantee payment of the bill’s face
▲ value at maturity. The more credit worthy the accepting bank, the
easier it is to sell the bills in the secondary market.
BA sold
L/C The accepting bank’s fee is derived from the difference between the
at
Accepting Bank discount rate the bank buys the original bill from its customer and
Bill of Lading discount
the lower re-discount rate at which it sells the accepted bill in the
▼ ▼
Accepted/Bank Bill secondary market.
▲
The majority of BAs in the US are created by international
BA re-discounted ▼ subsidiaries of money-centre banks. Originally the US market
Secondary market developed to finance US import and export markets – in much the
Investors same way as Bills of Exchange had developed in the UK. However,
many BAs now issued in the US finance trade in which neither
importer nor exporter are US organisations.
Eligible BAs
On this Bill of Exchange of 1898 you
The type of BA described so far is one created for a commercial
can see that it has been Accepted
transaction involving the supply of goods or services and which is
usually supported by a Letter of Credit. However, BAs are also issued
on the basis of less formal contractual agreements as a means of
satisfying credit demand which avoids Central Bank rules and
penalties.
During the 1960s and 1970s Central Banks in both the US and the
UK attempted to control the growth of money supply through bank
credit rationing rather than by raising interest rates. If banks
exceeded their domestic lending targets, then they were penalised by
their Central Bank.
This photograph is reproduced by kind permission
of the Archives Department, Midland Bank plc
40
To overcome these difficulties banks developed the following tactics: ■ BAs in the market place $ $
❑ Lending was channelled through the Eurocurrency markets Within the discount markets, instruments have two values Discount
which were not subject to the same Central Bank rules and 7 8 9 which you need to understand:
4 5 6
regulations 1 2 3
0
❑ Working Capital BAs or Finance Bills were created which today
were then sold in the secondary markets. Finance Bills are a
major source of working capital for organisations which ❑ Future value (FV) – the redemption amount
lack the credit rating to issue a Commercial Paper. payable on maturity
The result was that both the Bank of England and the Fed made The settlement amount payable on a discount instrument is
these bills ineligible for re-discount at the Central Bank and they calculated using Equation 1.
made the sale of such bills subject to reserve requirements.
What then is an eligible bill?
An eligible bill is a BA which a Central Bank is prepared to buy and

Settlement amount
[ (
= P x 1 – R x N
sell which does not incur a reserve requirement.
In broad terms an eligible bill is an acceptance which has been Where P = Redemption value, FV
created to fund specific types of short-term – usually up to 6 months – R = Discount rate as a decimal
commercial transactions. N = Number of days to maturity
Eligible BAs issued in the US tend to track T-Bill rates quite closely.
The distinction between eligible and ineligible BAs is therefore
important and it is normal to see quotes only for eligible BAs.
41
$ $ Example 1 Example 2
You are a Corporate Treasurer who needs to borrow £500,000 for the What would be the settlement amount for the following BA issued by
Discount next 182 days. Your bank offers you the following BA. If you took this Barclays Bank Plc.
BA what would be the redemption value or cost of the instrument at
maturity? Underlying trade: Beet export
Face value: £200,000
Settlement value: £500,000
Days to maturity: 142
Issue date: 5th January
Quoted rate: 6.5% pa
Maturity date: 5th July
Year basis: 365 days
Rate: 615/16% pa
Using Equation 1:
Using Equation 1:
500,000 = P x 1 –
[ ( 6.9375 x 180
365 x 100 )] Settlement amount
[ (
= 200,000 x 1 –
6.5 x 142
365 x 100 )]
Therefore the redemption or face value, P
Settlement amount = 200,000 x (1 – .02529)
P = 500,000
= £194,942. 46
[ (
1 –
6.9375 x 180
365 x 100 )]
In this case you would expect to pay £194,942.46 if you purchased this
BA with 142 days remaining to maturity. At maturity you would
= 500,000 receive £200,000. The difference between the two values is the
(1 – 0.03421) discount – the amount you receive to lend your money.
= £517,705.52
The cost of using the BA is therefore £17,705.52
42
■ Summary Your notes $ $

Discount
❑ A Bill of Exchange is an IOU in support of a commercial

transaction which is issued at a discount. Once a Bill of
Exchange is accepted there is an obligation by the
accepting party to honour the instrument.
❑ A Banker’s Acceptance or Banker’s Bill is a Bill of

Exchange drawn or accepted by a commercial bank which
is a negotiable instrument
❑ An Eligible Bill is a BA which a Central Bank is prepared

to buy and sell which does not incur a reserve
requirement
43
Discount The following exercises using Reuters products and the

RT may help your understanding of BAs and how they are
used.
RT For UK Eligible Bills type in GB/GOVT1 and press

Enter. If you double-click in the <GB/TBIL> field
you will see OTC Prices from contributors for T-Bills
and Eligible Bills. Double-click in the fields for
prices – in this case <ALEX> and <GNDB> for Alexanders
Discount PLC and Gerrard and King Ltd respectively.
Compare T-
Bill prices
44
$ $
3000 US Domestic BA rates from Garvin Guy Butler can Discount
be displayed from the MMDI page for USD.
45
$ $ Your notes
Discount RT For US BAs type in US/MMKT and press Enter. If

you double-click in the <NYAS> field you will see
Reuters prices for BAs from primary dealers.
46
■ What is it? ■ Who uses CPs? $ $

A Commercial Paper is a short-term unsecured, Corporations and banks Discount
promissory note issued for a specified amount and The Commercial Paper originated in the US in the
maturing on a specified date. It is a negotiable nineteenth century as a way of allowing large
instrument typically issued in bearer form. corporations to access capital across the country. At this
time most US commercial banks were restricted to lending
A CP is an unsecured bearer form, fixed maturity, promissory note operations in the State in which they were located. Banks sponsoring
issued on a discount basis by large corporations with good credit CP issues could thus earn issue fees from corporations without having
ratings. to lend funds.
They are used as an alternative to bank loans where the issuer CPs do not pay interest but are discount instruments issued to raise
promises to pay the buyer a fixed sum at a future date but without working capital. The CP to a corporation is what a Certificate of
being backed by assets. Large corporations often borrow large sums Deposit (CD) is to a bank. Although many large corporations issue
for capital investment using debt instruments and then ‘park’ the CPs, many banks now use short-term CPs to raise money which is
money temporarily in the CP market. used to swap USD into a LIBOR funding basis in other currencies.
Most CPs issued by banks have maturities of 30 days or less so that
Maturities range from a few days to 270 days – the usual period is 30 they do not compete with the CD market.
days. The rates offered are typically higher than for T-Bills of the
same maturity. Issuers of CPs tend to ‘roll-over’ the paper on maturity. This means
they sell a new CP to obtain funds to redeem the maturing paper.
A CP is a bearer instrument and because it is unsecured only the However, there is a risk that the new CP issue will not take place on
credit rating of the borrower is available as security. A CP does not the required day. To avoid this risk most CP issues are backed by a
pay interest and is issued on a discount basis. line of credit from a bank.
Investors
In general the CP market is a wholesale market for large institutional
investors although some large US issuers make some provision for
smaller investors.
A secondary market exists in CPs but most are sold to investors who
hold them to maturity. Dealers will buy back CPs they handle but only
after adding a wide spread to ensure a profit. CPs are not therefore as
liquid as T-Bills and CDs.
47
$ $ The yield differential between A1/P1 and A2/P2 rated CPs can be as ■ CPs in the market place
high as 200 points and as low as 15 points depending on the name of
Discount the issuer and the availability of credit. Within the discount markets, instruments have two values
7 8 9 which you need to understand:
4 5 6
Yields on CPs are usually slightly higher than those on T-Bills which 1 2 3
reflects the increased credit risk and reduced liquidity of the 0

instrument. today
Euro Commercial Paper, Euro CP or ECP ❑ Future value (FV) – the redemption amount
Alcoa, the US corporation, issued the first Euro CP in 1970 at a time payable on maturity
when US corporations were seeking USD funding outside the US.
The settlement amount payable on a discount instrument is
A Euro CP is a commercial paper issued on a Eurocurrency basis. calculated using Equation 1.
This means the regulatory conditions which apply to normal CPs
in their country of issue do not apply to ECPs which are issued
outside the country in which the corporation or bank is located.
Settlement amount , S = P x 1 –
[ ( R x N
Euro CPs are similar in most respect to CPs in that they are usually
issued in bearer form with maturities ranging from 30-270 days.
Where P = Redemption value, FV
However, the main difference between the instruments is as follows:
R = Discount rate as a decimal
❑ CPs are quoted on a discount to par or face value basis
❑ Euro CPs are quoted on a discount to yield basis. This
means that the quoted rate is the same as the Money By rearranging Equation 1 the Discount rate can be calculated using
Market Yield, MMY Equation 2.
Euro CPs face stiff competition from CPs and the Eurocurrency
deposit and lending markets which tend to be used for short-term
corporate financing. R% =
( P – S
P ) (
x
B x 100
N ) ...Equation 2
48
As in the case of other Money Market instruments, quoting a rate Example 1 – A US CP $ $

may not be that useful if you need to compare rates of return from Calculate the settlement amount and the MMY for the following US
different instruments. Rates of return for instruments held to CP issued by Motorola Finance. The quoted rate is on a discount to Discount
maturity are compared by calculating the Money Market Yield, MMY par basis for a normal CP.
for each instrument.
CP face value: $100,000
The MMY for an instrument can be calculated as follows:
Settlement date: 1st April
1. Calculate the profit to maturity on the instrument. Maturity date: 1st May
This is equal to (P – S). Discount rate: 8.83%
2. Express 1. as a proportion of the amount invested.
This is equal to (P – S) ÷ S
Using Equation 1:
3. Express 2. on a percentage annual basis
Therefore: [ (
S = 100,000 x 1 –
8.83 x 30
360 x 100 )]
MMY =
( P – S
S ) (x
B x 100
N ) ...Equation 3 Therefore the settlement value = $99,264.17
Using Equation 4:
Equation 3 is very similar to Equation 2 which can be used to express
MMY in terms of the Discount rate as in Equation 4. 8.83/100
MMY =
R/100
[ (
1 –
8.83 x 30
360 x 100 )]
MMY = ...Equation 4
[ (
1 –
R x N
B x 100 )] Therefore the MMY = 8.8955%
49
$ $ Example 2 – A Euro CP Using Equation 6:

Calculate the settlement amount and the MMY for the following Euro
100,000
Discount CP issued by Eurotunnel. The quoted rate is on a discount to yield Settlement value, S =
basis for a Euro CP. In this case the settlement value is calculated
using an equation similar to that used for CDs. [ (
1 +
7.12 x 31
360 x 100 )]
CP face value: $100,000 Therefore the settlement value = $99,390.63
Settlement date: 1st December
Maturity date: 1st January In the case of a Euro CP the MMY is the same as the Discount rate so
Discount rate: 7.12% no calculation is involved!
[ ( )]
Settlement value, S = P x 1 +
R x N
B x 100 ...Equation 5
[ ( )]
1 +
r x n
B x 100
Where P = Redemption value

R = Quoted coupon rate which is zero for a CP
r = Current discount rate
n = Current number of days to maturity
So for a Euro CP where R = 0, Equation 1 reduces to:

Settlement value, S = P ...Equation 6
[ (
1 +
r x n
B x 100 )]
50

Discount
❑ A Commercial Paper is an unsecured, negotiable,

promissory note issued at a discount by organisations with
good credit ratings
❑ A Euro CP is a commercial paper issued on a

Eurocurrency basis which avoids normal regulatory
conditions which may apply to Domestic CPs
❑ A Domestic CP is quoted on a discount basis whereas a

Euro CP is quoted on a Money Market Yield basis
51
$ $ ■ Using Reuters products Exercise

You are considering buying an A1P1 US CP and you view the GGB
Discount The following exercises using Reuters products and the prices on Money 3000. You are considering a CP with a 60 day
RT may help your understanding of CPs and how they are maturity period and face value of $1,000,000. The prices on screen
used. are as follows:
3000 To see prices for US CPs use the MMDI page for
USD. Select COMM PAPER to view prices from
Garvin Guy Butler. You can also select the rating of
the CP you require by selecting A1P1, A1P2 or
A2P2. Why not select all three and compare the rates?
a) If you bought the 60 day CP as quoted, what would the settlement

rate or price be?
b) Calculate the Money Market Yield and the true annual yield for
Remember these the CP.
are discount
prices not the
yields
52
$ $
RT To see prices for US CPs for the primary market Discount
type in US/MMKT and then double-click in the
field < CPAPERA>. This page displays BAs for large
US organisations for 5 – 240 days. You can also
double-click in the <RMFA> field to see a Reuters overview of US
CP, CD and BA rates.
In the UK the Bank of England publishes Euro CP rates it will

observe – type in BOE/ECP and press Enter.
53
$ $ Answers to exercise Your notes
Discount ✔ or ✖
a) $990,650.00 or price 99.065 ❑
Use Equation 1.
Settlement =
[ (
100,000 x 1 –
5.61 x 60
360 x 100 )]
= 100,000 x [(1 – (0.0093500)]
b) Money Market Yield = 5.6629% ❑

True annual yield = 5.7416% ❑
Use Equation 4.
MMY = 5.61/100
[(1 – (0.009350)]

360
Need you have calculated these values? The answer, as you might
expect is no – Money 3000 displays all these values in the
Instrument details fields.
MMY
Price/settlement value True annual yield

depending on face value
54
Forward Rate Agreement (FRA)
■ What is it? Example $ $

If a FRA is bought at an agreed rate of 5.00%, but at the start of the
A Forward Rate Agreement is a contract between two agreement LIBOR has been fixed at 6.00%, then cash must be Derivative
parties which fixes the rate of interest that will apply to a borrowed at the higher rate of 6.00%. The buyer receives a cash
notional future loan or deposit for which the following settlement of 1.00% on the notional principal amount to compensate
have been agreed: for the increased borrowing costs.
❑ The amount and its currency The seller of a FRA will be paid in cash by the buyer for any fall in
❑ A future date for the loan/deposit to be drawn/ the reference interest rate, below the agreed contract rate. Depositors
placed wishing to hedge against any future falls in interest rates therefore
❑ The term sell FRAs
A FRA is a derivative instrument in that its market price is calculated Example

from Money Market deposit rates. The instrument is similar to an If a FRA is sold at an agreed rate of 10.00%, but at the start of the
Interest Rate futures contract but involves no margin payments. FRAs agreement LIBOR has been fixed at only 8.00%, then cash is
have developed since 1983 and are the most widely used of the OTC deposited at the lower rate of 8.00%. The seller receives a cash
Money Market derivatives. They are used by market players to lock in settlement of 2.00% on the notional principal amount to compensate
short-term borrowing and lending rates. for the reduced income.
,,
Example
,,
A Corporate Treasurer has a forward borrowing requirement in 3
months time for a 3-month loan, but he believes that interest rates If interest rates rise
,,
will have risen by the time he requires the loan. To hedge the
▼
possibility of future borrowing costs the Treasurer buys a FRA for the
forward period. At the start of the FRA, interest rates have risen and
the Treasurer has to borrow in the cash markets at a higher rate.
▼
However, the Treasurer receives cash compensation from the
If interest rates fall
settlement of the FRA for the difference between LIBOR and the
FRA agreed rate. The Treasurer has in effect locked-in the cost of the
forward borrowing at the FRA rate. Buyer Seller
The buyer of a FRA will be paid in cash by the seller for any rise in It is important to remember that a FRA is an agreement to fix a
the reference interest rate, over and above the agreed contract rate. forward rate – there is no obligation to borrow or lend the notional
Borrowers wishing to hedge against rises in future borrowing costs principal amount involved.
therefore buy FRAs.
55
$ $ Key features of a FRA Terms used

FRAs have a number of features which market players need to assess There are a number of terms you need to know if you are to
Derivative before they decide on using the instrument. These features include understand how FRAs work and are used. The table below indicates
the following: the terms and their meanings.
❑ Cash settlement. As the loan/deposit is for notional funds Term Which means...
there is no exchange of principal. Cash compensation is
paid at the beginning of the notional loan/deposit period. Contract currency and amount The currency and amount of the
notional loan/deposit
❑ Flexibility. As the loan/deposit is for notional funds there is
no obligation by buyers/sellers in the markets to actually Trade date The date the deal is actually
lend or deposit their funds. Market players can use other made
instruments which offer the best returns for their specific
needs. Fixing date This is two business days before
the start of the FRA. It is the date
❑ Lock-in rate. Like Forward FX contracts, if future interest when the LIBOR, or other,
rates fall the buyer will have to compensate the seller and reference rate is fixed. The
forego any benefit from lower interest rates. Equally, if settlement amount is calculated
interest rates rise the seller has to compensate the buyer. using this rate.
FRAs effectively lock-in future interest rates for market
players. For domestic currency FRAs the
fixing date is usually the same as
❑ Low credit risk. As there is no exchange of principal a FRA the settlement date.
is an off-balance sheet instrument. The credit risk is low
because the main risk is concerned with finding a
replacement counterparty should the original party default. Settlement date This is the date when the
The risk involved is therefore on the settlement amount contract period starts and cash
rather than the notional amount. compensation is paid
❑ Cancellation and assignment. A FRA is a binding contract Maturity date The date the contract ends
and cannot be cancelled or assigned to a third party
without the agreement of both counterparties. As with Contract period This is the term of the notional
other instruments with binding contracts, FRA positions loan/deposit – the period from
can be closed using off-setting contracts. settlement to maturity in days
Contract rate The agreed forward interest rate

for the contract period – the
price of the FRA in % per annum
56
The events of the following 3 month FRA are summarised here: Before moving on use Money 3000 to have a look at BBALIBOR ... $ $
3 month FRA Use the Benchmark Watch page, MMBW for GBP Derivative
3000 and select BBALIBOR from the drop down menu.
Contract LIBOR Contract Contract
agreed rate fixed starts ends You can also use page FRASETT on the RT to see a
10th April 12th June 16th June 15th Sept list of all the fixings.
Trade Fixing Settlement Maturity
You should see pages similar to those shown here.
▼
Contract period – 92 days
Rules
1. The start and end dates are calculated from spot dates.
2. The fixing date is 2 days before the start date.
For the above FRA:
• The trade is agreed on 10th April 1997

