Professional Documents
Culture Documents
Interest Rate
Derivatives
2014
Submitted by,
Anadi Kaistha
Nabin Basha
Naveen Kumar
Sanoop S
Sreenandan Nambiar P
Exercise 1
ACME Manufacturing has two choices, either raise debt by
3-year Fixed Rate Note, Cost @7% for ACME
3 year Floating Rate Note, Cost@ (one year LIBOR, 3.7% +2 % spread)
The company prefers to have a Fixed Rate Liability; however looking at the above scenarios, the fixed
rate cost of Debt is 7% which is greater than the Floating rate Liability which at current level of Libor is
5.7%.
So it would be prudent to go for Floating rate Liability which is lower than fixed rate and subsequently take
Derivative contracts for exchanging floating rate liability into a fixed rate liability.
The Derivative contracts available from National Trust are Swaps, FRAs, Cap and Floor.
The Fixed rate cost calculation is as under for each Derivative Contract
Solution:
Given Details
1 yr LIBOR (%)
Loan Amount ($ mn)
3 yr US T-bill rate(%)
Duration (yrs)
2 yr US T-bill rate (%)
3 yr US T-bill rate (%)
Floating Case
Additional (%)
3.7
100
4.5
3
4.1
4.5
1 yr LIBOR + 2%
2
Condition
3 yr US T-bill rate + 250
basis
1 yr LIBOR + 2%
Actual Rate
7.0
21
7.0
5.7
NA
NA
Comments:
In case company goes for a Fixed rate of interest payment than Acmes total interest cost will be 7%
(amount $ 21 million) and in case of floating rate of interest Acmes total cost would be 5.7% for the first
year and thereafter as per the prevailing LIBOR for the concerned period at that point in time.
Offer 1 - SWAP
Case-1 - SWAP
Fixed pay
Floating rec
3 yr US t rate+ 30 bps
1 yr LIBOR
4.8
3.7
20.4
Pay (4.8-3.7= 1.1% of 100 mn) i.e 3.3 m n
11.1
6.8
It would receive a one year LIBOR floating rate from National Trust.
ACME has to pay 2% spread to meet the liability of Floating rate note
Offer 2 - FRA
2 instruments required, one for year 2 (12X24) and another for year 3 (24X36).
Instrument 1:
Characteristics of the instrument:
(12x24) i.e. the contract will expire in 12 months and due date is 24 months
FRA reference rate: 5% p.a. (given)
Underlying rate: 1 year LIBOR
Scenario-(b): In case if LIBOR goes down, 1 year LIBOR reduces from 5% to 4% p.a.
Assumption is that 1 year LIBOR stands at 4% p.a. In this case, the company would pay differential payoff
of 1% discounted at 1 year LIBOR.
Payoff = ((0.04-0.05)*12/12)/(1+(0.04*12/12)) =-0.01/1.04 =-0.00961538
Net payoff to be paid by the company = 0.00961538*100,000,000=961,538
Instrument 2:
Characteristics of the instrument:
(24x36) i.e. the contract will expire in 24 months and due date is 36 months
FRA reference rate: 6% p.a. (given)
Underlying rate: 1 year LIBOR
Offer 3 - Caps
Strike Rate
4.00%
4.80%
5.00%
6.00%
Comments:
Premium
2.23%
0.70%
0.49%
0.08%
Payoff from
cap
2.00%
1.20%
1.00%
0.00%
Commitment
Total
Commitment(incl cap
premium)
8.000%
8.000%
8.000%
8.000%
8.230%
7.500%
7.490%
8.080%
The cap is a Derivative that ACME can buy to limit the upside risk of paying more cost, as its liability is
linked to a Floating LIBOR. The company would not be able to fix the interest burden rate using the CAP
option. The Strike price with 5% is the least cost Scenario. Also in all the cases the interest cost crosses
the threshold limit of 7% of which company has an option as an alternative. Hence its unlikely that
company would enter into CAPS option.
Offer 4 - Floors
Buy Floor:
It would be a strategy for those interested in hedging against downside interest rate risk. In this case
however, company is not an investor, hence is not worried about the downside interest rate risk. So, it
would not buy floor.
Sell Floor:
Even if company sell floor all it gets is the premium on the option. However, it faces two risks; 1) payment
to counterparty if interest rates fall below the strike price and 2) upward interest rate risk.
