Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch.

13: 1
Chapter 13: Interest Rate Forwards
and Options
Well, it helps to look at derivatives like atoms. Split them
one way and you have heat and energy - useful stuff. Split
them another way and you have a bomb. You have to
understand the subtleties.
Kate Jennings
Moral Hazard, 2002, p. 8
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 2
Important Concepts
The notion of a derivative on an interest rate
Pricing, valuation, and use of forward rate agreements
(FRAs), interest rate options, swaptions, and forward
swaps
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 3
A derivative on an interest rate:
The payoff of a derivative on a bond is based on the
price of the bond relative to a fixed price.
The payoff of a derivative on an interest rate is based
on the interest rate relative to a fixed interest rate.
In some cases these can be shown to be the same,
particularly in the case of a discount instrument. In
most other cases, however, a derivative on an interest
rate is a different instrument than a derivative on a
bond.
See Figure 13.1, p. 446 for notional principal of FRAs and
interest rate options over time.
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 4
Forward Rate Agreements (FRA)
Definition
A forward contract in which the underlying is an
interest rate
A forward rate agreement (FRA) is an agreement that a
certain rate will apply to a certain principal during a
certain future time period
An FRA can work better than a forward or futures on a
bond, because its payoff is tied directly to the source of
risk, the interest rate.
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 5
Forward Rate Agreements (continued)
The Structure and Use of a Typical FRA
Underlying is usually LIBOR
Payoff is made at expiration (contrast with swaps)
and discounted. For FRA on m-day LIBOR, the
payoff is

Example: Long an FRA on 90-day LIBOR expiring
in 30 days. Notional principal of $20 million.
Agreed upon rate is 10 percent. Payoff will be



|
|
.
|

\
|
+ 0) LIBOR(m/36 1
0) rate)(m/36 upon Agreed - (LIBOR
Principal) (Notional
|
|
.
|

\
|
+ 60) LIBOR(90/3 1
60) 0.10)(90/3 - (LIBOR
00) ($20,000,0
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 6
Forward Rate Agreements (continued)
Some possible payoffs. If LIBOR at expiration is 8
percent,


So the long has to pay $98,039. If LIBOR at
expiration is 12 percent, the payoff is


Note the terminology of FRAs: A B means FRA
expires in A months and underlying matures in B
months.
039 , 98 $
(90/360) 08 . 0 1
60) 0.10)(90/3 - (0.08
00) ($20,000,0 =
|
|
.
|

\
|
+
087 , 97 $
(90/360) 12 . 0 1
60) 0.10)(90/3 - (0.12
00) ($20,000,0 =
|
|
.
|

\
|
+
Chance/Brooks
7
Zero Rates
A zero rate (or spot rate), for maturity T is
the rate of interest earned on an
investment that provides a payoff only at
time T

Chance/Brooks
8
Example

Maturity
(years)
Zero Rate
(% cont comp)
0.5 5.0
1.0 5.8
1.5 6.4
2.0 6.8
Chance/Brooks
9
Forward Rates

The forward rate is the future zero rate
implied by todays term structure of interest
rates
Chance/Brooks
10
Formula for Forward Rates
Suppose that the zero rates for time
periods T
1
and T
2
are R
1
and R
2
with both
rates continuously compounded.
The forward rate for the period between
times T
1
and T
2
is


R T R T
T T
2 2 1 1
2 1

Chance/Brooks
11
Calculation of Forward Rates

Zero Rate for Forward Rate
an n -year Investment for n th Year
Year ( n ) (% per annum) (% per annum)
1 3.0
2 4.0 5.0
3 4.6 5.8
4 5.0 6.2
5 5.3 6.5
Chance/Brooks
12
FRA Valuation
An FRA is equivalent to an agreement
where interest at a predetermined rate, R
K

is exchanged for interest at the market
rate
An FRA can be valued by assuming that
the forward interest rate is certain to be
realized
Chance/Brooks
13
Valuation Formulas
Value of FRA where a fixed rate R
K
will be
received on a principal L between times T
1
and
T
2
is
Value of FRA where a fixed rate is paid is