• Spot is therefore two business days later – 14th April
• The start date of the FRA is two business days from the forward
date – 16th June
• The fixing date is two business days before the start date – 12th
June
• The maturity date is 3 months from 16th June – 15th
September
The British Bankers Association (BBA) publishes a set of recommended

contract terms and conditions – referred to as FRABBA terms. This
means that most banks deal automatically on FRABBA terms unless
otherwise stated. FRA fixing rates are based on LIBOR which are
available daily to the markets. The fixings are made at 11.00 am
London time and are calculated as an average of 16 banks quoting
LIBOR in the London market.
57
$ $ Market pricing of FRAs In most financial centres market-makers quote the bid price first
The FRA is quoted as a two-way price with bid/offer prices in the whereas in London it is the offered rate which is quoted first – the
Derivative same way as for Money Market deposit rates. FRA market-makers take rate at which they sell. Either way the market-taker always pays the
on large trades because the credit risk is low as there is no notional higher rate!
exchange of principal. This means that the bid/offer spreads
available are tighter compared with cash deposit rates – typically 3 – 5 New York London
basis points for Eurodollar FRAs. These tighter spreads are available
only for standard minimum deal sizes of USD 5 million or equivalent.
Prices quoted are for standard or fixed dates. The table below gives
examples of the conventions for 3- and 6-month series of FRAs:
3-month series 6-month series

Bid/Offer Offer/Bid
Starts Ends Starts Ends
forward forward forward forward
Under the FRABBA system Eurocurrency FRAs involving currencies
1 x 4 1 month 4 months 1 x 7 1 month 7 months not linked to LIBOR cannot be traded. However, provided there are
underlying cash Money Market prices, ‘exotic’ FRAs can be priced
2 x 5 2 months 5 months 2 x 8 2 months 8 months and settled against mutually pre-determined reference rates.
3 x 6 3 months 6months 3 x 9 3 months 9 months
6 x 9 6 months 9 months 6 x 12 6 months 12 months
1 x 4 FRA
Contract period
Contract Start – 3 months End
▼
agreed forward forward
Trade 1 month 4 months
The most liquid FRAs are those for 3 x 6, 3 x 9, 6 x 9 and 6 x 12

agreements. Broken dates are available but the dealing spread may be
wider. Some FRA market-makers are prepared to quote shorter dates
than 1 month.
58
How are FRA prices determined? The Zero coupon yield curve, also known as the Spot curve, is a $ $
In most cases today, FRA prices are derived from short-term Interest graphical representation of the theoretical Yield To Maturity (YTM)
Rate futures contracts for the same currency. For example, estimate of the yield which should be paid on non-coupon bearing Derivative
Deutschemark FRAs are typically priced off the EuroDeutschemark instruments of different maturities, given the yields currently
future contracts traded on LIFFE or MATIF. It is for this reason the available for coupon bearing instruments.
FRA market has been referred to as the new Interbank Future
Interest Rate market. Because of the close relationship between FRAs Before moving on use Money 3000 to have a FRA analysis page...
and the futures market, FRAs are often quoted for the same periods
as are traded on Futures Exchanges. Use the Analysis page, FRA for GBP and select
3000 Deposits-MID, Futures curve and Zero curve from
There are a number of ways FRA prices can be calculated including the drop down menus for the same FRAs in the TV
those derived from: fields. You can now compare the rates derived from
the different methods.
❑ Cash deposits
For example, to price a 3 x 6 FRA the 3-month and 6-month
deposit rates are used.
Contract 3-month FRA rate? 6 month

▼
agreed deposit deposit
Trade 3 m rate 6 m rate
❑ Interest Rate futures contracts
❑ Zero coupon yield curve
The FRA is a Money Market instrument involving maturities up to 12

months. However, longer date FRAs are available, for example, 18 x
24. Typically these instruments are priced using the Zero coupon
yield curve.
Instruments such as bonds and Interest Rate Swaps typically pay

coupons regularly to maturity. Therefore their actual yields depend
on the reinvestment rates that can be achieved on the earned
interest. A Zero coupon instrument is one that pays no coupon but is
issued at a deep discount. The difference between the issue and
redemption prices compensates for any such reinvestment of
potential interest payments.
59
$ $ Comparing FRAs with Interest Rate futures contracts

As Interest Rate futures contracts could easily be used in place of
Derivative FRAs, it is useful to compare the following aspects of the instruments:
Forward Rate Agreement... Interest Rate futures contract...
Trading It is an OTC contract between counterparties. In some Contracts are traded in pits or electronically on an
cases the deal may be made via a broker. Exchange.
Contract terms Amount, period and settlement procedures are Amounts, expiry dates and settlement periods are fixed
negotiated between the counterparties. and standardised by the Exchange.
Confidentiality There are no obligations placed on the counterparties Deals are transacted open out cry or using electronic
to divulge the terms of the contract. Different market- systems. Orders and trades are immediately visible and
makers may well quote different bid/offer prices. transparent to all market players. On an exchange there
is only one market price at any one time.
Margin payments No margin payments are required. Usually Initial margin is paid as a % of the trade amount –
compensation payments are made on the settlement marked-to-market. The margin payments are held by
date. the Clearing House. Variation margin is also paid to the
Clearing House on a daily basis depending on the
market price movement.
Credit risk Each side is taking a risk on the counterparty, so each After a trade is made on the Exchange, the Clearing
side accepts a small credit risk. House stands as the counterparty, acting as seller to
every buyer and vice versa. The Clearing House
guarantees the performance of contracts and so there is
no credit risk to the contract parties.
Right of offset A FRA contract is binding and cannot be cancelled or Futures contracts can be off-set.
assigned to a third party without the agreement of both
sides.
60
The ways FRAs and futures contracts can be used to hedge a rise/fall ■ Who uses FRAs? $ $
in interest rates is summarised in the chart below:
Banks Derivative
To hedge rise in interest Within banks, Money Market desks are regular users of
To hedge fall in interest
rates FRAs. The larger US, UK, European and Australian banks
rates
are active market-makers and use FRAs for a number of
Futures Sell contract reasons including the following:
Buy contract
Interest Profit ❑ Balancing the bank’s books

Loss
rate rises
❑ Matching client FRA positions
Interest Profit Loss
rate falls ❑ Arbitrage opportunities against futures contracts
FRAs Buy FRA ❑ Hedging future loan/deposit positions

Sell FRA
Interest Profit ❑ Hedging mismatches in interest rate sensitive instruments

Loss
rate rises – forward gaps
Interest Loss Banks make a profit from the bid/offer FRA price spread.
Profit
rate falls
Corporations and non-bank financial institutions
These organisations also use FRAs to manage interest rate risk. The
credit risk to the market-maker is small as it only involves risk to the
potential settlement involved. No premium is paid by clients for FRAs
– the only costs they incur are those for any compensation payments.
Organisations can also use FRAs to speculate on future interest rate

movements. As FRAs are binding contracts, if a FRA needs to be
closed out for any reason, this is done by arranging a new FRA which
is opposite to the original instrument.
61
$ $ Risks involved ■ FRAs in the market place

There are two types of risk to be considered when using FRAs:
Derivative FRA settlement payments
❑ Basis risk. This arises if the instrument being hedged is not 7 8 9 The settlement rate is usually determined two business days
4 5 6
linked to LIBOR, for example, a US CP. In this case the risk 1 2 3 before the period of the notional loan/deposit for the
0
exists because the rate setting process for the underlying specified reference rate, LIBOR. It is important to note that
instrument is independent of the rate setting for the FRA. the settlement payment is made at the beginning of the loan
period rather than at maturity – the usual procedure for Money
❑ Funding risk. This is related to the creditworthiness of the Market deposits. Therefore the settlement payment has to be
parties involved. Can both sides meet any compensation discounted to its present value at the current market interest rate.
payments due on the settlement date?
You will need to know two equations in order to calculate settlement
There are also risks involved from both the bank’s and the client’s payments – both equations are very similar. One caters for the
points of view. If a bank sells a FRA and interest rates rise situation where the settlement rate is greater than the contract rate so
subsequently, then the bank will suffer a loss and have to pay the the FRA seller compensates the buyer. The other equation is for the
client compensation. The risk clients take is that the FRA locks-in a opposite situation where the settlement rate is less than the contract
future interest rate. If interest rates move in favour of the clients then rate so the FRA buyer compensates the seller.
they cannot benefit, if they move against them then they compensate
the bank.
Settlement rate greater than contract rate
(L – R) x D x A ...Equation 1a
Settlement payment =
(B x 100) + (L x D)
Settlement rate less than contract rate
(R – L) x D x A ...Equation 1b
(B x 100) + (L x D)
L = Settlement rate as a number not %

R = Contract rate as a number not %
B = Day basis – 360 or 365
D = Contract period in days
A = Contract amount
62
Example 1 In either case the XYZ loan will be based on the current LIBOR. The $ $
It is the 10th April 1997 and the XYZ Corporate Treasurer foresees a FRA payment acts as a subsidy bringing down the net cost of
forward funding requirement for 3 months (92 days) from 16th June borrowing. Derivative
to 15th September 1997. The Treasurer thinks that there is a possible
rise in interest rates and therefore wants to hedge against any interest But what would have happened if the Treasurer’s fears of an interest
rate rise. The Treasurer buys a 2 x 5 FRA on the 10th April from rate rise were unfounded and on fixing LIBOR was 6.50%? This time
OkiBank with the following terms: XYZ have to compensate OkiBank. The settlement amount can be
calculated using Equation 1b.
FRA contract amt. $10,000,000
Fixing date: 12th June 1997 (6.75 – 6.50) x 92 x 10,000,000
Settlement date: 16th June 1997 (360 x 100) + (6.50 x 92)
Maturity date: 15th Sept. 1997
230,000,000
Contract rate: 6.75% pa =
36598
= $6,284.50
What is the settlement due if the BBALIBOR 3-month fixing rate is
7.25% the 10th June fixing date, and who receives payment?
Even though XYZ have bought a FRA contract they still have to raise
the funds they require for 16th June to 15th September in the Money
Markets at the increased rate of 7.25%. However, as the interest rates
have risen, OkiBank have to compensate XYZ a cash sum. The
settlement amount is therefore calculated using Equation 1a.
(7.25 – 6.75) x 92 x 10,000,000

(360 x 100) + (7.25 x 92)
460,000,000
=
36667
= $12,545.34
At this point the FRA contract ceases to exist and the XYZ Corporate
Treasurer can now either reinvest the FRA settlement payment in the
Money Markets or arrange a loan for $10,000,000 – 12,545.34.
63
$ $ Forward/forward rates Forward/forward ask rate

It is possible to calculate forward/forward rates from deposit rates If a dealer wants to buy a 3 x 6 FRA, then he thinks that interest rates
Derivative using the following equation: will rise in the period from 3 to 6 months forward. The 3 x 6 FRA can
be considered to be the result of lending for 3 months and borrowing
for 6 as shown in the diagram below.
(RL x DL) – (RS x DS)
RFWD =
(DL – DS) x
[ (
1 + RS x DS
)] Lend
Fwd/fwd ASK
▼
Spot 3 months 6 months
B x 100
RL = Rate from spot to the far date – long period

RS = Rate from spot to the near date – short period
DL = Number of days from spot to far date
▼
DS = Number of days from spot to near date Borrow
B = Day basis This means that the Forward/forward Ask rate is calculated in
...Equation 2 Equation 2 using:
RL = Far deposit Ask

Forward/forward bid rate RS = Near deposit Bid
If a dealer wants to sell a 3 x 6 FRA, then he thinks that interest rates
will fall in the period from 3 to 6 months forward. The 3 x 6 FRA can
be considered to be the result of borrowing for 3 months and lending
for 6 as shown in the diagram below.
Fwd/fwd BID
Borrow
▼
Spot 3 months 6 months

▼
Lend
This means that the Forward/forward Bid rate is calculated in
Equation 2 using:
RL = Far deposit Bid

RS = Near deposit Ask
64
In many cases FRA strips of contracts are used to hedge against If you need to calculate the effective annual interest rate for a strip of $ $
longer term interest rate rises. A strip is simply a number of FRAs the following equation can be used which is based on Equation 3.
consecutive contracts. For example, a strip of four FRA contracts, Derivative
1 x 3, 3 x 6, 6 x 9, 9 x 12 could be used to hedge for a 12 month Effective annual rate, R =
period. However, if a strip of FRAs are used what is the effective rate
over the whole period as different contract rates are used for each
FRA? [[1+
( )] [ ( )] [ ( )] [ ( )]]
L0 x 3
4
x 1+
F3 x 6
4
x 1+
F6 x 9
4
x 1+
F9 x 12
4
–1
Suppose the following strip of two FRAs spans the two period 0 to n
and 0 to N. The rate of return for the time period n to N can be L0 x 3 = Current LIBOR or reference rate
calculated using an equation based on the interest rates due for the
F3 x 6, F6 x 9, F9 x 12 = FRA rates for periods 3 x 6, 6 x 9
time periods.
and 9 x 12 respectively
Rate = Rate = Rate = ...Equation 4
r RN - n RN
FRA1 FRA2
Time Time Time Example 2

▼
period period period XYZ Corporation now needs to protect interest rates for a six month
0 n N
period beginning in 6 months time – a 6 x 12 forward position. The
XYZ Corporate Treasurer could use a 6 x 12 FRA. However, a strip of
two 3-month FRAs, 6 x 9 and 9 x 12, offers the Treasurer the
Interest due for
time period, N
= ( Interest due for
time period, n )(
x
Interest due for
time period, N – n ) flexibility of reversing the hedge at the 9 month period if necessary.
The strip also provides a market limit for a 6 x 12 FRA quote.
Therefore: XYZ need to borrow $5,000,000 in 6 months time for a loan period of
6 months, but the Treasurer thinks interest rates will rise in this time.
[ (
1+
RN x N
B x 100 )] [ (
= 1+
r x n
B x 100 )] [ (
x 1+ RN - n x N – n
B x 100 )] The Treasurer investigates quotes from a number of banks offering
FRAs indexed on a 3-month LIBOR basis.
FRA Bank A Bank B
RN - n =
[ ( 1+
RN x N
B x 100 )] – 1 x 360 x 100 6 x 9 (91d) 6.21 – 6.15 6.23 – 6.18
[ ( 1+
r x n
B x 100 )] N
...Equation 3
9 x 12 (92d) 6.28 – 6.22 6.30 – 6.25
65
$ $ The Treasurer accepts the bid FRA prices from Bank A as the ■ Summary
cheaper and buys a strip of two FRAs – 6 x 9 plus 9 x 12. This
Derivative effectively locks in the interest rates for the 6-month borrowing
period.
6 x 12 month exposure of $5,000,000
▼
❑ FRAs are OTC contracts used to hedge interest rate risk
Buy @ Buy @ Rate = based on a notional future loan or deposit
6.21% 6.28% ?
❑ Settlement payments are made at the beginning of the

FRA 6 x 9 FRA 9 x 12 notional loan or deposit period
Time Time Time ❑ Rises and falls in future Money Market interest rates are
period period period
6 mths 9 mths 12 mths compensated by payments/receipts at the settlement date
❑ FRA contracts are firmly binding

What is the effective FRA rate?
▼
❑ FRA contracts involve no transfer of principal. The only
The effective FRA rate for the strip is calculated using Equation 3. cash payments made are those associated with settlement
payments
[ (
1+
R6 x 12 x N
B x 100 )] [ (
= 1+
R6 x 9 x n
B x 100 )] [ (
x 1+ R9 x 12 x N – n
B x 100 )] ❑ Most FRA contracts use LIBOR as the reference rate
❑ FRA contracts are indicated using the convention of
[ (
= 1+
6.21 x 91
360 x 100)] [ (x 1+ 6.28 x 92
360 x 100 )] (Start month forward) x (End month forward). For
example, 6 x 12 means the contract starts in 6 months
time and ends in 12 months, therefore lasting 12 months
= 1.0157 x 1.01605
= 1.03200
Therefore R6 x 12 = (1.03200 – 1) x 360 x 100

183
= 6.2955 or 6.30% rounded up
66

The following exercises using Reuters products and the Derivative
RT may help your understanding of FRAs and how they
are used.
RT To see the Forward Rate Agreement Speed Guide

type in FRA/1 and press Enter. To display the Major
Currency FRAs double-click in the <TOPFRA>
field.
67
$ $ From the 3-month and 6-month Bid and Ask deposit rates shown
3000 Exercise. Using the FRMW page in Money 3000 can opposite calculate the forward/forward Bid and Ask rates. Assume 3-
Derivative be useful as you can display Bid and Ask prices for a months is 90 days and 6-months is 180 days.
number of currencies from different contributors
simultaneously. For example, you decide to look at a) Forward/forward Bid rate
3 x 6 rates for DEM FRAs from 3 different contributors in order
to select the best rates for you for buying and selling. You look at
the rates and decide that those from HBEL are best. You now
decide to check these rates and calculate the forward/forward
bid and ask prices from deposit rates you display in the MMMW
page.
b) Forward/forward Ask rate
68
■ End check 5. Bank A sells Bank B a 3 x 6 USD FRA at a contract rate of 5.86%. $ $
On the settlement the LIBOR 3-month fixing rate is 5.75%. The
FRA contract details are as follows: Derivative
1. If you as a customer buy a FRA you are:
FRA contract amt.: $50,000,000
❑ a) Protecting against a rise in interest rates Contract period: 90 days
❑ b) Protecting against a fall in interest rates Contract rate: 5.86% pa
❑ c) Taking a cash delivery of principal from the counterparty
❑ d) Making a cash delivery of principal to the counterparty
a) What is the cash settlement amount involved?
2. Today is the fixing date for a 1x4 FRA which you sold for 5.67%. b) Who receives payment?
LIBOR has been fixed at 6.00%. Which of the following
statements is true? Answer a)
❑ a) You pay the counterparty
❑ b) The counterparty pays you
❑ c) No payment takes place until later
3. Which of the following statements best describes why corporations

may prefer to use FRAs rather than Interest Rate futures contracts
to hedge?
❑ a) FRAs are more liquid

❑ b) FRA prices are less volatile
❑ c) FRAs are priced more competitively
❑ d) FRAs are OTC and can be tailored Answer b)
4. A Forward/forward rate is the direct result of:
❑ a) Market expectations of future interest rates

