Interest Rate Derivatives Flashcards
What are the tree main uses of interest rate derivatives?
Hedging, speculation, and arbitrage
What are the two main types of interest rate derivatives?
Linear (forwards, futures, swaps) and non-linear (options, caps, floors, collars, swaptions)
What makes an interest rate derivative linear?
Its payoffs changes proportionally to interest rate movements.
What is an example of a non-linear interest rate derivative?
Options because their payoffs are asymmetric.
What risk do interest rate derivatives primarily manage?
Interest rate fluctuations affecting bond values, loan costs and investments.
What is a forward contract?
A private agreement to buy/sell an asset at a predetermined future price.
How is the price of a forward contract determined?
Using the no-arbitrage formula:
Price of the underlying / Discount rate
What is the payoff formula for a long forward contract?
Payoff = Actual price - Forward price
What happens to a forward contract when interest rates rise?
The forward price falls, benefiting short positions.
What are forward contracts on coupon bonds called?
Forward Rate Agreements (FRAs), where future coupon payments are included in pricing.
What is an interest rate swap?
A contract where two parties exchange interest payments (fixed vs floating)
What is a payer swap?
A swap where you pay fixed and receive floating
What is a receiver swap?
A swap where you receive fixed and pay floating
Why would a company enter a payer swap?
To lock in fixed borrowing costs and hedge against rising rates
What is the value of a swap at initiation?
Zero, since the fixed and floating legs are balanced at t=0.
How does the value of a swap change over time?
It fluctuates based on changes in interest rates and discount factors.
What is a swap spread?
The difference between the swap rate and Treasury bond yields
What is an overnight indexed swap (OIS)?
A swap where the floating leg is based on a compounded overnight rate instead of LIBOR.
What happens to a payer swap if interest rates rise?
Increases in value
What happens to a receiver swap if interest rates fall?
Increases in value
What is the key difference between options and swaps?
Options give the right but not the obligation to transact, while swaps are obligations
What is a bond call option?
A right to buy a bond at a fixed price before expiration.
What is a bond put option?
A right to sell a bond at a fixed price before expiration.
What is the payoff formula for a call option?
max(P - K, 0), where P is bond price and K is strike price
What is the Put-Call Parity for bonds?
Call - Put = Pfwd - K
What is an interest rate cap?
A series of call options (caplets) on interest rates to limit maximum borrowing costs.
What is an interest rate floor?
A series of put options (floorlets) on interest rates to guarantee a minimum return.
What is a collar?
An upper and lower limit of interest rate by a combination of a long floor and short cap to limit interest rate exposure.
How is a caplet’s payoff calculated?
Accrued period * (Actual rate - Caplet rate, 0) * Notional amount
How is a floorlet’s payoff calculated?
Accrued period * max(Floorlet rate - Actual rate, 0) * Notional amount
What is a swaption?
An option to enter into a swap at a future date.
What is a payer swaption?
The right to enter a payer swap (pay fixed, receive floating)
What is a receiver swaption?
The right to enter a receiver swap (receive fixed, pay floating)
Why would a company buy a receiver swaption?
To hedge against falling interest rates
What model is used to price swaptions?
The Black model, a variation of Black-Scholes
How do companies hedge floating-rate debt?
By using a payer swap or buying a cap.
How do banks hedge against falling interest rates?
By using a receiver swap or buying a floor.
How does a firm hedge a future loan’s rate exposure?
Using a forward rate agreement FRA
What is the main risk of a swap hedge?
If the loan is repaid early, the swap remains, creating exposure.
What is the role of the swap curve?
It represents market swap rates for different maturities.