R
F
is the forward rate for the period and R
2
is the
zero rate for maturity T
2

2 2
) )( (
1 2
T R
F K
e T T R R L


2 2
) )( (
1 2
T R
K F
e T T R R L


Chance/Brooks
14
Example: FRA Valuation
Suppose that the three-month LIBOR rate is 5%
and the six-month LIBOR rate is 5.5% with
continuous compounding. Consider an FRA
where you will receive a rate 7% measured with
quarterly compounding, on a principal of $1
million between the end of month 3 and the end
of month 6. The forward rate is 6% percent with
continuous compounding or 6.0452 with
quarterly compounding. The value of the FRA is
$1,000,000 x (0.07 0.0652) x 0.25 x e
-0.055 x 0.5

= $2,322
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 15
Forward Rate Agreements (continued)
Applications of FRAs
FRA users are typically borrowers or lenders with a
single future date on which they are exposed to
interest rate risk.
See Table 13.3, p. 452 and Figure 13.2, p. 453 for an
example.
Note that a series of FRAs is similar to a swap;
however, in a swap all payments are at the same
rate. Each FRA in a series would be priced at
different rates (unless the term structure is flat).
You could, however, set the fixed rate at a different
rate (called an off-market FRA). Then a swap
would be a series of off-market FRAs.
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 16
Interest Rate Options
Definition: an option in which the underlying is an
interest rate; it provides the right to make a fixed
interest payment and receive a floating interest payment
or the right to make a floating interest payment and
receive a fixed interest payment.
The fixed rate is called the exercise rate.
Most are European-style.
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 17
Interest Rate Options (continued)
The Structure and Use of a Typical Interest Rate Option
With an exercise rate of X, the payoff of an interest
rate call is

The payoff of an interest rate put is

The payoff occurs m days after expiration.
Example: notional principal of $20 million,
expiration in 30 days, underlying of 90-day LIBOR,
exercise rate of 10 percent.
( ) X)(m/360) LIBOR Max(0, Principal) (Notional
( ) 60) LIBOR)(m/3 - X Max(0, Prinicpal) (Notional
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 18
Interest Rate Options (continued)
The Structure and Use of a Typical Interest Rate Option
(continued)
If LIBOR is 6 percent at expiration, payoff of a call is

The payoff of a put is

If LIBOR is 14 percent at expiration, payoff of a call is

The payoff of a put is
( ) 0 $ )(90/360) 10 . 0 Max(0,0.06 00) ($20,000,0 =
( ) 000 , 200 $ )(90/360) 06 . 0 Max(0,0.10 00) ($20,000,0 =
( ) 000 , 200 $ )(90/360) 10 . 0 Max(0,0.14 00) ($20,000,0 =
( ) 0 $ )(90/360) 14 . 0 Max(0,0.10 00) ($20,000,0 =
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 19
Interest Rate Options (continued)
Pricing and Valuation of Interest Rate Options
A difficult task; binomial models are preferred, but the
Black model is sometimes used with the forward rate
as the underlying.
When the result is obtained from the Black model, you
must discount at the forward rate over m days to reflect
the deferred payoff.
Then to convert to the premium, multiply by (notional
principal)(days/360).
See Table 13.4, p. 456 for illustration.
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 20
Interest Rate Options (continued)
Interest Rate Option Strategies
See Table 13.5, p. 458 and Figure 13.3, p. 459 for an
example of the use of an interest rate call by a
borrower to hedge an anticipated loan.
See Table 13.6, p. 460 and Figure 13.4, p. 461 for an
example of the use of an interest rate put by a lender to
hedge an anticipated loan.

Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 21
Interest Rate Options (continued)
Interest Rate Caps, Floors, and Collars
A combination of interest rate calls used by a borrower
to hedge a floating-rate loan is called an interest rate
cap. The component calls are referred to as caplets.
A combination of interest rate puts used by a lender to
hedge a floating-rate loan is called an interest rate
floor. The component puts are referred to as floorlets.
A combination of a long cap and short floor at
different exercise prices is called an interest rate collar.
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 22
Interest Rate Options (continued)
Interest Rate Caps, Floors, and Collars (continued)
Interest Rate Cap
Each component caplet pays off independently of
the others.
See Table 13.7, p. 463 for an example of a
borrower using an interest rate cap.
To price caps, price each component caplet
individually and add up the prices of the caplets.
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 23
Interest Rate Options (continued)
Interest Rate Caps, Floors, and Collars (continued)
Interest Rate Floor
Each component floorlet pays off independently of
the others
See Table 13.8, p. 464 for an example of a lender
using an interest rate floor.
To price floors, price each component floorlet
individually and add up the prices of the floorlets.
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 24
Interest Rate Options (continued)
Interest Rate Caps, Floors, and Collars (continued)
Interest Rate Collars
A borrower using a long cap can combine it with a
short floor so that the floor premium offsets the cap
premium. If the floor premium precisely equals the
cap premium, there is no cash cost up front. This is
called a zero-cost collar.
The exercise rate on the floor is set so that the
premium on the floor offsets the premium on the cap.
By selling the floor, however, the borrower gives up
gains from falling interest rates below the floor
exercise rate.
See Table 13.9, p. 466 for example.
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 25
Interest Rate Options (continued)
Interest Rate Options, FRAs, and Swaps
Recall that a swap is like a series of off-market FRAs.
Now compare a swap to interest rate options. On a
settlement date, the payoff of a long call is
0 if LIBOR s X
LIBOR X if LIBOR > X
The payoff of a short put is
- (X LIBOR) if LIBOR s X
0 if LIBOR > X
These combine to equal LIBOR X. If X is set at R,
which is the swap fixed rate, the long cap and short floor
replicate the swap.



Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 26
Interest Rate Swaptions and Forward Swaps
Definition of a swaption: an option to enter into a swap at a
fixed rate.
Payer swaption: an option to enter into a swap as a fixed-
rate payer
Receiver swaption: an option to enter into a swap as a
fixed-rate receiver

Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 27
Interest Rate Swaptions and Forward Swaps
(continued)
The Structure of a Typical Interest Rate Swaption
Example: MPK considers the need to engage in a $10
million three-year swap in two years. Worried about
rising rates, it buys a payer swaption at an exercise rate of
11.5 percent. Swap payments will be annual.
At expiration, the following rates occur (Eurodollar
zero coupon bond prices in parentheses):
360 day rate: .12 (0.8929)
720 day rate: .1328 (0.7901)
1080 day rate: .1451 (0.6967)
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 28
Interest Rate Swaptions and Forward Swaps
(continued)
The Structure of a Typical Interest Rate Swaption
(continued)
The rate on 3-year swaps is, therefore,


So MPK could enter into a swap at 12.75 percent in
the market or exercise the swaption and enter into a
swap at 11.5 percent. Obviously it would exercise
the swaption. What is the swaption worth?


1275 .
360
360
6967 . 0 7901 . 0 8929 . 0
6967 . 0 1
=
|
.
|

\
|
|
.
|

\
|
+ +

= R
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 29
Interest Rate Swaptions and Forward Swaps
(continued)
The Structure of a Typical Interest Rate Swaption
(continued)
Exercise would create a stream of 11.5 percent fixed
payments and LIBOR floating receipts. MPK could
then enter into the opposite swap in the market to
receive 12.75 fixed and pay LIBOR floating. The
LIBORs offset leaving a three-year annuity of 12.75
11.5 = 1.25 percent, or $125,000 on $10 million
notional principal. The value of this stream of
payments is
$125,000(0.8929 + 0.7901 + 0.6967) = $297,463


Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 30
Interest Rate Swaptions and Forward Swaps
(continued)
The Structure of a Typical Interest Rate Swaption
(continued)
In general, the value of a payer swaption at expiration is