❑ b) Prices quoted for exchange traded Interest Rate futures
❑ c) Values derived from existing deposit rates
❑ d) None of the above
69
$ $ Answers to exercises End check answers to questions
Derivative Exercise ✔ or ✖
a) Forward/forward bid rate = 2.976% 1. a) ❑
Use Equation 2 – for Bid use Far depo Bid and Near depo Ask
(3.0625 x 180) – (3.125 x 90) 2. a) ❑
Interest =
(180 – 90) x
270.00
[ (
1 + 3.125 x 90
360 x 100 )] 3. d)
4. c)
❑
=
90.703125
5. a) $13,555.14 ❑
b) Forward/forward bid rate = 3.349%
Use Equation 2 – for Ask use Far depo Ask and Near depo Bid Use Equation 1b.
(5.86 – 5.75) x 90 x 50,000,000
Settlement =
Interest (360 x 100) + (5.75 x 90)
(3.1875 x 180) – (3.00 x 90)
=
0.11 x 90 x 50,000,000
(180 – 90) x
303.75
[ (
1 + 3.00 x 90
360 x 100 )] =
36000 + (517.5)
=
90.6750 b) Bank B pays Bank A ❑
By inputting the correct details in the FRA you require you can
check your calculations using the Model FRM page.
Bid = 2.9762
Ask = 3.3493
70
Interest Rate futures
■ What are they? particular currency deposited outside the country of origin. For $ $
example, a 3-month Eurodollar Interest Rate future is settled based
Interest Rate futures are forward transactions with on US Dollars deposited outside the US. Derivative
standard contract sizes and maturity dates which are
traded on a formal exchange. An exchange traded futures contract has the following characteristics:
Short-term Interest Rate futures contracts are almost ❑ A standardised specification in terms of unit of trading,
exclusively based on Eurocurrency deposits and are cash trading cycle of contract months, delivery days, quotation,
settled based on an Exchange Delivery Settlement Price minimum price movement etc
(EDSP) or the last price traded.
❑ The opportunity to trade the instrument and offset the
Long-term Interest Rate futures contracts are settled original contract with an equal and opposite trade. Very few
based on government bonds or notes with a coupon and contracts, less than 2%, reach maturity
maturity period specified by the exchange.
❑ A public market in that prices for contracts are freely
If you need an overview of futures derivatives or you need available. Trading takes place open outcry on an exchange
to remind yourself about derivatives in general, then you Derivatives floor and prices are published on exchange indicator
may find it useful to refer to the Introduction to Derivatives Section 2 boards, in the financial press and by providers such as
workbook, Section 2 at this stage. Reuters.
Interest Rate futures are some of the most common futures contracts ❑ Once a trade has been made a Clearing house acts as the
traded on exchanges. Their growth stems from the mid 1970s after counterparty to both sides of the trade. The contract is not
the breakdown of the Bretton Woods Agreement in 1973. The directly between buyer and seller. The Clearing house takes
resulting floating exchange rates in currencies created much more on the credit risk should a counterparty default. This is
volatility in interest rates and the subsequent need to hedge important because it means anyone can have access to the
investments. markets provided they have the required creditworthiness
by the Clearing house – in this way large organisations have
The Chicago Board of Trade (CBOT) introduced the first futures no advantage over smaller organisations or investors.
,,
contracts to hedge interest rate exposure in 1975 when it introduced
,,
contracts on the US Government National Mortgage Association
certificates – known as Ginnie Maes. These contracts are no longer
,,
traded but by 1977 CBOT has added contracts on T-Bonds and in
▼
1982 LIFFE started trading futures contracts on 3 month Sterling
time deposits.
▼
▼
Interest Rate futures are essentially forward contracts in underlying
fixed coupon instruments such as bank deposits and government Clearing house
bonds, notes and bills. Short-term Interest Rate futures based on
Eurocurrencies are cash settled based on interest rates for the Buyer Seller
71
$ $ Exchange contracts
Short and long-term Interest Rate futures contracts are traded on
Derivative exchanges worldwide. Some of the more important contracts are
summarised in the charts below.
LIFFE CME
Short-term Cash settled based on LIBOR Unit of trading Short-term Cash settled based on interbank rates Unit of trading
Three month Sterling (Short Sterling) GBP 500,000 Three month Eurodollar USD 1,000,000
Three month Eurodeutschemark (Euromark) DEM 1,000,000 One month LIBOR USD 3,000,000
Three month Eurolira ITL 1,000,000,000 One year T-Bills USD 500,000
Three month Euroswiss Franc (Euroswiss) CHF 1,000,000 Three month Euromark DEM 1,000,000
Three month ECU ECU 1,000,000 Three month Euroyen JPY 100,000,000
Three month Eurodollar USD 1,000,000 13-week US T-Bills USD 1,000,000
(This contract is for physical delivery)
Long-term Nominal value Maturity Notional CBOT

Government Bonds range years coupon, %
Long-term Nominal value Maturity Notional
Long Gilt (UK) GBP 50,000 10 - 15 9 Government Bonds range years coupon, %
German – Bund DEM 250,000 8.5 - 10 6
Japanese – JGB JPY 100,000,000 7 - 11 6 US T-Bonds USD 100,000 At least 15 8
Italian – BTP ITL 200,000,000 8 - 10.5 12 10 year US T-Notes USD 100,000 6.5 - 10 8
72
Typical contract specifications But what does it all mean? $ $

Short-term
Futures contracts specifications vary from type to type and from This Interest Rate futures contract is for a notional amount of Derivative
exchange to exchange. Have a look at the following 3-month LIFFE £500,000 – unit of trading – which is placed on a 3-month deposit
‘Short sterling’ contract details below. commencing on the delivery day (maturity) of the contract, at an
interest rate which is implied in the futures price agreed at the time
of the trade.
LIFFE 3-month Sterling
Interest Rate Future Typically for financial futures there are 4 delivery months per year –
Unit of £500,000 This is the standard March, June, September and December. It is also possible to have
Trading contract size maturity dates out to several years but ‘far month’ contracts are much
less liquid than the ‘near months’. This means that it is not always
Delivery Mar, Jun This is the trading cycle of possible to get prices for ‘far months’.
Months Sept, Dec contract months
Short-term futures are not quoted as an interest rate percentage.
Delivery Day First business day Instead they are quoted as:
This is the day contract is
after the last
settled 100 minus the implied forward interest rate
trading day
This is the last day and Example
Last Trading 11.00
time on which trading can A forward implied interest rate for a $1 million deposit is 5.55%.
Day Third Wednesday
take place
of delivery month
The futures contract price would therefore be 100 – 5.55 = 94.45.
The futures price is quoted
Quotation 100 minus rate of
according to the type of This convention for pricing short-term futures is based on the way T-
interest
future Bills are quoted – at a discount from the face value of the bill.
Minimum 0.01
price The price movement of a futures contract is measured in ticks. The
movement minimum price movement for a contract is determined by the
(Tick size (£12.50) This is the smallest amount exchange. Depending on the contract, its value is expressed in terms
and value) a contract can change of basis points – a basis point is one hundredth of one percent,
value and the ‘tick’ size 0.01%. So one tick equals one basis point.
Trading 07.15 – 16.02 Exchange trading hours –
hours London time open outcry
APT Trading 16.27 – 17.57
hours Computer-based trading
system hours
73
$ $ This means that a tick has a specific value determined using the Long-term
following equation: The contract specifications for these Interest Rate futures are very
Derivative similar to those for short-term instruments. The major difference is
Tick = Unit of x Basis points x Proportion of year over that settlement is by physical delivery of bonds or notes with coupon
trading 100 which contract runs rates and maturity dates stipulated by the exchange.
Example Although some long-term futures for bonds have prices and
The tick value for the 3-month LIFFE Short sterling contract is: minimum price movements quoted as hundredths of a basis point,
UK Gilts and US T-Bonds are quoted as thirty-seconds of a percentage
point.
= £500,000 x 0.01 x 1
100 4
Example
= £12.50 A UK Long Gilt futures quoted at 111-23 means a price of 111 23/32.
However there are indications that the market convention for UK
On the last day of trading, if a futures position is still open, most Gilts and US T-Bonds may be changed in the near future to that of
short-term Interest Rate futures are cash settled against the EDSP. using basis points.
The exception is the 13-week US T-Bills contract which involves
physical delivery of the instruments. Tick values are easy to calculate for long-term futures:
The EDSP depends on the exchange but typically involves a Tick = Unit of trading x minimum price movement
calculation of interest rates for the Eurocurrency deposit in question.
For example, LIFFE use the British Banking Association Interest
Settlement Rate (BBAISR) and the CME uses an average of a survey The contract details for CBOT T-Bonds are shown opposite.
of rates of the London interbank rates for Eurodollars, LIBOR and
Euromark.
On the last day of trading the futures contract ceases to exist and the
underlying cash market instrument and futures prices are the same.
It is the difference in contract and settlement prices that is paid in
cash – as the principal of these contracts is notional no delivery can
take place on expiry .
74
Profit and loss on a futures contract $ $

Chicago Board of Trade This is easy to calculate using the following method:
US Treasury Bond futures Derivative
Unit of T-Bond with face 1. Determine the number of ticks the price has moved up or down.
This is the standard
Trading value $100,000 The number of ticks is the number of one-hundredths of the
contract size
quotation price.
Delivery Mar, Jun This is the trading cycle of
Months Sept, Dec 2. Multiply the number of ticks by the tick value and the number of
contract months
contracts.
Delivery Day Last business day
of delivery month This is the day contract is Profit/ loss = Number of ticks x Tick value x Number of contracts
settled
Example
Last Trading 7th business day This is the last day and Two 3-month Short-sterling LIFFE contracts are bought when the
Day preceding last time on which trading can interest rate is 6.25%. The contracts are therefore priced at 100 –
business day of month take place 6.25 = 93.75.
Quotation Points and 32nds The futures price is quoted At the delivery date the 3-month LIBOR stands at 6.10% which
of point according to the type of represents a price of 100 – 6.10 = 93.90.
future
Minimum 1/32 of a point The contract has therefore gained in value and the number of ticks
price equals 93.90 – 93.75 = 15.
movement
(Tick size ($31.25) This is the smallest amount The profit on the contract = 15 x £12.50 x 2
and value) a contract can change = £375.00
value and the ‘tick’ size
Trading 07.20 – 14.00
hours Chicago time Exchange trading hours –
open outcry
Project A 14.30 – 16.60
Trading hours 22.30 – 06.00 Computer-based trading
system hours
75
$ $ Typical contract quotations

Interest rate futures quotations are available from the financial press
Derivative such as the Financial Times and The Wall Street Journal and from
products such as Reuters 3000. The information appears in formats
similar to those following.
Financial press – Short-term Interest Rate futures Financial press – Long-term Interest Rate futures
LIFFE 3 month Sterling Futures £500,000 points of 100% CBOT Treasury Bonds $100,000 points 32nds of 100%
Open High Low Settle Open High Low Settle

Mar 93.74 93.76 93.74 93.75 Mar 112-19 112-24 110-25 110-28
Jun 93.55 93.57 93.55 93.56 Jun 112-03 112-13 110-09 110-13
Sep 93.35 93.37 93.33 93.35 Sep 111-24 111-24 109-29 109-31
Dec 93.20 93.21 93.17 93.18 Dec 110-16 110-16 109-17 109-17
Reuters 3000 – LIFFE Short and Long-term Interest Rate futures Reuters 3000 – CBOT Short and Long-term Interest Rate futures
76
■ Who uses Interest Rate futures? As in any futures market place for commodities, hedgers can hold $ $
long or short positions and in order to hedge their positions market
Hedgers and speculators players need to take an opposite position to the ones they hold. Derivative
Originally futures contracts were devised so that holders
of an asset could hedge or insure its price today for It is important to understand that the principle of hedging is to
sometime in the future. Hedgers seek to transfer the risk maintain a neutral position. As prices in the cash market for the asset
of future price fluctuations by selling future contracts which move one way, the move is compensated by an equal and opposite
guarantee them a future price for their asset. If the future cash price move in the futures’ price. You can imagine the situation similar to
of their asset falls then they have protected themselves. However, if the movement of the pans on a pair of scales.
the future cash price rises then they have lost the opportunity to
profit. Hedging offers some degree of certainty for future prices and
therefore allows market players to fix prices, interest rate payments or
receipts etc.
Hedgers are typically banks, multinational organisations,

governments, bond dealers and fund managers. Cash Futures
Speculators are market players who take on the risk of a futures

contract for an appropriate price and the potential rewards.
The transfer of risk sought by hedgers is possible in the markets

because different market players have different strategies and Going short futures
include: If a market player holds, or intends to hold, an asset in the cash
market, then he has a long position. The opposite position in the
❑ Hedgers with opposite risks futures markets means he must go short or sell futures.
❑ Hedgers already holding positions who need to offset their A borrower, who intends to hold cash, needs to protect against the
positions possibility that spot prices fall with a corresponding rise in interest
rates. A short hedge will therefore lock in a selling price.
❑ Speculators with market views on likely price changes who
provide the futures markets with extra liquidity Going long futures
If a market player is short, or intends to go short, in the cash market,
then the opposite position in the futures markets means he must go
long or buy futures.
A lender, who intends to deposit cash, needs to protect against the

possibility that spot prices rise with a corresponding fall in interest
rates. A long hedge will therefore lock in a selling price.
77
$ $ Another way of considering market players using Interest Rate futures Sellers of Interest Rate futures
contracts is to look at whether they are buyers or sellers of the
Derivative contracts. ❑ Agree to deliver the underlying instrument and
therefore go short.
Buyers of Interest Rate futures
❑ Are borrowers and are hedging against any rise in interest
❑ Agree to take delivery of the underlying instrument and rates. If interest rates do rise, then any losses in selling the
therefore go long. underlying in the future are offset by gains from the futures
contracts on delivery.
❑ Are lenders and are hedging against any fall in interest
rates. If interest rates do fall, then any losses in buying the The diagrams below show how the losses in the underlying
underlying in the future are offset by gains from the futures instrument are offset by gains in the futures market.
contracts on delivery.
Underlying market Futures market
The diagrams below show how the losses in the underlying
Profit
Profit
instrument are offset by gains in the futures market. Futures price
Cash price
falling falling
+
rising
Underlying market Futures market rising
–
Profit
Profit
Loss
Loss
Cash price Futures price
falling
+
rising
Net cash loss Net futures gain
falling rising
–
Loss
Loss
In summary:
Net cash loss Net futures gain Short hedge Long hedge
• Sell futures • Buy futures
As interest rates So futures prices • Protects against rise • Protects against fall
in interest rates in interest rates
Rise Fall
• Locks in selling price • Locks in buying price
Fall Rise
• Used by borrowers • Used by lenders
78
Hedging and hedge ratio Short hedge – selling futures $ $

In order to hedge a position it is necessary to match the futures A short hedge can be used by an investor needing to hedge against
contracts as closely as possible with that for the underlying price falls resulting from rising interest rates. This type of hedge can Derivative
instrument in terms of maturity dates, amounts involved etc. In also be used to hedge a future loan to prevent higher borrowing
practice it is difficult to obtain the conditions for a perfect hedge! costs.
The number of futures contracts required – the hedge ratio – is Example

simply calculated from the equation: It is 12th June and a Corporate Treasurer has just borrowed £1
million for a 3-month period at an interest rate of 6.0%. In 3-months
Number of contracts required = time the loan will roll-over and the Treasurer is worried that interest
rates will rise by then. The treasurer decides to hedge his position by
Sum to be hedged Actual number of days Number of futures selling 3-month LIFFE Short sterling futures at 93.50. But how
x x
Unit of trading Day basis x No. contracts/year contracts per year many?
Number of = £1,000,000 = 2
For most short-term Interest Rate futures this equation reduces to: contracts required £500,000
It is 11th September and the loan is rolled over and interest rates
Number of = Sum to be hedged
have risen to 6.75%. What is the result of the Treasurer’s hedge?
contracts required Unit of trading
Money markets Futures market
In the examples that follow the sums to be hedged have been 12th June
selected to match unit of trading amounts to simplify the Fears of interest rate will rise from Sell 2 x Sept contracts at 93.50
calculations. 6% (implied interest rate of 6.5%)
30th April
Roll over loan at 6.75%% Buy 2 x Sept contracts for 92.75
(implied interest rate of 7.25%)
to close position
Extra cost Gain

0.75% on £1m for 3 months = £1875 75 ticks x £12.50 x 2 = £1875
This perfect hedge is unlikely in practice. For example, the futures

gain is not paid as a single instalment but as daily margin payments
which are described later. Also the extra roll over loan interest would
not be payable until the maturity of the loan in 3 months time.
79
$ $ So by selling the futures contracts the Corporate Treasurer has Suppose the following:
hedged the expected rise in interest rates. He has to borrow at a 1st July 31st July
Derivative more expensive rate in the Money Markets but this is compensated by
the gain in buying the futures cheaper than they were sold originally. 30-Day Fed Funds futures price 94.56 95.16
The hedge would also have worked if rates had fallen. The Corporate Implied 30-Day interest rate 5.44% 4.84%
Treasurer would have borrowed at a lower rate in the Money Markets
thus making a gain which would have been offset by a loss on the
futures because they would have risen in price from the original sale
On 1st July the rates have fallen, as expected by the Treasurer to
price.
4.80%. What is the result of the Treasurer’s hedge?
Long hedge – buying futures
Money markets Futures market
A long hedge is typically used by lenders of cash market funds who
need to fix an interest rate for a future date and are worried that
1st July
interest rates might fall.
Deposits $50 million at 4.80% Buy 10 futures at 94.56
Example
31st July
It is 12th June and a Corporate Treasurer has USD funds to lend in
Receive back $50 million plus Sell 10 futures at 95.16
July. The Treasurer is worried that rates may fall during June thus
interest at 4.80% for 1 month.
affecting the interest he is likely to receive.
Interest = $206,666.66 Gain on long position =
60 ticks x $41.67 x 10 =
The Corporate Treasurer will have $50 million to lend and decides to
$25,002.00
hedge his position using CBOT 30-Day Fed Funds futures. The unit
of trading is $5 million and the tick size is $41.67 per basis point.
Net gain on position = 206,666.66 + 25,002.00 = $231,668.66
Number of contracts required =
Net % return = 231,668.66 x 360
50,000,000 31 50,000,000 31
x x 12 = 10.33
5,000,000 30 x 12
= 0.0538
This means that the Treasurer has to buy 10 contracts – a perfect = 5.38%
hedge is not possible – and hold the futures until maturity or close
out prior to expiration. The perfect hedge requires a 5.44% return, but as only 10 contracts
could be bought, this compares well with a cash market return on
unhedged funds at 4.80%.
80
Speculation Relationship with OTC forward contracts $ $

Speculators attempt to exploit price movements in the markets and An interest rate future contract is in effect an exchange
thus provide additional liquidity for hedging activities. Speculators do traded 3-month Forward Rate Agreement (FRA). It is the MMI:FRA Derivative
not necessarily have a position and use their market knowledge to equivalent of a FRA with margins.
profit.
+ margins Interest
Example
▼
FRA Rate
A trader is expecting that the June balance of trade figures will be futures
better than expected causing short-term interest rates to fall and
therefore futures prices to rise. Based on this view the trader buys one The two instruments are compared in the table below.
3-month June LIFFE Short sterling contract at 93.55. This implies a 3-
month GBP interest rate of 6.45%. FRA Interest rate future
The next day the trader is viewing the news on his RT and is proven • Flexible • Standard contract
correct – interest rates have fallen by 0.5%. The trader therefore sells terms
his contract at the new market price of 94.05 and gains 50 ticks. • OTC market
• Exchange traded
His profit is 50 x £12.50 x 1 = £625.00. • No margin required
• Margin required
Suppose, however, that the trade figures had been worse than • Credit risk between
expected and interest rates had risen by 0.5%? The trader would have counterparties • No credit risk as
closed out the contract at 93.05 and made a loss of 50 ticks which is clearing house stands
£625.00. • No right of offset as counterparty
• Terms of contract are

confidential
The chart below compares the relative ways in which the two
instruments are used to hedge interest rate price movements.
To hedge an
Fall Rise
interest rate ..
Futures Buy Sell
FRAs Sell Buy
81
$ $ ■ Interest Rate futures in the market place The process is illustrated as follows:
On the contract date
Derivative This section deals with a number of important matters
The Seller sells a contract to the Buyer and both deposit initial
concerning Interest Rate futures which you will need to
7 8 9
margin with the Clearing house.
,,
4 5 6
1 2 3
understand.
0
How an Interest Rate futures contract works