In both the above scenarios, company does not achieve the set target of fixed rate payment and that too
below 7%. Hence in would not indulge in either of the strategies.
Total Commitment(incl
premium)
8.050%
8.330%
8.330%
7.010%
6.520%
6.800%
6.800%
5.480%
6.310%
6.590%
6.590%
5.270%
5.900%
6.180%
6.180%
4.860%
From the above table it is evident that using collars as a strategy the company can fix the interest rate
obligation. Also it is apparent from the table that the cost would be minimal in case of collar 4, with the
strike price of 6%. The interest cost would come to 4.86% (including the spread payment of 2%).
Exercise 2
For Easy Money Trading Company following Strategies could be likely course of action to earn arbitrage
from the given quotes by the National Trust.
Strategy 1
Strategy 1
SELL
SWAP
Fixed 4.8%
BUY
Collar 3
Fixed 5%
Notional Principal
10,00,000 ($)
Year 1, 2 & 3
Received Fixed
SELL SWAP
LIBOR Rate
BUY CAP@5
Received Fixed
Payoff
SELL FLOOR@5
Premium
Payoff
(%)
Guaranteed
Guaranteed
Return
Return
($)
(% )
48,000
4,900
0.49
-41,000
0.9
2,100
0.21%
48,000
14,900
0.49
-31,000
0.9
2,100
0.21%
48,000
24,900
0.49
-21,000
0.9
2,100
0.21%
48,000
34,900
0.49
-11,000
0.9
2,100
0.21%
48,000
44,900
0.49
-1,000
0.9
2,100
0.21%
48,000
54,900
0.49
9,000
0.9
2,100
0.21%
48,000
54,900
0.49
9,000
0.9
2,100
0.21%
48,000
54,900
0.49
9,000
0.9
2,100
0.21%
48,000
54,900
0.49
9,000
0.9
2,100
0.21%
48,000
54,900
0.49
9,000
0.9
2,100
0.21%
10
48,000
54,900
0.49
9,000
0.9
2,100
0.21%
Strategy 2
Strategy 2
SELL
BUY
Notional Principal
Year 1, 2 & 3
SWAP
Collar 4
10,00,000 ($)
Received Fixed
SELL SWAP
Received Fixed
Cash inflow ($)
LIBOR Rate
%
0
1
2
3
4
5
6
7
8
9
10
Strategy 3
Fixed 4.8%
Fixed 6%
48,000
48,000
48,000
48,000
48,000
48,000
48,000
48,000
48,000
48,000
48,000
0.08
0.08
0.08
0.08
0.08
0.08
0.08
0.08
0.08
0.08
0.08
-27,800
-17,800
-7,800
2,200
12,200
22,200
32,200
32,200
32,200
32,200
32,200
3.22
3.22
3.22
3.22
3.22
3.22
3.22
3.22
3.22
3.22
3.22
19,400
19,400
19,400
19,400
19,400
19,400
19,400
19,400
19,400
19,400
19,400
1.94%
1.94%
1.94%
1.94%
1.94%
1.94%
1.94%
1.94%
1.94%
1.94%
1.94%
Strategy 3
Notional Principal
Invest
Treasury 2yrs
SELL
FRA (24x36)
Fixed 6%
BUY
Collar 4
Fixed 6%
10,00,000 ($)
Year 1
Received Fixed
Invest in T-US(2)
LIBOR Rate
%
BUY CAP@6
Received Fixed
Payoff
Guaranteed
SELL FLOOR@6
Premium
%
Guaranteed
Return
Return
Payoff
Premium
($)
(% )
41,000
800
0.08
-27,800
3.22
12,400
1.24%
41,000
10,800
0.08
-17,800
3.22
12,400
1.24%
41,000
20,800
0.08
-7,800
3.22
12,400
1.24%
41,000
30,800
0.08
2,200
3.22
12,400
1.24%
41,000
40,800
0.08
12,200
3.22
12,400
1.24%
41,000
50,800
0.08
22,200
3.22
12,400
1.24%
41,000
60,800
0.08
32,200
3.22
12,400
1.24%
41,000
60,800
0.08
32,200
3.22
12,400
1.24%
41,000
60,800
0.08
32,200
3.22
12,400
1.24%
41,000
60,800
0.08
32,200
3.22
12,400
1.24%