The value of a receiver swaption at expiration is

=
|
.
|

\
|
n
1 i
i 0
) (t B
360
days
X) - R Max(0, Principal) (Notional

=
|
.
|

\
|
n
1 i
i 0
) (t B
360
days
R) - X Max(0, Principal) (Notional
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 31
Interest Rate Swaptions and Forward Swaps
(continued)
The Equivalence of Swaptions and Options on Bonds
Using the above example, substituting the formula for the
swap rate in the market, R, into the formula for the
payoff of a swaption gives
Max(0,1 0.6967 - 0.115(0.8929 + 0.7901 + 0.6967))
This is the formula for the payoff of a put option on a
bond with 11.5 percent coupon where the option has an
exercise price of par. So payer swaptions are equivalent
to puts on bonds. Similarly, receiver swaptions are
equivalent to calls on bonds.
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 32
Swaption and Callable Bonds
One application of swaptions relates to callable bonds
Recall callable bond issuer has sold (issued) bonds and
purchased a call option
A receiver swaption is comparable to the embedded
call option of a bond
See Figure 13.5, p. 474


Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 33
Interest Rate Swaptions and Forward Swaps
(continued)
Forward Swaps
Definition: a forward contract to enter into a swap; a
forward swap commits the parties to entering into a swap
at a later date at a rate agreed on today.
Example: The MPK situation previously described. Let
MPK commit to a three-year pay-fixed, receive-floating
swap in two years. To find the fixed rate at the time the
forward swap is agreed to, we need the term structure of
rates for one through five years (Eurodollar zero coupon
bond prices shown in parentheses).
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 34
Interest Rate Swaptions and Forward Swaps
(continued)
Forward Swaps (continued)
360 days: 0.09 (0.9174)
720 days: 0.1006 (0.8325)
1080 days: 0.1103 (0.7514)
1440 days: 0.12 (0.6757)
1800 days: 0.1295 (0.6070)
We need the forward rates two years ahead for periods of
one, two, and three years.
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 35
Interest Rate Swaptions and Forward Swaps
(continued)
Forward Swaps (continued)

1238 . 0
1080
360
1
360) .1006(720/ 0 1
/360) .1295(1800 0 1
years Three
1161 . 0
720
360
1
360) .1006(720/ 0 1
60) .12(1440/3 0 1
years Two
1080 . 0
360
360
1
360) .1006(720/ 0 1
/360) .1103(1080 0 1
year One
=
|
.
|

\
|
|
|
.
|

\
|

+
+
=
=
|
.
|

\
|
|
|
.
|

\
|

+
+
=
=
|
.
|

\
|
|
|
.
|

\
|

+
+
=
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 36
Interest Rate Swaptions and Forward Swaps
(continued)
Forward Swaps (continued)
The Eurodollar zero coupon (forward) bond prices





7292 . 0
) 360 / 1080 ( 1238 . 0 1
1
) 1800 , 720 ( B
8116 . 0
) 360 / 720 ( 1161 . 0 1
1
) 1440 , 720 ( B
9025 . 0
) 360 / 360 ( 1080 . 0 1
1
) 1080 , 720 ( B
0
0
0
=
+
=
=
+
=
=
+
=
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 37
Interest Rate Swaptions and Forward Swaps
(continued)
Forward Swaps (continued)
The rate on the forward swap would be

1108 . 0
0.7292 0.8116 0.9025
0.7292 - 1
=
+ +
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 38
Interest Rate Swaptions and Forward Swaps
(continued)
Applications of Swaptions and Forward Swaps
Anticipation of the need for a swap in the future
Swaption can be used
To exit a swap
As a substitute for an option on a bond
Creating synthetic callable or puttable debt
Remember that forward swaps commit the parties to a
swap but require no cash payment up front. Options give
one party the choice of entering into a swap but require
payment of a premium up front.



Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 39
(Return to text slide)
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 40
(Return to text slide)
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 41
(Return to text slide)
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 42
(Return to text slide)
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 43
(Return to text slide)
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 44
(Return to text slide)
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 45
(Return to text slide)
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 46
(Return to text slide)
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 47
(Return to text slide)
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 48
(Return to text slide)
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 49
(Return to text slide)
Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 13: 50
(Return to text slide)