When a futures contract is agreed no payment is made. Instead both
parties are required to deposit a margin with the Clearing house
initial margin
payment
initial margin
payment
,,
,,
▼
▼
which acts as the counterparty to both sides. The initial margin is only
a small percentage of the contract price and it is used to cover daily
price movements of the futures’ price in relation to the agreed price.
Clearing house
Each day the futures’ position is marked-to-market which means it is
revalued at the current market price. Any profits and losses are paid Buyer Seller
over daily. By marking-to-market and settling all positions daily the
Clearing house effectively rewrites all futures contracts at the
prevailing market price. During the contract
The Seller’s and the Buyer’s profit and loss accounts are adjusted
If the initial margin is depleted then extra margin – variation margin daily.
,,
– is required. If a profit is made the account will receive it and it may
,,
be withdrawn. The system of maintaining the correct margin ensures
that the loser can bear any losses and the winner is credited with
,,
gains.
▼
variation variation
Dealing on margin is an example of gearing or leverage. Gearing margin margin
allows investors to make a larger investment than could otherwise be payment payment
▼
afforded. Small investments are used to generate large profits,
however, losses can be correspondingly large! For example, a £1000 Clearing house
investment in a futures contract is equivalent to buying a basic
investment of £10,000 – 20,000. Buyer Seller
As the expiry date of the contract approaches the futures price will
equal the current instrument price and so the differential is not very
large. This is why the vast majority, over 98%, of futures contracts are
closed out before the contract reaches the agreed expiry date.
82
On the delivery date or contract closure Advantages and disadvantages of Interest Rate futures $ $
The Seller’s and the Buyer’s profit and loss accounts are settled for The following chart summarises the advantages and disadvantages of
the last time. Interest Rate futures: Derivative
,,
,,
Advantages Disadvantages
,,
▼ • Markets in the major • Only a limited number of
▼
variation variation contracts for Eurodollars, contracts available
margin margin US T-Bonds and UK Gilts are
payment payment large and very liquid • It can be difficult to hedge
positions exactly – matching
▼
▼
Clearing house • The use of margin payments exact amounts and required
allows highly leveraged dates is not always easy
Buyer Seller positions
• When hedging long-term
• Contracts can be bought and futures, the price/yield
sold without having to own relationship varies
the underlying continuously with time and
therefore the hedge ratio
• Most contracts are offset and varies continuously
only a very small percentage
expire resulting in delivery • The mark-to-market
settlement system can lead
to large cash outflows for
adverse price movements
• Trading is usually
concentrated in near month
contracts
• Liquidity can be limited for

far month contracts
83
$ $ Trading strategies for Interest Rate futures Have a look at the prevailing futures prices that the Treasurer sells
There are a number of strategies that traders adopt in order to hedge the contracts:
Derivative positions which do not have ‘perfect’ matches in the futures markets.
The simplest strategies used are: Sell 10 Sept contracts at 94.29 Implied rate 5.71%
Sell 10 Dec contracts at 94.27 Implied rate 5.73%
❑ Futures strips Sell 10 Mar contracts at 93.95 Implied rate 6.05%
Sell 10 Jun contracts at 93.56 Implied rate 6.44%
❑ Stacking futures
Using a strip of futures has effectively locked in the interest rate for
❑ Spread trading the forward 12 month period but what is the rate. The average of the
four interest rates is 5.98% but unfortunately the calculation is not
Futures strips that simple!
These are used to hedge interest rate exposures which span several
futures expiry dates, or span dates which do not exactly match The general equation to calculate a forward-forward rate is given
futures expiry dates. below:
The buyer of a September LIFFE Short sterling futures at 94.29

(La x da) x (Lb x db) 1
effectively commits him or herself to lending a notional £500,000 for F axb = x
3 months commencing on the contract expiry rate of 5.71%. The
seller of the same contract commits him or herself to borrowing the
notional amount.
[ (
1 +
(Lb x db
360 or 365
)
)] (db – da)
Example
F a x b = Forward starting in a days and ending in b days
It is early June and a Corporate Treasurer calls a bank to ask for the
price of a one year deposit loan for £5 million starting in September
La = Long period interest rate as a decimal
– a 3 x 15 forward price. The Treasurer is worried that rates will rise
in the next three months and wishes to hedge the current loan
Lb = Short period interest rate as a decimal
interest rates. The period required for the hedge spans four
consecutive, futures expiry dates and the Treasurer can sell a strip of
da = Long period in days
four futures. The number of contracts required to sell ( borrow
effectively) is 10 per contract – the unit of trading for the contract is
db = Short period in days
£500,000.
Sept Dec Mar June Sept

Exposure
Futures strip Sell 10 Sell 10 Sell 10 Sell 10
84
The rate is in fact a compound of the notional quarterly interest rate Stacking futures $ $
payments given by the following equation: Suppose in the previous example that the September futures contract
was the only one available. There is still a risk that interest rate will Derivative
rise over the next year but the Treasurer has only one contract
F = 1 –
[( 1 +
4)(
R1 R
)
x 1 + 2 x...
4 ( 1 +
Rn
4 )] available.
In such a situation a stack of futures are used. In this case 40

contracts are used – 4 x 10 contracts for the four periods. Using the
F = Forward compound rate
same futures prices for selling and buying 40 September futures with
Rn = Rate for period n a gain of 74 ticks results in a profit of 74 x £12.50 x 40 = £37,000.
n = Number of contracts in strip
Sept Dec Mar June Sept
Exposure
In this example the rate is 6.12%.
Suppose in September, the one year LIBOR is 6.75%. If the Treasurer Futures stack Sell 10
had accepted a quote of 6.12% then the loss covering the cash loan
would have been 5,000,000 x 0.0063 = £31,500. Sell 10
However, if the Treasurer closes out 10 contracts for each period by Sell 10
buying, then the gains are as follows. For each contract subtract the
buy from the previous sell price and to calculate the profit multiply Sell 10
the number of ticks by £12.50 and by 10 for the number of contracts.
Buy 10 Sept contracts at 93.55 +74 ticks profit = £9,250

Buy 10 Dec contracts at 93.45 +82 ticks profit = £10,250 The effectiveness of using a stack of futures depends on the yield
Buy 10 Mar contracts at 93.35 +60 ticks profit = £7,500 curve of interest rates. If the yield curve retains its shape then the
Buy 10 June contracts at 93.26 +30 ticks profit = £3,750 hedge using a stack is as effective as using a strip of futures. If the
Total gains = £30,750 yield curve is positive and steepens, then the stack produces poorer
results. However, even though the stack may not be as effective as
The net loss to the Treasurer is therefore 31,500 – 30,750 = £750. desired it produces better results than no hedge at all!
The hedge is not perfect but a large loss which could have resulted
from not hedging the deposit has been averted.
The use of strips is restricted to prices for the far months required,
but what happens if this is not the case?
85
$ $ Spread trading Basis and Basis risk

A spread trade is also known as a straddle. This method of trading Cash futures basis is a reflection of the net cost of carry for a cash
Derivative involves buying/selling futures contracts for one delivery month and position to expiry date of the futures contract. The relationships are
simultaneously selling/buying the same number of contracts for a shown here:
different month.
Futures price = Cash price + Net cost of carry
If interest rates move, then one position hedges the other. The result
is a less risky position than an outright long or short position. Basis = Cash price – Futures price
For futures contracts basis is also a term used to describe the

difference between the forward price of a gap in the underlying cash
markets, for example, 3 x 15, and the implied forward price in the
relevant futures contract. Basis risk describes how these prices vary or
the extent to which risk changes. The extent of this basis risk
determines the effectiveness of the hedge.
When dates of the underlying gap matches dates implied in relevant

futures contracts, basis risk can be small.
Where strips are used, mismatches in dates or underlying assets are

not directly priced against Money Markets, then basis risk can be
considerable.
Market players need to monitor basis and basis risk to hedge futures
to maximise profitability. It is also important to remember that
futures are marked-to-market daily which means that the underlying
Money Market exposure being hedged must be revalued daily.
86

Derivative
❑ An Interest Rate future is an exchange traded forward

transaction with a standard contract size and maturity
dates
❑ Short-term futures are mostly based on Eurocurrencies

and are cash settled against an Exchange Delivery
Settlement Price
❑ Long-term futures are settled by physical delivery of the

underlying government bonds or notes
❑ Hedgers who are lenders, buy futures or go long, to

protect against any fall in interest rates
❑ Hedgers who are borrowers, sell futures or go short, to

protect against any rise in interest rates
❑ A Clearing house acts as counterparty to both buyers and

sellers of a futures contract which is marked-to-market
daily
87
Derivative The following exercises using Reuters products and the

RT may help your understanding of Interest Rate futures
and how they are used.
RT To view the Speed Guide for Global Futures and

Options Exchanges type in FUTURES and press
Enter. Select the field for the country you are
interested in – in this case double-click in the
<GB/FUTEX1> field. From the list of exchanges select the
exchange of interest – double-click in the <LIF/FUTEX1> field.
From this page you can now select a chain of prices for a
particular contract and the contract specification if you require
this. The screens below show information for the LIFFE 3-month
Short Sterling contract.
88
$ $
RT You may also find the Exchange Traded Interest 3000 The Futures folder, IR Watch page, IFW, is useful Derivative
Rate Futures Speed Guide useful. These pages list for any particular currency to compare short and
all the contracts and easy access to chains of prices. long-term futures contracts. In the Contract 1 and 2
Type in FUT/IR1 and press Enter. Use the F12 and fields enter the details you require. In the example
F11 keys to page up and down respectively. here LIFFE Short sterling and Long Gilt information is displayed.
89
$ $
Derivative 3000 The IFW page can also be used to display one of the 3000 Finally the IFW page can be used to display details
most important futures contracts – the IMM 3- of similar futures contracts offered by different
month Eurodollar contract. The example here exchanges. In the example here you can compare
shows details for the IMM 3-month Eurodollar prices of Euroyen contracts from LIFFE and SIMEX.
contracts and the long-term CBOT US T-Bonds contracts.
90
■ End check 5. A trader at XYZ Bank thinks that trade figures will be better than $ $
expected resulting in a short-term interest rate fall. He buys 5
June LIFFE 3-month Short sterling contracts at 93.72. The Derivative
1. Which of the following interest rates is implied for a LIFFE 3- contract’s minimum price movement is 0.01 and the tick value is
month Short sterling futures contract with a price of 93.18? £12.50.
❑ a) 5.82% a) What is the implied interest rate for the contract?
❑ b) 6.72% b) If the trader is correct and interest rates fall and he sells the
❑ c) 6.82% contract at 93.17, how much profit does the dealer make?
❑ d) 7.82% c) If the trader is wrong and he has to close the contract at 94.03,
what is his loss?
2. If you place an order for a futures contract, when will you be
required to pay initial margin? Answer a)
❑ a) At expiry of the contract
❑ b) Only if you buy a contract
❑ c) At the time of trading the contract
❑ d) Only if you sell a contract Answer b)
3. When trading in futures, credit risk lies with which of the
following?
❑ a) The exchange Clearing house

❑ b) The broker who takes your order
❑ c) The counterparty with whom the trade is made
❑ d) The pit trader placing your order
4. Consider the following CME Eurodollar futures prices. Answer c)

Mar 9378 Jun 9374 Sep 9370 Dec 9366
Which one of the following statements is true?
❑ a) The USD yield curve is inverted

❑ b) The USD yield curve is positive
❑ c) A weak USD on foreign exchanges is expected
❑ d) None of the above
91
$ $ End check answers to questions Your notes
Derivative ✔ or ✖
1. c) ❑
2. c) ❑
3. a) ❑
4. b) ❑
5. a) 6.28% ❑
Implied interest rate = 100 – 93.72
= 6.28
b) £3437.50 ❑
Contract moves 93.72 – 93.17 = 0.55 = 55 ticks
Therefore profit = 55 x £12.50 x 5 = £3437.50
c) £1937.50 ❑
Contract moves 94.03 – 93.72 = 0.55 = 31 ticks
Therefore profit = 31 x £12.50 x 5 = £1937.50
92
Interest Rate Swap (IRS)
■ What is it? The growth of IRSs can be traced to the early 1980s. But why have $ $
these long term OTC derivatives become so important? IRSs are
An Interest Rate Swap is an agreement between characterised by the following: Derivative
counterparties in which each party agrees to make a
series of payments to the other on agreed future dates ❑ The interest amounts for both sides of the agreement are
until maturity of the agreement. Each party’s interest calculated from the same notional principal amount. This
payments are calculated using different formulas by means that there is no physical exchange of the principal.
applying the agreement terms to the notional principal Therefore the risk involved in the swap is reduced to that of
amount of the swap. assessing the credit risk that the other side may default on
their interest rate payments.
If you need an overview of swap derivatives or you need to
❑ The two rates of interest are calculated for the same
remind yourself about derivatives in general, then you Derivatives
currency.
may find it useful to refer to the Introduction to Derivatives Section 4
workbook, Section 4 at this stage.
❑ The interest payments between both parties are usually
netted so it is only the difference in payments which is paid
IRSs are the most important of the OTC swap derivatives currently
to one side or the other. It is for this reason that IRSs are
traded in the global markets. An IRS is in effect an agreement which
sometimes known as contracts for difference.
allows both parties access to better interest rates than they would
normally receive in the markets.
The OTC nature of IRSs means that their terms and conditions can
be very flexible. However, in practice, most agreements are for plain
In other words Party A and Party B both borrow the same amount, at
vanilla – fixed-for-floating – swaps. One side pays a fixed rate whilst
the best interest rates they can and then swap the interest rate
the other pays a floating rate – the situation illustrated in the original
payments to the benefit of both parties. The cost of borrowing for
diagram opposite.
both parties is reduced without altering the underlying principal
loans. The interest rates bases for the loans are therefore separated
Floating-for-floating swaps are available but terms and conditions
from the underlying instruments.
involved with these can be quite complex.
Fixed rate interest payments

,,
,,
▼
,,
▼
Floating rate interest payments
Party A Party B
93
$ $ Although OTC agreements are customised for individual customer

requirements, both the British Bankers Association (BBA) and the Confirmation
Derivative International Swaps and Derivatives Association (ISDA) issue Date: July 1, 1997
To: OkiBank
standard terms and conditions relating to a range of swap derivatives. Attention: Swaps Group Leader
From: MegaBank
Once an agreement is made, most confirmation notes include the
relevant information. For example, a plain vanilla IRS confirmation We are pleased to confirm our mutually binding agreement to enter into a Rate Swap Transaction with
you in accordance with our telephone conversation with Mr. Deal on July 1, 1997, pursuant to the Master
note typically includes: Interest Rate Exchange Agreement between us dated as of July 1, 1997.
OkiBank Rate Swap Transaction Reference Number 00000
❑ Effective date Effective Date:

Termination Date:
July 1, 1997
July 1, 2002
This is the date of the swap when interest on both sides Notional Amount $50,000,000
starts to accrue. For plain vanilla swaps this date
Fixed Rate Payor: OkiBank
is taken as spot and LIBOR is fixed on the trade Floating Rate Payor: MegaBank
date. These are the same conventions as used MMI:DEP MegaBank Calculation Periods for Payments:
for Money Market deposits. First period: Effective Date to but excluding January 5, 1998.
Last period and End Dates: Each July 1 and January 1 after the first Period End Date,
subject to the Modified Following Banking Day convention, and
finally the Termination Date.
❑ Termination date OkiBank Calculation Periods for Payments:
This is the end date of the contract – the date of the final First period: Effective Date to but excluding July 1, 1998.
Last period and End Dates: Each July 1 after the first Period End Date, subject to the
difference in interest payments. Modified Following Banking Day convention, and finally the
Termination Date.
❑ Notional amount Payment Dates:

Fixed Rate:
Each party date on its own Period End Dates
x percent per annum
This is the amount used for interest rate calculations on Fixed Rate Day Count Fraction: 30/360
both sides. Floating Rate Option: LIBOR

Designated maturity: six months
Floating Rate Day Count Fraction: Actual/360
Reset Dates: First day of each MegaBank Calculation Period
❑ Fixed rate payor/receiver
Office or branch through which we are acting: Principal Office in New York
As it could be misleading to refer to buying or selling swaps, Office or branch through which you are acting: Principal Office in New York
it is usual to refer to the party who pays or receives the fixed Arrangement Fee: None
rate. Documentation: The Master Interest Rate Exchange dated as a July 1, 1997 between OkiBank
and MegaBank as modified by this confirmation.
❑ Floating rate payor/receiver

Please confirm to us that the terms set forth herein accurately reflect our Rate Swap Transaction with
If the fixed rate receiver has been specified, then by you by signing a copy of this Confirmation and sending it back promptly by hand or by facsimile
transmission. Please notify us immediately if you believe there is an error in this Confirmation.
implication this side must be also the floating rate payer
Confirmed:
and vice versa. In many cases swap traders only specify what
is happening on the fixed side. MegaBank OkiBank
By By
❑ Interest rate calculations Title: Title:
This includes all the necessary details relating to:

• Reference interest rate, for example, LIBOR
• Payment periods and dates
• Day count conventions An example of a typical Fixed/Floating Swap Confirmation note based on
Sajitas Das, Swaps, IFR 1987
❑ Arrangement fees
94
IRSs are the most important of the swap derivatives both in terms of The ISDA data also shows that IRSs involving the USD dominate the $ $
the face value of OTC contracts not yet settled – the notional markets. The chart below indicates the top five currencies by
outstanding values, and in terms of the average daily turnover. The percentage market share based on the USD equivalent of notional Derivative
following statistics are taken from the BIS Report 1995: Central Bank principal outstanding.
Survey of Foreign Exchange and Derivatives Market Activity. Currency % Market USD billion
equivalent
Derivative Outstanding notional Average daily turnover
USD billions USD billions USD 34.12 4,371.7
JPY 22.61 2,895.9
Interest Rate Swap 18,283 62 DEM 11.23 1,438.9
FRF 9.52 1,219.9
Currency swap 1,957 7 GBP 6.67 854.0
Other 15.85 2030.6
The latest data from the ISDA Summary of Market Survey Statistics: 1995 Total 100.00 12,811.0
Year End confirm the dominance of the IRS markets as the chart
below shows.
Notional principal outstandings USD

15
12,811
USD Equivalent, Billions
12
9 JPY
Other
6
GBP
3,704
FRF DEM
3
1,197 Source: ISDA
0
Interest Interest Currency
Rate Swaps rate options swaps
Source: ISDA
95
$ $ ■ Who uses IRSs? It is this access to different markets which in effect provides credit
arbitrage in the markets. The difference in organisations‘ credit
Derivative Banks and corporations ratings can result in considerable differences in yield gaps on fixed
The ISDA data below shows that the market players using rate debt such as bonds and floating rates paid on loans. Many bond
IRSs the most are banks and multinational corporations. issues are swap driven because issuers can take advantage
of IRSs to swap the interest payments on the funds raised
Market player % of users based on into a different rate basis. Often these transactions also FXI:CSP
year end outstandings involve a Currency swap which effectively converts a
domestic loan into one for a foreign currency.
Corporations 24
Banks 53 Organisations with good credit ratings usually find it easier to borrow
Institutional investors 7 at fixed rates, whilst those with lower ratings tend to get their best
Government 9 terms on a floating rate basis.
Other 7
Have a look at the following example to see how a plain vanilla IRS
Total 100 works between the XYZ and AYZ Corporations. The original lenders
of the loans on both sides need not even know that the
counterparties have entered into a swap agreement.
IRSs are used increasingly by these market players for two main
reasons:
Example – a plain vanilla IRS
❑ To hedge exposure on interest rates Consider the following situation:
❑ To speculate in the swaps markets in order to make a profit XYZ is a multinational corporation with a credit
from offsetting fixed/floating rate transactions rating of AAA. XYZ needs to borrow $50 millions
for 5 years. XYZ can borrow at a low fixed rate but
IRSs also offer the following benefits to corporations and banks: would prefer to take advantage of a floating rate
basis loan. XYZ would like to take advantage of floating rates in order
❑ Counterparties are able to convert underlying interest rates to maximise any interest rate gaps.
from fixed to floating and vice versa over a long term
period AYZ is a corporation with a lower credit rating of
BBB who also need to raise $50 millions for 5
❑ Usually there are cost savings to both sides years. Because of AYZ‘s lower credit rating
borrowing on a floating rate basis or issuing a
❑ IRSs provide access to markets not normally available to the bond with a high value coupon is easier than obtaining a fixed rate
market players, for example, for reasons relating to credit loan. AYZ would prefer a fixed rate loan in order to predict future
rating interest rate payments.
96
The chart below summarises both corporation’s position. $ $

11.75%
Rates XYZ can borrow AYZ can borrow Derivative
Fixed @ 10.00% 12.00%

LIBOR + 1%
XYZ AYZ
Floating @ LIBOR LIBOR + 1%
Required basis Fixed Floating Pays fixed rate of Pays floating rate
10% to lender of LIBOR + 1% to
lender
In order to obtain the type of loan both corporations require they
enter into a swap agreement. Both corporations need to assess the
risks involved if the other side defaults on payments – if this does
happen then the party who does not receive an interest payment still
has to pay the interest due on the underlying loan.
This is how the IRS works...

