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AFMA Debt Markets > Ch 4: FRAs; Swaps & Futures > Flashcards

Ch 4: FRAs; Swaps & Futures Flashcards

1
Q

Forward Rate Agreement

  • Define
  • Principal
  • Settlement
A

Define
- Agreement between two parties to exchange interest payments at a future date, specific amount and agreed contract rate.

Principal
- No exchange of principal

Settlement

  • Net settlement of interest differential between contract rate and settlement rate (eg BBSW)
  • On settlement date one party owes the other
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2
Q

FRA terminology

  • Contract date
  • Start date
  • Settlement date
  • Contract / agreed / fixed rate
  • 1/4
  • 2/5
  • buy a FRA
  • sell a FRA
A

FRA terminology

  • Contract date (date 2 parties enter FRA transaction)
  • Start date (commencement date of FRA)
  • Settlement date (Cash settlement date of FRA)
  • Contract / agreed / fixed rate (rate at which parties agree to settle on SD)
  • 1/4 (FRA for 3 month period starting in 1 month from contract date)
  • 2/5 (FRA for 3 month period, starting 2 months from contract date)
  • buy a FRA (borrower wishes to lock in contract rate and pay fixed)
  • sell a FRA (lender who locks in investing rate and receives fixed)
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3
Q

Advantages of FRAs ((4)

A
  1. Effective hedge against ST interest rate exposures
  2. OTC, therefore tailoring possible
  3. Convenience
  4. FRA mkt is large & efficient, no up front cost and bid-offers are narrow
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4
Q

Disadvantages of FRAs (4)

A
  1. No centralised secondary market for FRA contracts, contracts standardised hence less liquid
  2. Cover only ST rates; however a strip can be used
  3. Default / counterparty risk
  4. FRA market is non transparent
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5
Q

Interest Rate Swap

  • Define
  • Interest paid:
  • Settled
A

Define:

  • Agreement betw 2 counterparties: agree to make periodic payments for an agreed period based on a notional amount.
  • Interest is paid in arrears
  • Settled on net cash basis
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6
Q

Swaps - usage (6)

A
  1. obtain lower funding cost for borrowers
  2. hedge interest rate exposure or portfolio of interest rate risk
  3. obtain higher yielding investment assets
  4. create types of investment assets not otherwise obtainable
  5. implement overall asset/liabilities management strategies (eg change characteristics, not composition)
  6. Take speculative positions
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7
Q

Advantages of swaps (4)

A
  1. floating to fixed rate increases certainty of future interest rate obligations
  2. swapping allows issuers to revise their interest rate profile (take advantage of current or expected future monetary policy and interest rate conditions
  3. can more closely match cash flows between assets & liabilities
  4. Can be tailored
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8
Q

Valuing a swap

A
  1. Calculate the cash flow
  2. Calculate the discount factors
  3. Calculate the NPV of the swap
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9
Q

Swap is at the money when”

A

when the NPV of the swap is zero

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10
Q 
DEFINE
Accreting swap
Amortising swap
Basis
Balloon
Forward Swap
A

Accreting swap
- where the notional swap increases in time
Amortising swap
- where the notional principal reduces in time
Basis
- a floating - floating margin with a different roll basis (eg, 3mth vs 6 mth)
Balloon
- lump or balloon principal adjusted usually at end of period
Forward Swap
- standard fixed for floating swap that starts out of a forward date

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11
Q

Forward Swap

A
  • standard fixed for floating, starting on a forward date

- Use zero curve and discount coupon methodology

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12
Q

Calculate forward swap

A
  • Draw in the cashflows, eg if swap doesn’t start till 2 years; the first cash flow will be in two years time.
  • Calculate the discounted cashflows
  • Calculate the NPV
  • Find the market yield (if substantially positive or negative, swap is in / out of the money relative to current yield curve. Iterate coupon rate to find NPV of zero to give current market rate of swap
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13
Q

Overnight Interest Swap

  • Define
  • Term
  • Interest
  • Principal
  • Advantage
A

Define
- fixed rate swap against floating rate index which is the overnight cash rate compounded daily

Term
- Typically between 1 week and 2 years

Interest
- Compounded daily over the term of the transaction, difference between fixed and floating leg is exchanged on the day following maturity

Principal
- No principal is exchanged, effectively reduced credit risk

Advantage
- Allows interest rate exposure to be managed off balance sheet freeing up credit, reducing capital charges and managing mismatches

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14
Q

Pricing OIS - selecting curve

A
  • priced similar to IRS
  • can trade relative to money market curve as well as compounded cash rate
  • also forward FX rate, or 30 day cash futures. S
  • Starting point remains current cash rate
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15
Q

OIS settlement

A
  • final reset day is 1 Sydney BD prior to termination date
  • Local non business days are included as extra business days in the day count of the previous local business day (eg daycount for Friday preceding weekend = 3 days)
  • Settlement = difference between fixed amount and floating amount paid on business day after maturity date
  • Reference page RBA 30 is quoted to 2 dp; floating amount rounded to nearest cent
  • Interbank overnight cash rate is the rate specified on RBA30 at or about 9am on business day following the relevant business day on which rates are quoted on the page
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16
Q

