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Financial Markets & Instruments Chapter 8: Specialised Interest Rate Derivatives 8.1 Introduction 8.1 Introduction With the fluctuations in interest rates shown in recent years, investors in interest rate products and lenders who pay interest on their loans have discovered that there are risks attached to their investments/liabilities which they have not always anticipated. Some large losses were suffered due to the movements in interest rates. This resulted in specialised interest rate derivatives being created in the market to hedge the risk of large financial losses due to movements in interest rates. These derivatives, although developed to manage the risk of interest rate fluctuations, can also in certain circumstances be used to hedge other risks, such as price risks, etc. The interest rate derivatives that will be discussed in this chapter are:
8.2 Forward rate agreements (FRA) 8.2.1 Introduction to forward rate agreements A forward rate agreement can offer protection against unfavourable movements in interest rates for future borrowings or investments. A forward rate agreement determines the interest rate for a borrowing or an investment for a certain period, with the borrowing or investment starting at a specified date in the future. The FRA is an agreement based on a notional principal amount, and the settlement takes place in cash on a prespecified date that is normally the starting date of the underlying investment or borrowing. An FRA will have two interest rates in the contract:
The fixed rate specified in the contract will be compared to the specific floating rate on the starting date of the underlying investment/loan, and a net payment will be made by or to the buyer/seller. One of the common rates used as the floating rate is the 90day BA rate converted to a yield. 8.2.2 The working of a FRA An FRA is quoted by using the fixed rate, the notional principal, the time until the start of the underlying loan or investment and the time until expiry of the underlying loan or investment. The following quote is given on an FRA: 16% on R10 million for 3 against 6 months. This will fix the interest rate of a loan starting in three months' time and maEagle Tradersg in six months, at 16%. The total period of the loan is thus 3 months (63). The agreement further stipulates that settlement takes place on the date that the underlying loan starts, and that the floating rate is the 90day BA rate converted to a yield. To calculate the settlement that has to take place under the FRA, the following formula is used: SA = (Fi  Fli) x d/365 x N Where SA = settlement amount Fi = fixed interest rate Fli = floating interest rate d = number of days from the start of the underlying loan/investment until the expiry of the underlying loan/investment N = notional principal amount of the agreement. If the fixed rate is higher than the floating rate (which gives a positive answer to the formula), the buyer has to pay the seller the settlement amount and vice versa. If, in the above example, the 90day BA rate converted to a yield on settlement date (three months after the closing of the contract) is 16,5%, the settlement amount will be: SA = (16%  16,5%) x 91/365 x R10 000 000 = (R12 466) to be paid by the seller to the buyer on settlement date. 8.3 An interest rate swap agreement 8.3.1 Introduction An interest rate swap agreement is an agreement between two parties to swap a fixed rate and a floating rate paid on loans of a certain notional principal for a certain period. If a company, for instance, pays a floating rate on a loan, and the company is of the opinion that the market rates and the floating rate will increase, it could swap its floating rate with another company paying a fixed rate on a loan but with a different opinion about interest rates. In the case of an interest rate swap (as with an FRA), both parties are exposed to the upside (interest rates moving as anticipated) and the downside (interest rates moving in the opposite direction from the anticipated direction). 8.3.2 The working of an interest rate swap agreement No exchange of principal amounts takes place. The agreement will stipulate:
Agapé Limited borrowed R3 million to build a new shopping complex in a suburb in Pretoria where business is booming. Agapé borrowed this amount from Newsa Bank over a period of 10 years at a fixed rate of 15%. The company is of the opinion that interest rates will decrease over the next period, and would rather be paying a floating rate on the loan. The following swap agreement is closed with Wisdom Bank on 1 Jan. 19.1:
The spot floating rate on the reset date will be compared to the fixed rate, and a calculation made for the period from the last reset date (or the starting date if it is the first reset date). The net payment (settlement amount for that reset period) made on settlement date will be calculated as follows: SA = (Fi  Fli) x d/365 x N where SA = settlement amount for that reset period Fi = fixed interest rate Fli = floating interest rate d = number of days in relevant reset period N = notional principal amount If the fixed rate is higher than the floating rate (which would give a positive answer to the formula), the fixedrate payer would make a net payment to the floatingrate payer of the amount calculated, and vice versa. On 1 April 19.1 the 90day BA rate was 14,9%. The following calculations would now be made: Firstly the BA rate must be converted to a yield. The 90day BA rate of 14,9% converts to a yield of 15,46% SA = (15%  15,46%) x 90/365 x R3 million = (R3 403) that Agapé pays to Wisdom bank on 1 July 19.1 (the settlement date for this reset). On the next reset date, which is 1 July 19.1, the same calculation will take place, and the payment date for this second reset date is 1 October 19.1. The merchant banks which deal in derivatives will normally give quotes on swaps. They will, however, also manage their own exposure to swaps from a risk and cash flow point of view. A bank would try either to cover each swap transaction with another swap agreement which counter the effects of the first, or take a view on interest rates so that the exposure to floating interest rates reflects the view of the bank. In the following example, the bank has two swap agreements:
The bank in the above situation has an open position in swaps of R2 million. The movement of rates in the market will not affect the fixed rate payments, but will affect the floating rate payments. Because the bank receives the floating rate (prime  2%) on R2 million more than it pays on the floating rate, the bank is exposed to floating rates decreasing. In net terms, if the floating rate decreases, the bank will lose money and if the floating rate increases the bank will gain. This is similar to a short position in the bond market. An offset such as the one illustrated above can be done with any two swaps where the same basic floating rate is used (such as the BA rate or the prime rate, etc.) and where the spread between the fixed rate and the floating rate is the same. The following swaps can, on this basis, also be set off against each other:
The difference between the fixed rate and the floating rate in the abovementioned swaps will always be the same, no matter what the prime rate does. 8.4 Swaptions A swaption is an option on a swap agreement. The option is bought at a premium, and it can be an American or a European option. The starting date of the swap agreement will be the settlement date of the option (normally the same as the date that the option is exercised). The terms of the swap would be agreed at the time the writer writes the option, and that would be the underlying instrument of the option. 8.5 An interest rate cap agreement 8.5.1 Introduction to a cap The interest rate cap agreement was developed to protect the buyer of the cap against rising interest rates. Where a company, for instance, pays a floating rate on a loan and is scared that interest rates might increase, resulting in the company paying more interest, it can buy an interest rate cap. This is an agreement whereby a maximum rate (the cap rate) for a floating rate is agreed upon with the effect that, should the floating rate increase above the cap rate, the seller would pay the buyer the difference between the floating rate and the cap rate, calculated on an agreed notional principal amount for a certain period. Because the seller is the only party taking a risk in the agreement, the buyer has to pay the seller a premium for the agreement. 8.5.2 An example of a cap agreement Shalom Limited pays a floating rate (prime  2%, currently 15%) on a loan to construct a hotel in Bloemfontein, a city where social activities are booming. The company is of the opinion that interest rates are on the increase. The estimated return on the investment at current interest rates is 19%. If interest rates increase and the prime rate increases by more than 4%, the return on the investment would be lower than the cost of capital. Shalom thus wants to hedge against a prime rate higher than 21% (which would give it a rate of 19% on its loan. The following interest rate cap agreement is bought from Hedgem Bank for which Shalom pays Hedgem Bank a premium of R5 000:
On each reset date, the floating rate will be compared with the cap rate. If the floating rate on the reset date is less than the cap rate, no payment will be made between the two parties. If the floating rate on the reset date is higher than the cap rate, a payment will be made by the seller to the buyer, equal to the following: SA = (Fli  Fci) x d/365 x N where SA = settlement amount for that reset period Fli = floating interest rate of the agreement Fci = fixed cap rate of the agreement d = number of days in relevant reset period N = notional principal amount If, in the above example, the floating rate on 1 April 19.1 was 20.5%, no payment would be made between the two parties. If, however, the prime rate on 1 Jan. 19.1 was 22%, the following payment would be made: SA = (22%  21%) x 90/365 x R10 000 000 = R24 657 by Hedgem Bank to Shalom on 1 July 19.1 (the first settlement date). 8.6 Interest rate floors Interest rate floor agreements were designed for investors to hedge against decreasing interest rates. An investor buying an interest rate floor, specifies a minimum rate (the floor rate). The floating rate in the agreement must drop below the floor rate before any cash payment takes place between the two parties. An interest rate floor agreement is thus an agreement whereby the minimum rate (the floor rate) for a floating rate is agreed upon with the effect that, should the floating rate decrease to a level below the floor rate, the seller would pay the buyer the difference between the floor rate and the floating rate, calculated on a notional principal amount, and for a certain period. The seller takes on the risk of decreasing interest rates, and will be paid a premium by the buyer. Similar to an interest rate cap agreement, a notional principal amount will be agreed on and a term for the contract will be specified, together with reset and settlement dates. Calculations of payments take place when the floating rate is below the floor rate, and the calculation will be similar to that used for the cap calculation. 8.7 Interest rate collars An interest rate collar agreement is a combination of cap and floor agreements. This will normally be done when there is a strong opinion that rates will move only in one direction and protection is needed for that move. Depending on the floor and cap rate specified in the collar agreement, no premium or a very small premium might be payable. The purchase of a collar is the simultaneous purchase of a cap and the sale of a floor. The sale of a collar is the simultaneous sale of a cap and the purchase of a floor. With the purchase of a collar agreement, a fixed rate investment can be changed to a floating rate investment outside the cap and floor rate specified.