The chart below shows how both sides benefit from the swap.
❶ XYZ borrows at a fixed rate of 10%
XYZ AYZ
❷ AYZ borrows at a floating rate of LIBOR + 1%
Pays out LIBOR + 1% + 10% 11.75% + LIBOR + 1%
❸ XYZ and AYZ enter into an IRS agreement for a notional
principal amount of $50 millions with interest payments to Receives in 11.75% LIBOR + 1%
be exchanged for a 5 year period where:
Payments = LIBOR + 0.75% 11.75%
• XYZ make floating rate payments of LIBOR + 1% to AYZ
• AYZ make fixed rate payments of 11.75% to XYZ Without swap LIBOR 12.00%
AYZ pays this higher fixed rate to XYZ to compensate this
corporation as it has the higher credit rating Savings 0.75% 0.25%
97
$ $ Another way of considering the swap is as follows: Market-makers

Most IRS agreements now involve a market-maker and two separate
Derivative ❑ Without the swap both XYZ and AYZ pay a total of clients who wish to enter a swap, but not necessarily with each other.
12.00% + LIBOR in interest rate charges For example, it may be that the perceived credit risks involved in a
direct swap agreement are not acceptable to one or both parties. By
❑ With the swap both parties pay a total of 11.00% + LIBOR acting as a two-way market-maker a bank acts as an intermediary
(10.00% + LIBOR + 1%) in charges creating a double swap in which both parties are effectively
guaranteed interest payments will take place.
,,
Thus using the swap there is a net saving of 1.00% which in this case
is split 0.75%/0.25% in favour of XYZ which is the organisation with
the better credit rating.
Fixed rate Fixed rate
,,
,,
▼
Originally swaps were arranged directly between counterparties with
banks merely acting as agents for both sides. Now many banks act as
▼
intermediaries and make a two-way market in swaps by taking one
side of the transaction. Floating rate Floating rate
Market-maker
Party A Party B
Of course, the market-maker does not enter into these swaps for no
reward. The intermediary is paid a fee which is either based on the
principal notional amount involved, a spread between the two-way
prices quoted for swap repayments – the swap rate, or both.
In the US and to a lesser extent in the UK, swap rates are quoted over
the yield on a Treasury note with comparable maturity.
For example, a market-maker may quote ‘70/75 over’ for a swap

based on a 5-year T-Bond which has a yield of 8.00%. This means the
market-maker pays at a rate of 8.70% and receives at a rate of 8.75%.
Have a look at the following example to see how a double swap

works...
98
Example – a double swap $ $

Consider the following situation: 8.70% 8.75%
Derivative
A US swap market-maker, BigBank, are quoting a
LIBOR LIBOR
fixed rate of 70/75 over for a 5-year period against
a floating rate of LIBOR flat.
XYZ BigBank AYZ
8.70/8.75
XYZ is a Money Markets fund which has invested in
floating rate assets which are yielding, on average,
LIBOR + 0.2%. XYZ believe that LIBOR will fall so
they would prefer fixed rate interest payments.
LIBOR + 0.2% LIBOR + 1%
XYZ enter into a swap with BigBank to receive a
fixed rate of 8.70% against paying a floating rate of LIBOR.
AYZ is a corporation that can either borrow at a

fixed rate of 10% or issue a Floating Rate Note Floating Floating
(FRN) with a floating rate repayment of LIBOR + The chart below shows how both XYZ and AYZ effectively turn their
1%. AYZ would also prefer fixed rate interest interest rate payments/receipts into fixed rates and the savings AYZ
payments for their loan. AYZ also enter into an IRS makes.
with BigBank but AYZ pay 8.75% against receiving LIBOR.
XYZ AYZ
Pays out LIBOR LIBOR + 1% + 8.75%
Receives in LIBOR + 0.2% + 8.70% LIBOR
Payments = 8.90% 9.75%
Without swap – 10.00%
Savings – 0.25%
Loan basis Fixed Fixed
99
$ $ The convention of quoting a swap rate as described separates the Your notes
credit risk element from the general interest rate in the market.
Derivative However not all currencies have well developed government Treasury
instruments across a range of maturity dates. In these cases swap
dealers will quote all-in prices as a total rate.
Are IRSs as simple as has been described. Well, in principle the

answer is yes, but in practice there are a number of issues to be
reconciled if you are trying to compare swap rates. In other words are
you comparing like-with-like?
Differences between swap rates can arise based on the following:
❑ Quotation terms for fixed and floating rates
❑ The underlying instruments used to calculate swap rates
❑ The frequency of interest rate payments
❑ Day count bases used to calculate interest rate payments
These issues are all discussed in the next section.
If you were asked to explain the mechanics of an

IRS to a colleague would be able to do it?
100
■ IRSs in the market place Underlying instruments $ $

The instruments used to calculate swap rates for different currencies
This section deals with a number of important matters vary. For example, USD swaps are usually quoted as a spread over the Derivative
7 8 9 concerning IRSs which you will need to understand: appropriate Treasury instrument which have semi-annual coupons;
4 5 6
1 2 3 DEM swaps are quoted on an annual Eurobond basis.
0
❑ Swap differences
The chart below indicates the various instruments used for the major
❑ Swap spreads currencies together with the Day count method used for the interest
payment calculations.
❑ Swap valuations
Currency Quoted as... Coupon Day count
❑ Swap structures
USD Spread over T-Bond Semi-annual Actl/Actl
Swap differences DEM Fixed Eurobond Annual 30/360
The four main types of difference were mentioned at the end of the CHF Fixed Eurobond Annual 30/360
last section. FRF Fixed Eurobond Annual 30/360
GBP Spread over Gilt Semi-annual Actl/365
Quotation terms JPY Fixed Government Bond Semi-annual Actl/365
Within the US markets in particular there are a number of different
ways interest payments can be calculated for fixed and floating rates
together with a number of different ways payment schedules can be Frequency of interest payments
stipulated. Different swaps may use a combination of any of the In order to compare swap rates fairly you may need to convert annual
following terms payments into semi-annual or vice versa.
The chart below indicates the equations to use to convert yields or

Terms Fixed rate Floating rate
swap rates as appropriate.
Rate quotation • Absolute level • Any LIBOR
• Spread over • Prime rate From ➟ To ➟ Use ➟
Treasury instrument • CD, CP or T-Bill
[( )]
2
Payment • Quarterly • Periodic Semi-annual Annual RA = 1 + RS –1

2
schedule • Semi-annually • Irregular
• Annually
Basis • Eurobond • Bond

Annual Semi-annual RS = 2 x
[ (1 + RA ) – 1
]
• T-Bond • Money Market RA = Annual rate % ÷ 100
• Money Market Instrument RS = Semi-annual rate % ÷ 100
Instrument
101
$ $ Day count bases Swap spreads

You may also need to convert swap rates depending on the day count Interest rate trends cause variations in swap spreads over the yield
Derivative basis used to calculate interest payments in order to compare like- curves for Government benchmark instruments.
with-like or value swaps.
When interest rates are expected to fall there are many fixed rate
The chart below gives the various methods of converting different issuers wanting to swap into paying floating and receiving fixed, so
day counts. spreads narrow.
When interest rates are expected to rise there are plenty of

From ➟ To ➟ Use ➟
borrowers wanting to swap into fixed but not many willing to receive
it, so spreads widen.
30/360 or Actual/360 Yield x 360
Actual/365 365 Another factor affecting swap spreads is credit risk. In a swap the
market player and the market-maker take on each other’s risk. If
Actual/360 30/360 or Yield x 365
either party fail to honour payment commitments, then the other
Actual/365 360 party has an unwanted interest rate exposure.
Actual/365 30/360 No adjustment
For IRSs the net difference in fixed/floating payments is made, so
the risk of loss is based to some extent on an estimate of the
30/360 Actual/365 No adjustment
volatility of the future floating rate basis, for example, LIBOR.
102
Swap valuation The interest payments are netted between XYZ and AYZ based on the $ $
Consider a plain vanilla IRS in which XYZ Corporation borrow $100 following calculation:
millions for 5 years at a floating rate but enter into an IRS agreement Derivative
with AYZ Bank to make fixed rate payments at 9.00% every 6 months. LIBOR – 9 x $100 millions x No. of days in 6 month period
In return the swap dealer, AYZ, will pay a floating rate of LIBOR every 360 x 100
6 months.
9.00% Fixed Depending on the value, either XYZ or AYZ receive the net payment.
At the start of the plain vanilla swap the derivative has no value to
either party. The interest rates that have been agreed for both sides
are determined so that the present value – the value the swap will
LIBOR Floating have at a future date – of the fixed side equals the present value of
XYZ AYZ
Both payments are the floating side taking into account the conditions of the agreement.
made every 6 months
If the terms of the agreement remain constant then neither side gain
The spot rate for the transaction is 1st June so the first payment is or lose at the expense of the other.
due on 1st December. The amount of interest due on the 1st
December is already known on the 1st June. How can this be the However, suppose interest rates rise and LIBOR increases. In this case
case? The answer is that LIBOR for the first payment is fixed on the XYZ will gain at the expense of AYZ because XYZ pays a fixed rate
1st June as the floating rate to be paid in 6 months time. In a similar and receives a floating rate which has just increased. So the swap now
manner the 1st December LIBOR fixing determines the rate to be has a positive value to XYZ which can be considered to be an asset.
paid for the second payment on the following 1st June and so on The actual value of the asset can be calculated from the difference in
until the final payment in 5 years. present values. Unfortunately in the case of AYZ the swap has a
negative value and is considered to be a liability.
1st June 1st Dec. 1st June
There are two basic ways that swaps can be valued:
1st June Use LIBOR Use LIBOR
from from
1st June 1st Dec. ❑ Pricing from swap curve
Spot Payment 1 Payment 2 ❑ Pricing from the spot curve
LIBOR Net LIBOR Net LIBOR Using the spot curve method produces a more accurate figure than
➝ ➝
➝ ➝
fixed fixed fixed
payment payment the swap curve method, but the calculations involved can be quite
made made complex. Both methods of pricing involve calculations for bonds
which are dealt with in more detail in the Debt Instruments workbook.
Why Debt Market instruments? Read on...
103
$ $ Pricing from the swap curve Example – Fixed side – Straight bond: Floating side – FRN
Yield curves are an essential part of valuing future cash flows and Suppose a plain vanilla swap has been arranged between XYZ
Derivative calculating forward interest rates. Plain vanilla swap rates are priced Corporation and AYZ Bank for a $100 millions notional principal
from benchmark bond yield prices as has already been mentioned. amount for a 3 year period. On the fixed side the payments are
The benchmark Yield To Maturity (YTM) curves are used for pricing 9.30% on an annual basis; on the floating side the payments are 12
over a range of maturities. months LIBOR.
The cash flows over the 3 year period would look something like
those shown in the chart below.
Payments equivalent to coupons from a straight bond
Fixed 9.30% 9.30% 9.30%

This is taken from page SMWM
for a DEM swap Payment 1 Payment 1 Payment 2 Payment 3
In terms of valuing a fixed-for-floating swap the transaction can be

Floating LIBOR? LIBOR? LIBOR?
thought of as a series of coupon payments from an imaginary straight
bond on the fixed side netted against a series of payments from an
imaginary or synthetic Floating Rate Note (FRN) on the floating side. Payments equivalent to those from a Floating Rate Note
A plain vanilla swap can therefore be valued as follows:

Can you see how this works?
Notional straight bond – Notional floating instrument
present value present value
104
XYZ and AYZ enter into the swap on the stated conditions. On the The present value for the floating side can be calculated using the $ $
spot date LIBOR is fixed at 7.50% for the first payment. As has been more direct relationship between the present and future value of an
mentioned the swap has no value at the start of the agreement. On instrument, Equation 2. Derivative
the first payment date the 3 year swap rate is now quoted at 9.00% on
the fixed side and 12 months LIBOR is fixed at 7.79%. What is the
Future Value
value of the swap now? Is the swap an asset or a liability to the receiver PV =
of the fixed side? (1 + R)
Principal + Interest due
What is the value now of the swap that matures in the future? The =
present value of the fixed side can be calculated using the general (1 + R)
straight bond valuation equation. For a bond with an annual coupon
this is Equation 1. Where: R = Discount or LIBOR rate
as a decimal ...Equation 2
C C (C + 100)
Present Value (PV) = + + ...+
1 + R (1 + R)2 (1 + R)n
In this example then: Principal = 100 millions; Interest = 7.50;
R = 0.0779. Because the floating rate is based on Actual/360 the
Where: C = Coupon rate values used need to be adjusted to a 365 day year.
R = Discount or swap rate as a decimal
n = Number of years to maturity
...Equation 1
[ 100 +
( 7.50 x 365
360 )]
PV =
In this example then: C = 9.30%; R = 0.090; n = 3
9.30 9.30 109.30

1+
( 0.0779 x 365
360 )
PV = + +
1.09 (1.09)2 (1.09)3 = $99.7257 millions
= $100.7594 million The net value of the swap is therefore $1.03 millions in favour of the
fixed side. This is because the swap rate quoted by the bank at the
end of the first payment is less than the coupon rate of 9.30% on the
position. The floating side has lost value because LIBOR has
increased.
105
$ $ Treating the value of a swap as the difference between a straight bond Pricing from the spot curve
and a floating rate instrument gives rise to market-makers hedging or The Yield To Maturity (YTM) curve is simply a graph of YTM values
Derivative warehousing a swap position by temporarily buying or selling the of bonds against maturity period. Unfortunately this is a simplistic
underlying bond. view of yields and it is better to use a graph of spot rate against
maturity period. The spot rate is a measure of the YTM on an
The payer of the fixed side buys the underlying which can then be instrument at any moment in time which takes into account a variety
sold to offset the position if the swap rates fall. of market factors. A graph of spot rate against maturity is known as a
spot curve. It is also known as a Zero Coupon yield curve because the
The receiver of the fixed side sells the underlying to offset any losses spot rate for an instrument is equivalent to the yield on an
if swap rates rise. instrument which has no coupon repayment – zero coupon. This
means that spot rates for a series of instruments with zero coupons
The calculations here are quite complicated and time consuming to for a range of maturity periods can be compared directly.
perform. In practice, traders will often use a graphical representation
to assess the relationship of the swap with a benchmark instrument of The curves represent the perceived relationship between the return
the same maturity. The graphical representation used is the spot on an instrument and its maturity – usually measured in years.
curve or Zero Coupon yield curve. Depending on the shape of the curve it is described as either:
❑ Positive
❑ Negative or inverse
Positive yield curve

In this case the shorter term interest rates are lower than the longer
term rates. This is usually the case – the longer the period of the
investment the higher the yield paid. If an interest rate rise is
expected, then investors will move their assets into long term
instruments which produces a fall in short term rates and an increase
in long term rates.
Negative or inverse curve

When short term rates fall investors move their investments into
longer term instruments to lock in a higher rate of return. This
increase in supply of long term funds causes the long term rates to
fall.
106
The shapes of ‘theoretical’ yield curves are shown below – in practice How does the spot curve help in pricing a swap? A more accurate way $ $
they may not appear so clear! of considering an IRS is to consider the instrument as a series of fixed
cash flows on one side combined with a series of notional Derivative
Positive yield curve floating cash flows on the other which are considered as a
MMI:FRA
strip of FRAs or futures contracts.
In other words the spot curve rates are used to calculate,

Yield
in advance, the net settlement amount of each future

interest payment date. MMI:FUT
The swap rate is effectively an average rate for a strip of

Maturity FRAs or futures contracts.
The calculations are quite complex and in the previous example if

Negative or inverse yield curve the swap were valued using this more accurate method, then the net
value in favour of the fixed side is $1.043 millions.
Yield
Maturity
Yield curves are used to identify anomalies between instruments of

similar credit standing, for example, an IRS and a T-Bond of similar
maturity.
The following chart may help in assessing the value of an instrument

when compared to its spot curve.
Instrument curve Instrument value
Above spot Cheap
Below spot Expensive
107
$ $ Swap structures Accreters, Amortisers and Rollercoasters

Plain vanilla swaps usually have very narrow spreads – typically only 5 These are all IRSs which involve variable notional principal amounts
Derivative to 10 basis points. This means that the profit margins for dealers are in the agreement.
small. In order to widen their profit margins and to cater for more
complicated client requirements, dealers can structure more Accreting and amortising swaps consist of strips of swaps with
complex IRSs based on the following basic types: different start or end dates.
❑ Plain vanilla swap ❑ Accreting swaps have notional amounts that increase in
steps over the life of the swap
❑ Forward start swap
This is a fixed-for-floating IRS in which the accrual date of ❑ Amortising swaps have notional amounts that decrease in
the swap for the first interest period starts sometime after steps over the life of the swap
the spot date. This type of swap can still be considered as a
strip of FRAs on the floating side except the near FRAs have These types of swaps are used in real estate markets where developers
been removed. Forward start swaps are often used to hedge seek to lock in the interest cost of future floating rate borrowings
against forward interest rate movements. which either diminish or expand over time. The following charts
illustrate these swaps.
❑ Swaption
This is similar to a forward start swap to which has been Accreting swaps
added the option whether or not to start the swap on the
Notional amount
accrual date. Hence the name is derived from the fact it is
an option on a swap. One counterparty buys the option,
whilst the other writes or sells the option.
If you need to know more about the basics of

options then you may need to refer to the Derivatives
Introduction to Derivatives workbook Section 3. Section 3 Maturity
Swaptions are also dealt with in more detail in
this workbook – Options on IRSs - Swaptions.
Amortising swaps
MMI:SWP
Notional amount
There are many types of structured swaps available now – some of the
more common types are briefly discussed next.
Maturity
108
A rollercoaster swap is simply a combination of one or more Basis swaps $ $

accreting and amortising swaps and is illustrated in the chart below. Whereas most IRS are plain vanilla swaps, basis swaps cater for
floating interest payments on both sides. The interest rates for both Derivative
Rollercoaster swaps floating sides are calculated on different bases. Typical basis swaps
include the following:
Notional amount
❑ USD prime rate against LIBOR
❑ 12 month LIBOR against 6 month LIBOR
❑ LIBOR against US Commercial Paper (CP) rates

Maturity
In all other respects basis swaps are used, priced etc in the same way
as described previously.
One important variation is the cross-currency basis swap in which

floating rates in different currencies are exchanged, for example,
USD LIBOR against DEM LIBOR.
Why is this type of basis swap important? If a plain vanilla swap

is arranged in one currency and combined with a cross- FXI:CSP
currency basis swap, then the result is a Currency swap.
This is how it works...