10
41,000
60,800
0.08
32,200
3.22
12,400
Year 2
Received Fixed
Invest in T-US(2)
LIBOR Rate
%
BUY CAP@6
Received Fixed
Payoff
Guaranteed
SELL FLOOR@6
Premium
%
1.24%
Guaranteed
Return
Return
Payoff
Premium
($)
(% )
41,000
800
0.08
-27,800
3.22
12,400
1.24%
41,000
10,800
0.08
-17,800
3.22
12,400
1.24%
41,000
20,800
0.08
-7,800
3.22
12,400
1.24%
41,000
30,800
0.08
2,200
3.22
12,400
1.24%
41,000
40,800
0.08
12,200
3.22
12,400
1.24%
41,000
50,800
0.08
22,200
3.22
12,400
1.24%
41,000
60,800
0.08
32,200
3.22
12,400
1.24%
41,000
60,800
0.08
32,200
3.22
12,400
1.24%
41,000
60,800
0.08
32,200
3.22
12,400
1.24%
41,000
60,800
0.08
32,200
3.22
12,400
1.24%
10
41,000
60,800
0.08
32,200
3.22
12,400
Year 3
Received Fixed
SELL FRA
LIBOR Rate
%
BUY CAP@6
Received Fixed
Payoff
Guaranteed
SELL FLOOR@6
Premium
%
1.24%
Guaranteed
Return
Return
Payoff
Premium
($)
(% )
60,000
800
0.08
-27,800
3.22
31,400
3.14%
60,000
10,800
0.08
-17,800
3.22
31,400
3.14%
60,000
20,800
0.08
-7,800
3.22
31,400
3.14%
60,000
30,800
0.08
2,200
3.22
31,400
3.14%
60,000
40,800
0.08
12,200
3.22
31,400
3.14%
60,000
50,800
0.08
22,200
3.22
31,400
3.14%
60,000
60,800
0.08
32,200
3.22
31,400
3.14%
60,000
60,800
0.08
32,200
3.22
31,400
3.14%
60,000
60,800
0.08
32,200
3.22
31,400
3.14%
60,000
60,800
0.08
32,200
3.22
31,400
3.14%
10
60,000
60,800
0.08
32,200
3.22
31,400
3.14%
Strategy 4
Strategy 4
Invest
BUY
Notional Principal
Treasury 3yrs
Collar 4
10,00,000 ($)
Received Fixed
Pay floating part
Guaranteed
Guaranteed
Invest in T-US(3)
BUY CAP@6
SELL FLOOR@6
Return
Return
Received Fixed
Payoff
Premium
Payoff
Premium Net Cash inflow Net Cash inflow
Cash inflow ($) Cash outflow ($)
%
Cash inflow ($)
%
($)
(% )
LIBOR Rate
%
0
1
2
3
4
5
6
7
8
9
10
45,000
45,000
45,000
45,000
45,000
45,000
45,000
45,000
45,000
45,000
45,000
800
10,800
20,800
30,800
40,800
50,800
60,800
60,800
60,800
60,800
60,800
0.08
0.08
0.08
0.08
0.08
0.08
0.08
0.08
0.08
0.08
0.08
-27,800
-17,800
-7,800
2,200
12,200
22,200
32,200
32,200
32,200
32,200
32,200
3.22
3.22
3.22
3.22
3.22
3.22
3.22
3.22
3.22
3.22
3.22
16,400
16,400
16,400
16,400
16,400
16,400
16,400
16,400
16,400
16,400
16,400
1.64%
1.64%
1.64%
1.64%
1.64%
1.64%
1.64%
1.64%
1.64%
1.64%
1.64%
In the above mentioned strategies the company would be able to make sure shot profit.
When LIBOR is expected to lie below 2.4%, then Easy Money trading should enter into a Cap and
simultaneously enter into opposite into FRA, Floor, Collar or SWAP to gain.
When LIBOR is expected to lie between 2.4% to 5.8%, then Easy Money trading should enter into either
collar or floor contract. Simultaneously it should enter into opposite position FRA, Cap or SWAP to gain.
When LIBOR is expected to lie above 5.8%., then Easy Money trading should buy a collar and
simultaneously it should enter into opposite position either into FRA, Cap, SWAP or Floor