Interest Rate Markets

Module 6

Types of rates
Interest rate applicable in a situation depends on the credit risk. I. Zero rates II. Treasury rates III. LIBOR IV. Repo/ Reverse repo rate

LIBOR (London Interbank offered rate)

The rate at which an individual contributor panel bank could borrow funds, were it to do so by asking for and then accepting interbank offers in reasonable market size, just prior to 11.00 London time.

Repo/ Reverse Repo

It is a transaction in which 2 parties agree to sell and repurchase the same security. The seller executing the transaction would describe it as a repo while the buyer in the same transaction would describe it as a reverse repo.

Bond Pricing
Bonds pay coupons to the holder periodically The Bonds principal ( face value) is paid at the end of its life. The theoretical price of a bond can be calculated as the present value of all the cash flows that will be received by the owner of the bond. It is better to use a different zero for each cash flow.

Bond Yield
A bonds yield is the single discount rate that, when applied to all cash flows, gives a bond price equal to its market price.

Forward Rates
Forward rates of interest are rates to cover future time periods that are implied by currently available spot rates. A spot rate is a yield prevailing at a given moment in time on a security. Given a set of spot rates, it is possible to calculate forward rates for any intervening time period. It is possible to calculate any forward rate, if its given relevant spot rates.

FRA (Forward Rate Agreements)

A FRA is an interest rate forward purchase or sale contract. The difference between the FRA contract rate and the market interest rate on the settlement date on the notional principal is paid or received. FRA rate evaluation model requires the Future rate and Risk Free interest rate.

 A FRA is a contract between one party ( the banker ) has given the other party ( customer) a guaranteed future rate of interest to cover a specified sum of money over a specified period of time in the future. A FRA is an off balance sheet instrument. Any trade entered into does not appear as an asset or liability. FRA can be used 1. By market participants who wish to hedge against hedge against future interest rate risks by setting the future interest rate today. 2 Who want to make profits based on their expectations of the future development of interest rates 3 Who try to take advantage of the different prices of FRA s and other financial instruments eg: futures by means of arbitrage

Treasury Bond
Treasury Bills: Zero coupon securities with a maturity at issuance of one year or less. The Treasury currently issues 1-month, 3-month, 6-month bills Treasury Notes: Coupon securities with maturity at issuance greater than 1 year but not greater than 10 years. The Treasury currently issues 2- year, 5- year and 10 year notes

 Treasury Bonds: Coupon securities with maturity at issuance greater than 10 years. Although Treasury bonds have traditionally been issued with maturities upto 30 years, the Treasury suspended issuance of the 30 year bond in October 2001.

Interest Rate Derivatives

IRD s are used in managing interest rate risk. IRD s are contracts that are used to hedge other positions that expose them to risk or speculate on anticipated price moves. Advantages * They allow banks to completely customize their interest rate risk profile * Since the derivatives can replicate the interest rate exposure of fixed income securities without the requirement of an upfront investment, they may have lower credit risk and greater liquidity

 Transaction costs are lower than in the spot market. They tie up much less capital than do positions in the underlying assets. They can be used for hedging and to take on risks intentionally They can be employed quite effectively for tax optimization reasons.

Terminologies
American style option: An option contract that can be exercised at any time between the dates of purchase and expiration. European style option: An option contract that can only be exercised on the expiration date.

Interest Rate Caps (IRC)

IRC is an option based technique practiced in over the counter market. A cap is a series of European interest calls that expire at or near the interest payments dates on a floating rate loan. If the benchmark rate underlying the cap is higher than the strike, the buyer will exercise the option and the seller has to compensate the buyer to an amount equivalent to the notional principal times the difference between the underlying rate and the strike rate. Therefore, an interest rate cap limits the amount of interest to be paid by the institution purchasing the cap. They are often used to protect against rising interest rates when one is having a floating rate loan ( normally sold by financial institutions or banks) as a hedge against interest rate risk. Each individual call option in the cap is known as a caplet.

Interest Rate Floor (IRF)

IRF is different from IRC in as much as the IRF protects against a fall in the interest rates. So it is the investor or depositor who buys IRF, whereas IRC, is bought by a borrower. The seller of IRF compensates for the loss of the buyer on account of change (fall) in interest rates . For this privilege, the buyer pays premium to the seller. A floor is a strip of European interest rate puts which like caplets expire at or near the effective dates of a loan. A floor contains series of interest rate put options, each of which is called a floorlet. Each option is an independent option and its exercise is not conditional upon whether the preceding / successive option will be exercised or not. Each option will compensate the buyer to the extent of strike rate on the expiry day of that option. Banks and institutional lenders often buy floors as a tool to hedge their variable rate loans advances against interest rate declines.

Interest Rate Collars

Interest rate collar is a combination of caps and floors. It is just like a tunnel where an importer buys a call option and sells a put option simultaneously, or an exporter buys a put option and sells a call option. Similarly a borrower buys a cap and sells a floor simultaneously or an investor or a depositor buys a floor and sells a cap simultaneously. This way the collar fixes a maximum and minimum interest rate.

Black- Scholes Analysis

Option Pricing Theory Used to calculate a theoretical call price ( ignoring dividends paid during the life of the option) using the 5 key determinants of an options price; stock price, strike price, volatility, time to expiration and short term ( risk free) interest rate. The Traders could risklessly hedge a long options positions with a short position in the stock and continuously adjust the hedge ratio ( the delta value one of the option sensitivities known as greeks) as needed.

Blacks Model
This model is an adaptation of the famous Black Scholes model with the exception that it takes the futures price as an input to compute the cost- of carry of the underlying , thus making redundant the entry of the short term interest rate or the funding rate into the model.