A market-maker enters into a plain vanilla DEM swap for fixed DEM
and floating DEM LIBOR. This swap is then combined with a cross-
currency basis swap for USD LIBOR and DEM LIBOR. In effect the
DEM LIBOR payments cancel out leaving a swap of fixed DEM for
floating USD LIBOR – a Currency swap.
USD LIBOR DEM
DEM LIBOR DEM LIBOR

Market-maker
109
Derivative
❑ An IRS is an exchange or swap of interest rate payments

calculated according to different formulas on the same
notional principal amount
❑ No exchange of principal occurs during a swap – no funds

are lent or borrowed between the counterparties as part of
the swap
❑ Interest rate payments are usually netted and only the

difference is paid to one party or the other
❑ Any underlying loan or deposit is not affected by the swap

– the swap is a separate transaction
110

RT may help your understanding of IRSs and how they
are used.
RT To see the Speed Guide for Currency and Interest

Rate Swaps type in SWAP/1 and press Enter.
Double-click in the <TOPIRS> field to see the Fixed/floating basis for
Interest Rate Swap rates for the major currencies. swap
The fixed/floating basis for each currency is indicated. If you
need to find out more about a particular price, double-click on it
and the latest prices from different contributors will be displayed.
Double-clicking on this
price displays this screen
111
$ $
Derivative 3000 Use the Multiple Watch page, SWMW, in the Swaps
folder to view up to three different contributor
quotes for the same currency. Different contributors Fixed/floating terms
may use different swap terms so you may need to
check this in the Basis fields. You can also compare up to three
different currency swap rates in this page.
You may also find it useful to use the Model page, SWM. Enter
the details of the swap you are interested in and the fixed/
floating payments are calculated and displayed in the Cash Flow
Analysis fields.
Enter details in these fields
Fixed/floating
cash flows
112
■ End check Your notes $ $

Derivative
1. In an IRS, the principal amounts involved are usually:
❑ a) Exchanged at the end date

❑ b) Exchanged at the start date
❑ c) Not exchanged
❑ d) Exchanged at an interim date
2. In an IRS, interest payments are exchanged:
❑ a) On a net basis at the end of each interest period

❑ b) On a gross basis at the end of each interest period
❑ c) At the start of each interest period, as with a FRA
❑ d) On a cumulative basis at maturity
3. A client asks you to quote for a 2 year GBP IRS. You quote
7.43 – 7.39. The client deals at 7.39. What have you done?
❑ a) Agreed to receive fixed/pay floating

❑ b) Transacted a basis swap
❑ c) Agreed to pay fixed/receive floating
❑ d) Transacted a fixed/fixed swap
4. A borrower pays LIBOR + 5/8% for floating USD. He decides to fix

his interest repayments using an IRS. He receives a quote of
6.75 – 80 using the same interest basis and decides to fix. What
will be the net cost of his borrowing?
❑ a) 6.750%
❑ b) 6.800%
❑ c) 7.375%
❑ d) 7.425%
113
1. c) ❑
2. a) ❑
3. c) ❑
4. d) ❑
114
Options on Interest Rate futures
■ What is it? The relationship between the rights and obligations for the different $ $
types of options is summarised in the following diagram – you may
An Interest Rate option is an agreement by which the find it useful to refer to when considering some of the examples Derivative
buyer of the option pays the seller a premium for the which follow.
right, but not the obligation –
Options
to buy a call option
or sell a put option
a specific quantity contract amount

Call Put
of a specific instrument the underlying instrument
is a short or long-term
Interest Rate futures contract
on or by a set date the expiry date depends on

the style of the option – Buyer/holder Seller/writer Buyer/holder Seller/writer
American or European Long Call Short Call Long Put Short Put
at an agreed price Strike price for the Right but not Obligation to: Right but not Obligation to:
interest rate obligation to: obligation to:
• Buy underlying • Sell underlying • Sell underlying • Buy underlying
instrument instrument instrument instrument
If you need an overview of options or you need to remind • At the strike • At the strike • At the strike • At the strike
yourself about derivatives in general, then you may find it Derivatives price price price price
useful to refer to the Introduction to Derivatives workbook, Section 3 • If the call is • If the holder • If the put is • If the holder
Section 3 at this stage. exercised decides to buy exercised decides to sell
115
$ $ Interest Rate options are financial derivatives first introduced in the Exchange traded Interest Rate options
1980s to hedge interest rate exposure. The underlying instrument for Interest Rate options on an exchange
Derivative can either be for cash or for Government bonds. Exchange traded
If the option is Exchange traded, then it is settled using the same options are standardised in terms of :
conditions as for the underlying futures contracts. There are two
types of Exchange traded options on futures contracts: ❑ Underlying instrument and its trading amount
❑ Options on short-term Interest Rate futures contracts which ❑ Strike prices – in general exchanges try to have a range of
are cash settled if the option expires In-The-Money, At-The-Money and Out-of-The-Money strike
prices
❑ Options on long-term Interest Rate futures contracts which
are settled on Government bonds if the option expires ❑ Expiry dates
OTC Interest Rate options are used to control maximum ❑ Style – most exchange options are American
and minimum levels of borrowing and lending money
and are in effect options on Forward Rate Agreements MMI:IRG ❑ Premium quotations – these are percentage rates expressed
(FRAs). These options are described in greater detail in in decimal points for short-term contracts and as fractions
the section Options on FRAs – Interest Rate Guarantees. for long-term contracts
The diagram below indicates the availability of Interest Rate options. ❑ Margin payments are required to be paid to the Clearing
house
Interest Rate options In effect Interest Rate options on futures give the buyer or the seller
of the instrument the right to lend or borrow money. The following
chart indicates these rights from the buyer’s perspective – sellers
would have the opposite views.
OTC Exchange traded

Option Buyer Used to hedge
Call Gives right to lend Falling interest rates

money at a
IRGs Short-term Long-term predetermined rate
Caps Settled for Settled for Put Gives right to borrow Rising interest rates
Floors cash Government money at a
bonds predetermined rate
116
Exchange contracts $ $
Options on both short-term and long-term Interest Rates are
available on a number of exchanges worldwide. The charts below Derivative
indicate a selection of the Interest Rate options on futures available.
LIFFE CME
Short-term Cash settled based on LIBOR Unit of trading Short-term Cash settled based on interbank rates Unit of trading
Three month Sterling (Short Sterling) GBP 500,000 Three month Eurodollar USD 1,000,000
Three month Eurodeutschemark (Euromark) DEM 1,000,000 One month LIBOR USD 3,000,000
Three month Eurolira ITL 1,000,000,000 One year T-Bills USD 500,000
Three month Euroswiss Franc (Euroswiss) CHF 1,000,000 Three month Euromark DEM 1,000,000
13-week US T-Bills USD 1,000,000
Long-term Nominal value Maturity Notional CBOT

Long-term Nominal value Maturity Notional
Long Gilt (UK) GBP 50,000 10 - 15 9
German – Bund DEM 250,000 8.5 - 10 6 US T-Bonds USD 100,000 At least 15 8
Italian – BTP ITL 200,000,000 8 - 10.5 12 10 year US T-Notes USD 100,000 6.5 - 10 8
117
$ $ Typical contract specifications

Options contracts details vary from type to type and from exchange
Derivative to exchange but the following examples taken from a LIFFE contract
and a CBOT contract are typical specifications.
Option on 3 month Sterling Interest Rate future Options on US Treasury Bond futures
Underlying contract One 3-month Sterling futures This is the standard contract size. Underlying contract One US Treasury Bond
contract – GBP 500,000 futures contract – $100,000
Quotes as either decimals or
Premium quotations Multiples of 0.01 ( 0.01%) fractions of rate Premium quotations Multiples of 1/64th of a point
Minimum Price 0.01 This is the smallest amount a Minimum Price 1/64
Fluctuation (Tick) (£12.50) contract can change value and Fluctuation (Tick) ( $15.625)
the ‘tick’ size.
Contract expiry March, June, September, Contract expiry March, June, September,
December Option contracts are referred to December
by the trading cycle of the futures
Exercise procedure American contract months. Exercise procedure American
This means that contract can be

exercised on or before expiry
date – American
118
■ Who uses Options on Interest Rate futures? If the treasurer had been in the position of a lender of funds and $ $
wanted to guarantee a minimum rate of interest on a deposit then
Buyers/sellers she would have used a put option. Derivative
Interest Rate options are used to hedge interest rate
exposure. The chart below indicates the buyers and Originally these types of option were written on real loans/deposits.
sellers of options and the rights to the respective Now they are settled on a cash compensation basis where the writer
underlying instruments if the options are exercised. or the holder, pays or receives the difference between the interest
rate on the underlying loan or deposit and the strike price of the
Option on futures Buyer/holder has On exercise Seller/ option. This means that options are traded independently and
contract right to: writer has obligation to: separately from the actual instruments.
Call Buy a futures contract Sell a futures contract Another way of looking at the use of Interest Rate options on futures
– – is summarised in the chart below:
Go long Go short
Market player who is a ... wants to...
Put Sell a futures contract Buy a futures contract
– – Money Market buyer of a Call guarantee minimum
Go short Go long fund manager deposit rates on future
deposits – a floor
Example
Corporate seller of a Put guarantee maximum
A Corporate Treasurer has a loan of $1 million with an interest rate
Treasurer borrowing rates on
of LIBOR, reset every 3 months. The current interest rate is 6.25%
future loans – a cap
but she feels that interest rates may rise. If she buys an Interest Rate
futures contract she effectively locks in her borrowing at the futures
contract rate and cannot take advantage of any interest rate falls.
Using the futures contract limits her losses but does not give her the
opportunity to profit. The solution is to use an option contract. In
this case she buys an interest rate call option with a strike price of
93.75 (6.25%) and a maturity to suit the roll-over date of the loan.
On maturity:
If LIBOR is 6.25% or less If LIBOR is greater than 6.25%
The treasurer pays the interest The treasurer exercises her

and allows the option to right to buy the option and pays
expire. the strike price of 93.75.
119
$ $ ■ Options on Interest Rate futures in the market place The information in the chart allows you to calculate the premium
cost of any option which is quoted.
Derivative This section deals with typical contract quotations and how
7 8 9 options are traded and premiums are calculated for Interest Example
4 5 6
1 2 3
Rate options which are derived from exchange traded futures Suppose you need to hedge a 6.25% interest rate on a 3-month
0
contracts based on: Eurodollar investment starting at the end of September. To hedge
the return on this investment you decide to use an option. You will
❑ Short-term interest rate instruments need to buy a Sep Call option but what strike price should you use?
❑ Long-term interest rate instruments The strike price for 6.25% is simply determined by subtracting 6.25
from 100. So the strike price is 100 – 6.25 = 93.75. Buying a Sep Call
Typical exchange contract quotations
option gives you the right, but not obligation, to buy a 3-month
Interest Rate option quotations are available from the financial press
Eurodollars futures contract on or before the September expiry date
such as the Financial Times and The Wall Street Journal and from
at an interest rate of 6.25%. But how much will you have to pay the
products such as Reuters Money 3000. The information appears in a
seller for this right?
similar style to those in the following examples.
Contract premium price
Financial press – Option on short-term Interest Rate futures contract
This is calculated using the following simple equation:
Minimum price movement Premium cost = Number of ticks x Tick size

3-month Eurodollar = 0.01: Tick price = $25
contract
Eurodollar (CME) $ million; pts of 100% From the chart opposite the premium for a Sep9375 Call is 0.11. So
the premium cost is therefore:
Strike Calls Puts
price Mar Jun Sep Mar Jun Sep Expiry
= 0.11 (quote) x $25 (tick size)
dates of
futures 0.01 (tick size)
9325 0.50 0.30 0.29 0.00 0.15 0.42
9350 0.26 0.16 0.18 0.01 0.26 0.55 contracts
= 11 x $25 = $275.00
9375 0.05 0.07 0.11 0.05 0.42 0.73
The rates of interest implied in the strike

prices are calculated by deducting the
quoted strike price from 100.
A March 9350 strike represents a forward

rate interest of 100 – 93.50 = 6.50%
120
Reuters Money 3000 – Options on short-term Interest Rate futures Financial press – Option on long-term Interest Rate futures contract $ $
Options on short-term Interest Rate futures can be found using the
IR Options folder, Futures Option Watch page IFOW for any Minimum price movement Derivative
US Treasury Bond future = 1/64: Tick price = $15.625
particular currency. The following is a section of a screen dump
showing Bid/Ask prices for the IMM 3-month Eurodollars futures
Call and Put options on the Index and Option Market (IOM) of the T-Bonds (CBOT) $ 100,000; 64ths of 100%
CME.
Strike Calls Puts
price Apr Jun Sep Apr Jun Sep Expiry
dates of
110 1-23 2-15 2-61 0-61 1-53 2-63 futures
111 0-55 - - 1-29 - - contracts
112 0-32 1-21 2-04 2-06 2-58 4-03
This is the strike price for the underlying This represents

futures contract. This means that the a premium of
underlying T-Bond futures contract has a
43/64%
market value of $112,000
Contract premium price

This is calculated as before. The premium cost for a Sep110 Put
which gives you the right to sell US Treasury Bond futures at the
strike price at any time to expiry is quoted at 263/64% in the chart
above. So the premium cost is therefore:
= Number of ticks x $15.625
63
= 2 /64 x $15.625
1
/64
= 191 x $15.625 = $2984.38
121
$ $ Reuters Money 3000 – Options on futures contracts How an Exchange traded Interest Rate option contract works
Options on long-term Interest Rate futures can be found also using Exchange traded Interest Rate options on futures are traded in a
Derivative the IFOW page for any particular currency. The following is a section similar way to exchange traded futures contracts in that margin
of a screen dump showing Bid/Ask prices for US T-Bond futures Call payments are required by the Clearing house. Initial margin is
and Put options on CBOT. payable by the appropriate party at the time of the trade.
The price of an option is marked-to-market every day that the option

is open and the resulting profits/losses are credited/debited to both
counterparty margin accounts.
,,
,,
,,
▼
Profits and Profits and
losses losses
▼
Clearing house
Buyer Seller
If an Interest Rate option on a short-term futures contract is allowed

to expire, then expiry takes place on the same date as the underlying
futures contract. Also, as for the underlying futures contract, the
option is cash settled.
The settlement price is calculated simply from the difference

between the Exchange Delivery Settlement Price (EDSP) and the
strike price using the following equation:
Settlement price = (EDSP – Strike price) x Tick price
122
Example Trading strategies for options $ $

A buyer of a LIFFE Short sterling Jun9300 Call allows the option to There are many strategies available in the options markets – some are
expire. This gives the buyer the right to receive interest at a rate of quite complex and have colourful names. Derivative
7.00% on the underlying futures contract. At the time of expiry the
EDSP is 9375 – an interest rate of 6.25%. Therefore the buyer The various strategies are usually represented diagrammatically as
receives a cash settlement: break-even graphs which show the potential for making a profit. The
diagrams use the break-even point as the basis for the diagram where
= (9375 – 9300) x £12.50
Break-even point = Strike price ± premium
= 75 x £12.50 = £937.50
The option premium was 0.30. This means that the premium cost The most basic buy /sell strategies for puts and calls are
was: illustrated using profit/loss charts in the following Derivatives
examples. You may find it useful to refer to option Section 3
= 30 x £12.50 = £375.00 strategies in general by referring to the Introduction to
derivatives workbook.
The net profit on the option is therefore £937.50 – 375.00 = £562.50.
Depending on whether the market player is a buyer or seller of a call
A simpler way of calculating the option profit is to use the following or put, gains or losses either have ceiling values or are limitless.
equation:
Profit = (EDSP – Strike price – Premium in ticks) x Tick value
So in this case the profit is calculated as:
= (9375 – 9300 – 30) x £12.50
= 45 x £12.50 = £562.50
123
$ $ Buying a Call option – Long Call At expiry the profit/loss chart for the Long Call looks like this:
A fund manager has investments that mature in the future which he
Derivative will need to re-invest. The manager believes that interest rates will be
lower in the future and needs to protect his position. He buys Call
options on futures contracts that correspond to the fund Strike price = 93.00
investments. In other words he buys the right, but not obligation to Profit
make a future Money Market loan at a pre-determined interest rate.
If interest rates decline, then gains made on the options should help
offset the lower interest rate return. However, if interest rates rise,
then the fund manager can still take advantage of the higher rates Futures
and not exercise the options. 9225 9250 9275 9300 9325 price
The fund manager decides to protect his investment by buying Call