Currency Swap

- Define

A

Define:

  • exchange between 2 parties of the principal and interest payment (either fixed or floating) denominated in one currency for an equivalent principal amount and interest payment (fixed or floating) in another currency
  • Strictly speaking should just be fixed vs fixed
17
Q

Types of currency swaps

3

A
  1. Currency Swap (fixed vs fixed)
  2. Cross currency swap; fixed vs floating
  3. Cross currency basis swap: floating vs floating
18
Q

Currency swap usage (4)

A
  1. Take position on direction of interest rate
  2. Alter exposure of existing assets / liabilities to change exchange rates
  3. Reduce borrowing costs (if more favourable in foreign currency)
  4. Enhance return on assets by investing in higher yielding currency and hedging with currency swaps
19
Q

How currency swap works

A
  1. initial exchange of principal at an agreed rate (usually spot). Can be notional or physical.
  2. Exchange interest based on outstanding principal amounts at the rates agreed
  3. Re-exchange principal.
20
Q

Cross currency swaps

A
  • take advantage of arbitrage
  • allow access to cheapest source of funds
  • allow active currency exposure management
21
Q

Disadvantage of cross currency swap

A
  1. default by one counterparty leaves a currency exposure
  2. higher credit risk issues
  3. can be expensive to terminate
22
Q

Currency swap types (5)

A
  1. Asset swap (currency swap with interest streams backed by cashflows from assets
  2. Differential swap (cross currency basis swap with no exchange of principal)
  3. Circus Swap (cross currency swap, one stream is fixed, the other is floating “combined interest rate and currency swap”
  4. Annuity swap (cash flow streams are exchanged with no change of principal at maturity
  5. Amortising currency swap (reexchanged in stages; principals repaid over the life of the swap)
23
Q

90 day bank bill futures

A
  • deliverable
  • price represents expected market value of 90 day physical bank bill on contract expiry date
  • basis for all pricing in short dated physical and derivatives markets
  • notional face value = 1m
  • Mar, Jun, Sep, Dec at 12 pm on 2nd Thursday of expiry month
  • contracts exist out to 5 years
  • actual / 365
24
Q

3 and 10 year bond futures

A
  • represent 6% coupon 3 and 10 year Commonwealth Govt Tsy bonds on expiry date
  • Notional face value 100K
  • Multiples of 0.005
  • Mar Jun Sep Dec on 15th of month or succeeding business day
  • cash settled against a basket of Cwlth bonds preselected by SFE
  • tick value calculated as difference between contract value at current market price and at current market price + 0.01%
  • Tick values increase as yields go lower and decrease when they go higher
25
Q

30 day interbank cash rate futures

A
  • based on interbank overnight cash rate published on RBA30
  • speculate on short end of the yield curve
  • hedge fluctuations in overnight cash rate and manage daily cash exposures
  • 3m notional
  • cash settled on the average monthly interbank overnight cash rate
  • fixed tick of 24.66 per bp
  • prices quoted in 0.005
  • monthly, up to 18 months ahead
  • last trading day 4.30pm on last business day of expiry month, settlement on 2nd BD after last trading day
26
Q

Exchange for Physical

A
  • exchange physicals for futures
  • no outright risk, just basis risk
  • dealt off exchange; therefore must be delta matched, futures price agreed must be within market at time of execution
27
Q

Pricing OIS

- current cash rate 6%, notional = $100. Calculate 1 week OIS

A
  1. Calculate the Future Value
    FV = PV (1+(I x d/365))^n
  2. Calculate OIS rate
    OIS rate = (FV / PV -1) x 365/n
28
Q

Settlement rate on IB contract (weight by # days at RBA rate)

A

Settlement rate = average interbank rate for given month

eg ((0.06 x 5) + (0.0575 x 26)) / 31

29
Q

When calculating cash settlement for forwards, remember the days / 365….

A

days / 365 component represents the term of the forward, not the term before the forward commences
(eg 1/4; use 90/365)

30
Q

BUY a FRA

A

borrowers who wish to lock in a borrowing rate to pay fixed

31
Q

SELL a FRA

A

lenders who lock in a rate to receive fixed

32
Q

To annualise a number - eg to calculate effective rate over 90 days:

A

(FV / (cost) - 1)) x 365 / 90

33
Q

To calculate effective yield using futures transaction:

A
  1. calculate difference on futures contract (eg, 95.00 - 94.50 = 0.5%)
  2. Add back to the yield on the investment - eg buy bonds at 4.5%, add back the 0.5% from futures profit; effective yield is 5%
34
Q

tick value 30 day IBs:

Calculate profit: difference in price (95.7 - 95.53)

A

Tick value = 24.66

P/L: 95.7 - 95.53 = 17 ticks. 17 * 24.66 = 419.22

AFMA Debt Markets (8 decks)

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