Break-even point
options on a LIFFE 3-month Short sterling futures contract having a
= 93.00 + 0.04 = 93.04
strike price corresponding to an interest rate of 7.00%. He buys Loss
9300Sept Calls with a premium of 0.04.
Maximum loss = premium price
Remember that short-term futures contracts have strike prices = 0.04
determined from 100 – interest rate. So as strike price increase, the
interest rate falls.
Market price Outcome
> 9304 Profit increases as futures prices rise

(interest rates fall) and are unlimited
9304 Break-even point
9304 – 9300 Loss which decreases as futures price

falls ( interest rates rise)
< 9300 Loss is limited to a maximum of the

premium price
124
Buying a Put option – Long Put At expiry the profit/loss chart for the Long Put looks like this: $ $
The Treasurer of XYZ Corporation may or may not need to borrow
funds at a specified time in the future depending on the outcome of Derivative
a tender bid but he is worried that interest rates will rise. By buying Strike price = 93.00
Put options the Treasurer can lock in the maximum interest cost in
the event he needs to borrow. In other words the Treasurer buys the Profit
right to sell the underlying futures contract and therefore he is
entitled to borrow money at a future date at a fixed interest rate.
This protects him against a future rise in interest rates.
If interest rates rise, then the option can be exercised at a profit to Futures
offset the increased borrowing costs. If interest rates fall, then the 9275 9300 9325 9350 9375 price
Treasurer can take advantage of lower interest rates and not exercise
the option. If the tender is unsuccessful and no borrowing is
required, then the Treasurer can exercise or sell the option for
whatever value it has but his loss is limited to the option premium Loss
cost.
Maximum loss = premium price
The Treasurer decides to buy Put options on a LIFFE 3-month Short Break-even point = 0.21
sterling futures contract having a strike price corresponding to an = 93.00 – 0.21 = 92.79
interest rate of 7.00%. He buys 9300Sept Puts with a premium of
0.21.
Market price Outcome
> 9300 Maximum loss is equal to the premium
9300 – 9279 Loss decreases as future prices fall

(interest rates rise)
9279 Break-even point
< 9279 Profit increases as future prices fall

(interest rates rise) and is unlimited
125
$ $ Selling a Call option – Short Call Selling a Put option – Short Put
A fund manager expects interest rates to remain relatively steady for This is more or less the same scenario as for a Short Call except that
Derivative the next few months or possibly fall slightly. The manager would like this time the fund manager believes that interest rates will remain
to earn extra income on his portfolio and decides to sell Call steady or rise slightly.
options on long-term futures contracts.
At expiry the profit/loss chart for the Short Call looks like this:
If interest rates remain steady and the options are not exercised,
then they expire worthless and the fund manager has earned extra
Maximum profit = premium received
income equal to the value of the premium received.
The risk the fund manager takes is that prices on the underlying Profit
bond contracts rise. If the options are exercised then he has the
obligation to deliver the bonds.
Writing At-The-Money Calls produces more premium and may be Futures

appropriate if the Treasurer firmly believes the underlying bond 100 111 112 113 114 price
prices are unlikely to rise. By writing Out-of-The-Money Calls, less
premium is received but the options are less likely to be exercised.
At expiry the profit/loss chart for the Short Call looks like this:
Loss
If bond prices decrease
Maximum profit = premium received then the option may be
exercised
Profit
Futures
100 111 112 113 114 price
Loss
If bond prices increase
then the option may be
exercised
126

Derivative
❑ Exchange traded Interest Rate options are available on

short and long-term futures contracts. On expiry options
on short-term futures are cash settled, options on long-
term futures are settled by physical delivery of the bonds.
❑ The buyer or holder of a Call/Put has the right to buy/

sell the underlying futures contract if the option is
exercised
❑ The seller or writer of a Call/Put has the obligation to

sell/buy the underlying futures contract if the option is
exercised
❑ Most options traded on exchanges are American style
❑ Premium quotations are as decimal percentage points for

short-term underlying futures and fractional percentage
values for long-term underlying contracts
127
Derivative The following exercises using Reuters products and the

RT may help your understanding of options on Interest
Rate futures and how they are used.
RT To view the Exchange Traded Interest Rate Options

Speed Guide type in OPS/IR1 and press Enter.
From this page there are a limited number of
contracts to view – mainly those from CBOE and
EOE. Double-click in a field of interest – the screen here shows
the CBOE 10 Year Treasury Yield Calls and Puts for a number of
strike prices for different months.
128
$ $
3000 To see premium prices for Interest Rate options Derivative
select the FuOpt Watch page, IFOW, for IR Options
for any particular currency you need. In the screens
shown here LIFFE 3-month Short sterling and IOM
3-month Eurodollar Call and Put premiums are displayed for
various strike prices for the underlying September and December
futures contracts respectively. If it is more convenient, you can
view the information by name rather than the contract RIC.
129
$ $
Derivative 3000 You may also find it useful to use the Interest Rate
History page, IOIR, and FuOpt Model, IFOM page.
The IOIR page displays the deposit rates you select
for up to three currencies simultaneously – you can
choose any combination of currencies and deposit periods as
required from the drop down menus. The IFOM page can be
useful if you need to know the option delta values and whether
an option premium is In-The-Money, At-The-Money or Out-of-
The-Money.
Interest rate history for GBP using the IOIR page

Using this IFOM page you can see that the Call for this 9275 strike
for the September contract which has an underlying value of 92.85
has a delta value of 0.6281 which means it is ITM
Using this IFOM page you can see that the Call for this 9300 strike
for the September contract which has an underlying value of 92.85
has a delta value of 0.2965 which means it is OTM
130
■ End check 3. What is the maximum interest rate that the buyer of a 9375Sept $ $
Put is guaranteed on a future loan?
Derivative
Using the chart of premium prices for options on Eurodollars answer Answer:
the following:
Eurodollar (CME) $ million; pts of 100%
Strike Calls Puts

price Mar Jun Sep Mar Jun Sep
9325 0.50 0.30 0.29 0.00 0.15 0.42 4. What is the premium cost for a 9350Jun Call?
9350 0.26 0.16 0.18 0.01 0.26 0.55
9375 0.05 0.07 0.11 0.05 0.42 0.73 Answer:
Tick size for this contract is 0.01 and the tick value is $25
1. Why are the Calls with higher strikes cheaper than those with
lower strikes, and why are the Puts with higher strikes more
expensive than those with lower strikes?
Answer:
5. You buy an option on LIFFE which can exercised at any time.
Which of the following describes this type of option?
❑ a) European
❑ b) American
❑ c) Asian
❑ d) Average
2. At what price would the buyer of a 9325Jun Put break even at

expiry?
Answer:
131
1. The higher the strike the lower the Call prices ❑
because they are further Out-of-The -Money.
The higher the Put prices because they are further
In-The-Money.
2. Put break even = Strike – Premium ❑

= 93.25 – 0.15
= 93.10
3. Maximum interest rate locked in by the potential ❑

borrower is given by 100 – (Strike – Premium)
= 100 – (93.75 – 0.73)

= 100 – 93.02
= 6.98%
4. Premium is 0.16, the tick size for this contract is ❑

0.01 and the tick value is $25
Premium cost = 0.16/0.01 x $25

= 16 x 25
= $400
5. b) ❑
132
Options on FRAs – Interest Rate Guarantees (IRGs)
■ What is it? Interest Rate caps and floors thus provide insurance against interest $ $
rate movements over a consecutive number of roll-over loan dates
An Interest Rate Guarantee is a financial derivative which which are subject to floating rate payments. They can be used by Derivative
can be considered to be an option on a series of Forward borrowers and lenders for the protection they need.
Rate Agreements (FRAs).
Caps and floors are a series of OTC options which coincide with the
An Interest Rate Cap is an agreement between roll-over dates on floating rate loans which can be considered to be a
counterparties in which one party agrees to make series of Forward Rate Agreements (FRAs) with the same strike prices
payments to the other if floating rates exceed an agreed for the loan maturity period.
strike rate.
series of
▼
An Interest Rate Floor is an agreement between FRA IRGs
options
counterparties in which one party agrees to make
payments to the other if floating rates fall below an
agreed strike rate. An OTC call is an option to buy a FRA and is known as a borrower’s
option.
If you need an overview of options or you need to remind Example

yourself about derivatives in general, then you may find it Derivatives A borrower has a loan which has floating rate LIBOR interest rate
useful to refer to the Introduction to Derivatives workbook, Section 3 payments. The borrower fears that interest rates could rise. The
Section 3 at this stage. borrower could buy a FRA which would fix payments but what
happens if interest rates fall? The borrower would not be able to take
Caps and floors are OTC options which in effect ‘guarantee’ buyers a advantage of the fall. If the borrower buys an OTC call option on
hedge on rising and falling interest rates respectively. Hence these LIBOR to match the roll-over dates of the loan, then the borrower
options are also known as Interest Rate Guarantees (IRGs). has the right to buy a FRA at each roll-over date.
Caps and floors are based on a floating rate such as LIBOR, Prime If floating rates rise, then the option is exercised and the borrower
rates and CPs and are sold for a one-off premium. The most receives a cash settlement. If floating rates fall, then the option is not
commonly quoted caps and floors use 3-month or 6-month LIBOR. exercised but the borrower can take advantage of lower cash market
rates. The borrower pays a premium for this insurance protection to
Exercise for both caps and floors occurs automatically on set dates the option writer or seller.
during the maturity period of the option if this is to the holder’s
advantage.
133
$ $ An OTC put is an option to sell a FRA and is known as a lender’s Caps

option. A cap is a series of options that gives the buyer the right to pay the
Derivative lower of the market rate or strike rate.
Example
An investor is due to receive floating rate LIBOR payments 3 monthly A cap offers the buyer the protection against rising interest rates by
for the next 15 months. The investor fears that interest rates will fall setting a maximum limit for payments whilst the buyer retains the
and in this case buys an OTC put option on LIBOR to match the roll- right to benefit from falling prices. The use of Interest Rate Swaps or
over dates of the payments. The investor now has the right to sell a Interest Rate futures locks in borrowing rates to a fixed rate for the
FRA at each roll-over date. whole transaction.
If interest rates fall, then the option is exercised and the investor The cost to the buyer is limited to the premium which is paid to the
receives a cash settlement from the option seller. If floating rates rise, seller – the buyer has no further obligations.
then the option is not exercised but the investor can take advantage
of the higher cash market rates. Most caps are based on LIBOR and the following example illustrates
how a cap works.
Some of the advantages offered by these OTC options include:
Example
❑ Flexibility covering a wide range of maturity periods, A Corporate Treasurer has borrowed $10 million on a floating rate
amounts and strike prices basis for 15 months using 3-month LIBOR roll-over dates. The
Treasurer believes that interest rates will rise and wants to cap the
❑ The one-off cost of the option premium is known at the loan at 6.00%. The Treasurer buys a cap option and pays a premium
beginning of the transaction to the seller.
❑ A single agreement may cover a maturity period of several The Treasurer’s loan can therefore be considered to be a series of
years and is therefore less costly in fees FRAs starting in 3 months from the first loan period – 3 x 6, 6 x 9, 9 x
12, 12 x 15.
If on any roll over date LIBOR exceeds the cap rate agreed, the seller
of the option has to pay the Treasurer the difference between LIBOR
and the cap rate as a cash settlement.
The chart opposite indicates the LIBOR fluctuations over 15 months

and the various payments made to the buyer of the cap.
134
Difference between LIBOR and Floors $ $

cap rate is paid to the buyer These are the opposite type of options to caps in as much as they
provide the buyer with a guaranteed minimum interest rate. They can Derivative
be considered to be a series of put options on FRAs all with the same
Cap rate
strike price.
LIBOR
A floor offers the buyer protection against falling interest rates by

setting a minimum limit for the rate of return whilst the buyer retains
the right to benefit from rising rates.
No payment No payment Example

A Corporate Treasurer has invested $10 million in FRNs with an
interest rate linked to 3-month LIBOR. The Treasurer is concerned
Maturity that interest rates might fall and needs to protect against interest
rates below 6.00%. The Treasurer buys a 6.00% floor for 15 months
3x6 6x9 9 x 12 12 x 15 based on 3-month LIBOR and pays a premium to the seller.
FRA FRA FRA FRA
The chart below indicates the LIBOR fluctuations over 15 months
If LIBOR is above the cap rate then the Corporate Treasurer can take and the various payments made to the buyer of the floor.
out a loan at LIBOR knowing that the extra cost above the agreed cap
rate is guaranteed by the option. In other words the Corporate Seller has to pay the buyer the
Treasurer’s interest payments have been limited to the cap level set. difference between LIBOR and
floor rate
If LIBOR is below the cap rate, then the seller makes no payments to
Floor rate
the buyer. However, the Corporate Treasurer now pays interest at a
lower rate than the cap level which is within the interest rate
maximum set.
LIBOR
The overall effect is that the Corporate Treasurer protects his interest
rate payments from rises above a cap level whilst simultaneously
taking advantage of any falls in interest rates. No payment No payment
Maturity
3x6 6x9 9 x 12 12 x 15
FRA FRA FRA FRA
135
$ $ If the interest rate falls below the floor rate agreed, then the buyer
receives the difference between LIBOR and the floor rate as a cash Summary
Derivative payment.
Caps Floors
If the interest rate is above the floor level, then the buyer receives no
• Protect buyers from rising • Protect buyers from falling
payment. The option is not exercised and the Treasurer receives a
interest rates above an interest rates below an
higher rate of return from the underlying.
agreed level whilst agreed level whilst
allowing the opportunity allowing the opportunity
The overall effect is that the Corporate Treasurer protects the rate of
to benefit from any fall in to benefit from any rise in
return on the investment from falls below a floor level whilst
rates rates
simultaneously taking advantage of any rises in interest rates.
• Establish a maximum • Establish a minimum rate
Collars borrowing cost for buyers of return for buyers over
The collar is the natural combination of a cap and a floor where a over the maturity period the maturity period of the
market player wants to restrict interest rates between guaranteed of the option option
maximum and minimum limits and reduce overall premium costs.
• Do not affect the • Do not affect the
This can be achieved by buying a cap to place a maximum interest underlying loan underlying deposit or
rate limit whilst simultaneously selling a floor to earn premium investment
income or vice versa.
• Provide a flexible • Provide a flexible
alternative to fixed rate alternative to fixed rate
borrowing lending
• Are a series of call options • Are a series of put options

on FRAs all with the same on FRAs all with the same
strike price strike price
136
■ Who uses IRGs? $ $

Buyers/sellers of caps and floors Derivative
The various buyers and sellers of caps and floors are
summarised in the charts below:
Caps Floors
Buyers Sellers Buyers Sellers
• Organisations with a • Organisations with a • Organisations with a • Organisations with a

floating rate debt who fixed rate debt who floating rate debt who floating rate debt who
anticipate rising interest anticipate interest rates anticipate falling interest take the view that interest
rates will fall or remain stable rates rates will not fall below a
minimum value
• Investors with fixed rate • Financial institutions who • Investors wishing to set a
assets who want to protect have issued capped minimum return for
the net interest margins floating rate liabilities sell interest rates on their
on their investments a cap to hedge the value investments
of the liability
• Organisations wanting to • Organisations who take
• Organisations wanting to • Organisations who take hedge the risk of falling the risk that interest rates
hedge the risk of rising the risk that interest rates interest rates whilst at the will fall and have to make
interest rates whilst at the will rise and have to make same time taking a payment to the buyer.
same time taking a payment to the buyer. advantage of rises in This risk is taken in
advantage of any falls in This risk is taken in interest rates. The cost of return for a premium
interest rates. The cost of return for a premium the option is limited to payment.
the option is limited to payment. the premium payment.
the premium payment.
137
$ $ Collar – Buyer of a cap/seller of a floor Collar – Buyer of a floor/seller of a cap

In this case a market player has the view that market rates will rise so Example
Derivative a cap is required. However buying a cap requires a premium In a similar way to the previous example a Corporate Treasurer
payment. By selling a floor, premium is received which the market wishes to hedge an investment by setting the minimum rate of return
player uses to offset the cap premium. The market player’s view is he expects. This is therefore the Treasurer’s floor. At the same time
that interest rates will not fall and therefore the floor will not be the Treasurer sells a cap which will earn premium income. If the
exercised – this is a risk. floor is bought at 5.0% and the cap sold at 7.0%, then the collar is
indicated in the chart below.
Example
A Corporate Treasurer borrowing money decides to limit borrowing
costs to 6.0% because the current interest rates are only slightly Seller of cap pays the buyer the
higher than this. This is therefore the Treasurer’s cap. At the same difference between LIBOR and
time the Treasurer sells a floor at 4.0% thus placing a collar on cap rate
interest rate payments and earns premium income. The collar is Cap rate 7.0%
indicated in the chart below.
LIBOR
Collar – margin 2.0%
Buyer of cap receives the
difference between LIBOR and
cap rate
Cap rate 6.0%
Floor rate 5.0%
Buyer of floor receives the
LIBOR
Collar – margin 2.0% difference between LIBOR and

floor rate Maturity
If LIBOR falls below 5.0%, then the Treasurer receives a payment

Seller of floor pays the buyer Floor rate 4.0%
from the floor option. If LIBOR rises above 7.0% then the Treasurer
the difference between
will have to make a payment to the cap buyer. However, the
LIBOR and floor rate
Maturity Treasurer’s view is that interest rates will not rise and that the cap
option will not be exercised.
The option guarantees that if LIBOR rises above 6.0%, then the For collars in general, because the option involves a simultaneous
Treasurer receives payment from the seller. If LIBOR falls below purchase and sale, the premium charges involved are partially or fully
4.0%, then the Treasurer will have to make a payment to the floor eliminated. One premium is received whilst the other is paid.
buyer.
138
■ IRGs in the market place Example $ $

For the cap bought by the Treasurer in the previous example, on the
This section deals with premiums and OTC caps and floors first LIBOR roll-over date, the floating rate is 7.00%. Derivative
7 8 9 quotations with particular reference to the importance of
4 5 6
1 2 3
implied volatilities in pricing these options. The Treasurer therefore receives a cash payment which equals:
0
7.00 – 6.50 x 20,000,000 x 90 = $25,000

Premium payments and settlements 100 360
The purchase of caps and floors involve the payments of premiums.
Usually market-players requiring quotations from banks for IRGs are
quoted premiums in terms of basis points.
Typical OTC contract quotations
Interbank quotations for IRGs are not made using basis points.
The value of the premium is then calculated by multiplying the basis
Instead professional options market-makers use complex analytical
points by the notional principal amount of the loan.
models to calculate option prices based on the following factors.
Example
1. Strike price
A Corporate Treasurer wishes to buy a 3 year 6.5% USD 3-month
LIBOR cap for a $20 million notional principal amount. The
2. Time to expiry
premium is quoted at 115 basis points – one basis point is one
hundredth of a percentage point.
3. Interest rates
The cash premium required to be paid by the Treasurer to the cap
4. Volatility
seller is:
Of the factors, volatility is the only one for which the market-maker
20,000,000 x 0.0115 = $230,000
does not have a precise value. But what is this volatility? In the case of
Interest Rate options, the volatility is a measure of the rate of
Any cash settlements due on the roll-over LIBOR dates are calculated
fluctuation in interest rates. How is a volatility value derived?
using the simple equation:
The volatility implied in an option price is calculated using statistical
Notional standard deviations of historic underlying price movements over a
(LIBOR% – cap/floor rate %) x principal x Actual no. of days given period, expressed as a percentage per annum.
100 amount 360
139
$ $ The implied volatilities are therefore forecasts of the proportional Cap and floor volatilities are available from individual market-makers
percentage range, up or down, within which the underlying interest on the RT.
Derivative rate is expected to finish at the expiry date of the option.
Probability RT Type in IRGS/1 and press Enter. From the list of

The confidence level of the various currency Caps and Floors double-click in a
volatility forecast being field of interest, for example, <GBPCAP=ICAP>.
correct for one standard You will now see the cap Bid and Ask volatility prices
deviation either side of the as percentages from International Brokers Ltd. If you need to see
mean in a statistical normal more information about the contributor just double-click on the
distribution is 68%. For two figure to display a page of information. Why not try? You should
68% standard deviations the see screens similar to those shown here.
confidence level of
forecasting the correct
volatility range is 95%.
95%
– Market price + Market price
Example
DEM one year forward interest rates are 4.00% and the one year
volatility is forecast at 10%. So the standard deviation is ±0.04 and two
standard deviations is ±0.08.
The price ranges for the two confidence levels are shown in the table
below:
Confidence level USD/DEM price range
68% 3.96 to 4.04 (4.00 ± 0.04)
95% 3.92 to 4.08 (4.00 ± 0.08)
It is important to recognise that the implied volatility percentages are

not the implied forward interest rates.
140
Example The following chart is a summary of the movement in premium levels $ $

A market-maker might quote 11.50 – 13.50 % volatility for a 3 month for options based on the movement of four of the pricing factors. You
LIBOR GBP At-The-Money Cap. may find it useful in looking at historic option prices. Derivative
Increase in... Price of Call Price of Put

This two-way Bid/Ask price quotation means:
➞
➞
Strike price
On Bid side The market-maker will buy Puts or Calls at 11.50%
➞
➞ ➞ ➞
Underlying forward price
per annum
➞ ➞
Expiry date
On Ask side The market-maker will sell Puts or Calls at 13.50%
per annum Volatility
This Bid/Ask spread in volatility translates into a corresponding

spread in the option premium.
The prices are for At-The-Money options – the strike price is at the
current underlying forward rate. Why not test the summary above by using the RT?
Once the counterparties want to trade, all the factors, including the
volatilities, are entered into each side’s pricing models to calculate
the premium to be paid. If both sides agree then the transaction
proceeds.
Strike price
▼
Expiry date
▼
Premium
▼
Interest rate
▼
Volatility
▼
Pricing model
Each
counterparty
141
Derivative
❑ An OTC financial derivative which can be considered to

be an option on a series of Forward Rate Agreements
(FRAs)
❑ OTC contracts for caps which place a maximum on

interest rate payments and floors which fix a minimum
rate of return
❑ The combination of a cap and floor is a collar which

confines interest rate commitments between
predetermined maximum and minimum limits
❑ Interbank premium quotations are quoted in terms of

implied volatilities for caps and floors
142

RT may help your understanding of IRGs and how they
are used.
RT As interbank OTC caps and floors are quoted as

implied volatilities type in VOL/1 and press Enter
to see the Implied Volatilities Speed Guide. In the
Interest Rate Volatilities field double-click in the
<IRGS/1> field. Now double-click in the field for the cap or floor
for the currency you require, from the contributor you require.
Try double-clicking in <GBPCAP=ICAP> to see the At-The-Money
volatilities for GBP from Intercapital Brokers Ltd.
To see more
information from the
contributor, double-
click on the quote
143
$ $ Your notes
Derivative RT To see a different way of presenting contributor

information use F12 to page forward from IRGS/1.
Double-click in the <USDIRG=TKFX> field. You
should now see IRG caps and floors volatility quotes
together with other options and swaps quotes from Tokyo Forex.
144
■ End check $ $
Derivative
1. Your company obtained a 3-year rollover credit for $10 million on 2. Your organisation wishes to speculate by placing $10 million in
the basis of 6-month LIBOR from XYZ Bank one year ago. As FRNs for 2 years based on 6-month LIBOR. Although you are
Treasurer you are of the opinion that interest rates are likely to convinced that interest rates will rise from their current rate of
rise in the future. Therefore you want to hedge against an interest 5.00% and you would like to benefit from any rise, you would still
rise of 0.25% above the prevailing interest level of 5.00%. like to protect yourself against an adverse movement of 1% in
interest rates.
a) Do you buy a Cap or Floor?
Answer: a) Do you buy a Cap or Floor?
Answer:
b) Note the terms of the contract here:

b) Note the terms of the contract here:
Underlying index
Term Underlying index
Reset period Term
Strike Reset period
Notional amount Strike
Notional amount
c) If the premium costs 120 basis points, how much does the
option cost you? c) If the premium costs 50 basis points, how much does the
Answer: option cost you?
Answer:
d) At the first settlement date 6-month LIBOR is at 6.00%. Do you

exercise the option? Calculate any settlement amount involved. d) At the first settlement date 6-month LIBOR is at 3.50%. Do you
Answer: exercise the option? Calculate any settlement amount involved.
Answer:
e) At the third settlement date the rate is 5.00%. Do you

exercise this option? e) At the third settlement date the rate is 6.00%. Do you
Answer: exercise this option?
Answer:
145
Derivative ✔ or ✖ ✔ or ✖
1. a) Buy a Cap ❑ 2. a) Buy a Floor ❑
b) ❑ b) ❑
Underlying index 6 month LIBOR Underlying index 6 month LIBOR
Term 2 years Term 2 years
Reset period Every 6 months Reset period Every 6 months
Strike 5.00 + 0.25 = 5.25 Strike 5.00 – 1.00 = 4.00
Notional amount $10,000,000 Notional amount $10,000,000
c) 1.20% of $10,000,000 = $120,000 ❑ c) 0.50% of $10,000,000 = $50,000 ❑
d) You exercise the option because you have to d) You exercise the option because you have to
borrow at 6.00%. ❑ lend at 3.50%. ❑
You receive compensation You receive compensation
= 10,000,000 x 0.75 x 180 = 10,000,000 x 0.50 x 180
100 x 360 100 x 360
= $37,500 ❑ = $25,000 ❑
e) You do not exercise the option because you can ❑ e) You do not exercise the option because you can ❑
borrow in the market at 5.00% lend in the market at 6.00%
146
Options on IRSs – Swaptions
■ What is it? ■ Who uses Swaptions? $ $

A Swaption is a financial derivative which grants the Banks and corporations Derivative
right, but not the obligation, to buy or sell an Interest Swaptions are used by the same market players who use
Rate Swap (IRS) on agreed terms of interest rate, IRSs – banks and multinational corporations.
maturity, fixed or floating rate payer, on or by an agreed
date. In return for this right the buyer of a swaption pays Swaptions are used increasingly by these market players for two main
the seller a premium. reasons:
If you need an overview of options and swaps derivatives
❑ To hedge exposure on interest rates
or you need to remind yourself about the types of Derivatives
derivatives available, then you may find it useful to refer Section 3/4
❑ To speculate in the swaps markets in order to make a profit
to the Introduction to Derivatives workbook, Sections 3 & 4 at
from offsetting fixed/floating rate transactions
this stage.
Swaptions offer similar benefits to corporations and banks as IRSs:
Swaptions are OTC contracts used by market players who seek the
advantages of an IRS but who also would like to benefit from any
❑ Counterparties are able to convert underlying interest rates
favourable interest rate movements.
from fixed to floating and vice versa over a long term
period
Swaptions, in common with other options, use the terms Call and
Put. However, their meanings are not quite as obvious as before. The
❑ Usually there are cost savings to both sides
meanings and uses of Swaptions Calls and Puts are described in the
chart below.
❑ IRSs provide access to markets not normally available to the
market players, for example, for reasons relating to credit
Call Swaption Put Swaption rating
• Also called a Payer or • Also called a Receiver or

Right-to-pay Swaption Right-to-receive Swaption
• The buyer has the right to • The buyer has the right to
pay the fixed side to and receive the fixed side
receive the floating side from and pay the floating
from the holder of the side to the holder of the
underlying IRS underlying IRS
• The buyer is hedging • The buyer is hedging

against falling interest against rising interest
rates rates
147
$ $ ■ Swaptions in the market place
Derivative This section deals with examples of how Call and Put
6.50% ,,
,,
6.00%
7 8
4 5
1 2
0
9
6
3
Swaptions work in the market place.
,,
LIBOR LIBOR
Call Swaptions
Example Swaption Swaption Underlying
XYZ Corporation decides to hedge against falling interest rates using seller buyer IRS
a 1 plus 4 Call Swaption. This means they buy an instrument which
grants the right to exercise the option in one year for an underlying 4
year Fixed pay/Floating receive (Current interest rate/LIBOR) IRS
for a Swaption rate of Fixed pay/Floating receive, 6.5%/LIBOR. Payments XYZ receive XYZ pay Net % position
This means that if XYZ, the Swaption holder, exercises their right in a Fixed 6.50% 6.00% + 0.50
year, they will pay the IRS holder a fixed rate and receive LIBOR, and
at the same time receive 6.5% fixed interest from the option seller Floating LIBOR LIBOR Cancel out
and pay LIBOR.
To justify exercising the swaption, the interest rates of the underlying

instrument must be less than the Swaption rates.
At expiration the current rate for a 4 year Fixed pay/Floating receive

IRS is 6.0%/LIBOR. XYZ exercise their right on the Swaption and
make a net gain of 0.5% in interest rate payments, so hedging against
falling interest rates.
The process is illustrated in the chart opposite.
148
$ $
,,
Put Swaptions
,,
Example 6.50% 6.00%
XYZ Corporation needs to hedge against rising interest rates using a Derivative
1 plus 4 Put Swaption. This means they buy an instrument which
grants the right to exercise the option in one year for an underlying 4 ,,
year Fixed receive/Floating pay (Current interest rate/LIBOR) IRS
for a Swaption rate of Fixed receive/Floating pay, 6.5%/LIBOR. LIBOR LIBOR
This means that if XYZ, the Swaption holder, exercises their right in a Swaption Swaption Underlying
year, they will pay the IRS holder LIBOR and receive a fixed rate, and seller buyer IRS
at the same time receive LIBOR from the option seller and pay a
fixed rate of 6.5%.
To justify exercising the swaption, the interest rates of the underlying Payments XYZ receive XYZ pay Net % position
instrument must be greater than the Swaption rates.
Fixed 7.00% 6.00% + 0.50
At expiration the current rate for a 4 year Fixed receive/Floating pay
IRS is 7.0%/LIBOR. XYZ exercise their right on the Swaption and Floating LIBOR LIBOR Cancel out
make a net gain of 0.5% in interest rate payments, so hedging against
rising interest rates.
The process is illustrated in the chart opposite.
149
Derivative
❑ A Swaption is an OTC derivative which grants the right,

but not obligation, to buy or sell an Interest Rate Swap at
agreed terms on or by an agreed date
❑ A Call Swaption – also known as a Payer or Right-to-pay

swaption – gives the buyer the right to pay the fixed side/
receive the floating side from the holder of the
underlying IRS
❑ A Put Swaption – also known as a Receiver or Right-to-

receive swaption – gives the buyer the right to receive the
fixed side/pay the floating side from the holder of the
underlying IRS
150

RT may help your understanding of Swaptions and how
they are used.
RT To view the Speed Guide for Swaptions type in

SWAPTION/1 and press Enter. As with other OTC
option prices the Bid and Ask quotes from the
various contributors are as volatilities. If you double-
click in the <USDSTN=TXFX> field you will see Swaption
volatilities for the USD from the Tokyo Forex Co Ltd. If you
double-click in the <DEMSWPTNS=TTKL> field you will see the
volatilities from Tullets on DEM – these are mid-quotes.
151
$ $ Your notes
Derivative
152
What’s next?
■ Do you need to study further? Further resources
You have now completed this Level 3 workbook which has Books What’s next?
been designed to give you a better understanding of the The Penguin International Dictionary of Finance
market and product information you may need for your Graham Bannock & William Manser, Penguin, 2nd Edition 1995
job. ISBN 0 14 051279 9
You may have all the knowledge and understanding you Investments
require or you may still need to study further workbooks William F. Sharpe, Gordon J. Alexander & Jeffrey V. Bailey, Prentice
and /or Web materials in the Know your Markets series. Hall, 5th Edition 1995
ISBN 0 13 18 3344 8
In particular you may need to study the Level 3 workbook:
Foreign Exchange Instruments – the companion workbook to A–Z of International Finance
this one. Stephen Mahony, FT/Pitman Publishing, 1997
ISBN 0 273 62552 7
The remaining workbooks in the Know your Markets package cover the
following markets at both Level 2 and Level 3: Financial Derivatives
David Winstone, Chapman & Hall, 1st Edition 1995
❑ Debt ISBN 0 412 62770 1
❑ Equities Booklets
Chicago Mercantile Exchange
❑ Commodities, Energy and Shipping • An Introduction to Futures and Options: Interest Rates
You may also find the Further resources useful for further reference. Swiss Bank Corporation
The order of the materials/information has no significance and • Financial Futures and Options
covers many of the sources used in the preparation of this workbook. • Options: The fundamentals
ISBN 0 9641112 0 9
If you have access to the Internet, then you may find the Web
addresses listed useful.
Chicago Board of Trade
• Financial Instruments Guide
The decision to study further workbooks or use the Web site is yours –
• An Introduction to Options on Financial Futures
Good luck! • Trading in Futures
London International Financial Futures and Options Exchange

• An Introduction
• Options: a guide to trading strategies
153
What’s next?
Further resources
What’s next? Reuters Money 3000 – Training Programme Futures - Hedging with Short-term Interest Rate Futures
1. Foreign Exchange & Money Markets • Item code: UKCA0349
2. Futures & Forward Rate Agreements
3. Bonds & Swaps FRAs - Fundamentals
4. Options • Item code: UKCA0306
FRAs - Applications
Intuition Plus: CAT
• Item code: UKCA0364
Call & Fixed Deposits - Fundamentals
• Item code: UKCA0290 Swaps - Interest Rate Swaps - Fundamentals
Fixed Deposits - Dealing
• Item code: UKCA0320 Swaps - Interest Rate Swaps - Applications
Treasury Bills - Fundamentals
• Item code: UKCA0291 Options - Fundamentals
Treasury Bills - Dealing
• Item code: UKCA0323 Options - Transactions
Certificates of Deposit - Fundamentals
• Item code: UKCA0292 Options - OTC Options - Fundamentals
Certificates of Deposit - Dealing
• Item code: UKCA0322 Repurchase Agreements - Fundamentals
Bills of Exchange - Fundamentals
• Item code: UKCA0293 Internet Web sites
Applied Derivatives Trading
Commercial Paper - Fundamentals • http://www.adtrading.com/
• Item code: UKCA0294 Have a look at the ADT Guide
Futures - Fundamentals Derivatives Research Unincorporated
• Item code: UKCA0301 • http://fbox.vt.edu:10021/business/finance/dmc/DRU/contents.html
A good collection of well explained articles
Futures - Hedging with Long-term Interest Rate Futures
• Item code: UKCA0348 AIB: Derivatives in plain English
• http://cgi-bin.iol.ie/aib/derivs-pe/
Futures - Hedging with Long-term Interest Rate Futures
154

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Contents

Money Market Deposits DEP 1 Treasury Bill (T-Bill) TBL 29

Forward Rate Agreement (FRA) FRA 55

■ Money Markets and Foreign Exchange Instruments

Money Markets Money Markets

Money Market Deposits MMI:DEP Forward Rate Agreement (FRA) MMI:FRA

Certificate of Deposit (CD) MMI:CD Interest Rate futures MMI:FUT

Repurchase Agreement (Repo) MMI:REP Interest Rate Swap (IRS) MMI:IRS

Treasury Bill (T-Bill) MMI:TBL Options on Interest Rate futures MMI:OPT

Commercial Paper (CP) MMI:CP Options on IRS – Swaptions MMI:SWP

Foreign Exchange (FX) Foreign Exchange (FX)

Spot transactions – Cross rates FXI:CRS Currency futures FXI:FUT

Forward outright transactions FXI:OUT Currency swap FXI:CSP

FX Swaps FXI:SWP Currency options – on Cash and on Futures FXI:OPT

basic questions outlined below:

❑ Institutions and Regulation

Level 2 workbooks http://www.trn.uki.ime.reuters.com/markets_matrix

Cross market information

Insitutio Competi Introduc

Market information – What instruments are used?

on the instruments traded in the particular market, this is a very brief

The instrument in the market place

Using Reuters products

It’s important to remember that learning is not a race – everyone

■ Coupon bearing instruments Before you start

Money Market Deposits 1

Certificate of Deposit (CD) 13

Repurchase Agreement (Repo) 23

Treasury Bill (T-Bill) 39

Bills of Exchange/Banker’s Acceptance (BA) 47

Interest rate futures 71

Interest Rate Swap (IRS) 93

Options on Interest rate futures 114

Options on FRAs – Interest Rate 133

Instruments Level 3 code Start date Completion date Comments

Coupon bearing instruments

Money Market Deposits MMI:DEP

Certificate of Deposit (CD) MMI:CD

Repurchase Agreement (Repo) MMI:REP

Treasury Bill (T-Bill) MMI:TBL

Bill of Exchange/Banker’s Acceptance (BA) MMI:BA

Commercial Paper (CP) MMI:CP

Forward Rate Agreement (FRA) MMI:FRA

Interest Rate futures MMI:FUT

Interest Rate Swap (IRS) MMI:IRS

Options on Interest Rate futures MMI:OPT

Options on FRAs – Interest Rate Guarantee (IRGs) MMI:IRG

Options on IRS – Swaptions MMI:SWP

$ $ Maturity dates Broken dates

Fixed periods Months

Money Markets maturities do not normally extend longer than one

$ $ How are interest rates expressed?

❑ Decimals. Now it is much more common to see decimals

These are Note: London quotes offer/bid style

Offered and Bid rates ■ Who uses Money Market Deposits? $ $

$ $ ■ Money Market Deposits in the market place Example 1

Future Value = Principal + Interest due ...Equation 2

Depending on the calculations you need to perform concerning

Example 2 ❑ Fixed term, non-negotiable

$ $ ■ Using Reuters products

RT Type in MONEY and press Enter to display the

3. What is the true annual yield of a 12 month Euromark deposit

4. A market-maker quotes a 6-month (180 days) Eurodollar rate of