OTC Derivatives

Chapter 4

14 Questions

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 Further information
1. OTC Pricing Considerations
1.3.1 FRA pricing – cash market rates or futures price
1.1 Prices driven by continuous changes in market movements such as:
Forward pricing – fair value (cash price + cost of carry)
• Interest rates (yield curves) 1.3.2 IRS pricing – a series of futures contracts or yield curves
• Currency rates 1.3.3 Option pricing – option pricing models
• Equity prices 1.3.4 Credit derivatives – bank’s own pricing model
• Underlying asset prices

1.3.6 All financial products in the markets have the following features:
• Bid: Price/rate dealer buys at
• Offer: Price/rate dealer sells at
• Mid: Average of bid and offer prices/rates
• Spread: Difference between bid and offer prices/rates

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 Hints
1. OTC Pricing Considerations Note that the yield curve does not show yields on securities at different points
in time: It shows current yields on securities of different lengths of time to
1.2 Building a Theoretical Yield Curve maturity.
Yield curves (a.k.a. term structure of interest rates) reflect the different yields to
maturity for different maturity dates across a particular bond market.

Normal/upward UK
Gilts
US Tsy
Yield

DE Bund

Maturity Source: Bloomberg

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1. OTC Pricing Considerations
All of the bonds used to construct the yield curve have the same risk rating
• Yield curves built from non-treasuries will yield more at each date, known as
the ‘spread’over treasuries
• It is possible to have options whose pay-off is related to this spread (credit
spread options)
AAA spread over
Maturity T-bond YTM (% pa) AAA YTM (% pa)
Treasuries
Three months 1.02 1.62 +0.6

Six months 1.37 2.07 +0.7

Two years 2.56 3.26 +0.7

Five years 3.9 4.45 +0.55

10 years 4.76 5.76 +1.0

30 years 5.45 6.05 +0.6

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 Hints
2. Interest Rates
Which OTC products are related to interest rates?
2.1 Interest Rate Changes • Forward rate agreements (FRAs)
What affects the changes in interest rates? • Interest rate swaps (IRSs)
• Currency swaps
Health of underlying economy
• Interest rate caps, floors and collars
• Rate of inflation • Amortising, accreting and rollercoaster swaps
• Central bank policy • Overnight index swaps (OISs)
• FX resettable swaps
• Options on interest rate swaps (‘swaptions’)
Who is affected by changes in interest rates?
• If interest rates rise, the value of fixed-rate paying bonds drops (and vice-versa)
• Depositors
• Borrowers

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2. Interest Rates
2.2 Benchmark Interest Rates
•Loans and deposits which accrue interest at a variable rate are linked to a
market determined benchmark rate; usually the rate which banks give on
deposits or charge for making loans
- London interbank offered rate (LIBOR) is an example of such a benchmark

•LIBOR:
- Announced at 11:45am London time daily (fixing time)
- Administration passed to ICE Benchmark Administration (LIBOR scandal)
- Available through quote vendors (Reuters etc.)
- LIBOR is set for major currencies for terms available up to 12 months

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 Hints
2. Interest Rates Please note the difference between US Fed funds rate and US prime rate.
The Prime Rate
2.2 Other Benchmark Interest Rates The rate at which banks lend to companies of top creditworthiness
Fed Funds
• Euribor is the interest rate benchmark for EUR
The US Federal Reserve central rate.
• Fed Funds interest rate is the interest rate benchmark for domestic US dollar Both are used widely as US domestic rates.
(US dollar LIBOR is the benchmark for international dollars)

Effective Date (Fixing)

Further information
• GBP LIBOR = same day value
Euribor
• Most other currency LIBOR = value two business days later
• Set by a group of European banks called the European Banking
• Euribor and Fed Funds = value two business days later Federation.
• Fixed at 11.00 Central European Time in Brussels and available through
Telerate.

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 Keeping on target
3. Forward Rate Agreements (FRAs) A company buys a 1v4 FRA on £20m at a rate of 5%. Three-month
LIBOR is agreed as the benchmark. By the effective date, LIBOR has
Definition risen to 5.2%.
• An FRA is an agreement to pay or receive the difference between a fixed rate
and a reference rate on a fixed future date Calculate the profit or loss.
• FRAs can be used to hedge/speculate on the future direction of interest rates
• Expressed as ratio: ‘start month’ (or effective date) vs. ‘end month’ (or
termination date), e.g. 1v4
• Payout on effective date
1 x 4 period (91 days)

0 1 2 3 4

Effective date Termination date

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3. Forward Rate Agreements (FRAs)
Question 5:
• An FRA is traded on 8th January for the period 8th March to 8th June at 3.25%.
The notional principal is €10,000,000. If the three-month Euribor is set at 3.0%
(Euribor on 6 March) determine:
- The FRA is a 2v5
- The effective date (settlement date) is: 8th March
- The Euribor fixing date would be on 6 March (two business days prior to settlement)

What is the settlement amount? Assume 92 days in the period and 360 days in
the year.

Who pays (Buyer/Seller of FRA)?

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Answer to the question on the previous slide:

Step one
This is a profit for the company. It goes long and the LIBOR goes up by 0.2%.
Step two
This need to be turned into a three-month rate, so 0.2 / 4 = 0.05%.
Step three
Apply the profit to the notional amount.
£20m x 0.0005 = £10,000.
Step four
Discount the amount by the current interest rate (adjusted for the time period):
£10,000 / 1.013 = £9,872.

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4. Interest Rate Swaps (IRSs)
Definition
• An IRS is an agreement to exchange, over an agreed term, two periodic
payment streams, each calculated using a different type of interest rate but
which are based on the same notional principal amount

4.2 Comparison between IRSs and FRAs

• The effect of a fixed/floating IRS is the same as the effect of a series of FRAs
for consecutive periods
• There are practical differences:
- Settlement of an FRA takes place at the beginning; for an IRS, it takes place at the
end of each period
- Settlement of an FRA is always netted; for an IRS, the payments may not necessarily
coincide

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4. Interest Rate Swaps (IRSs)
4.1 Fixed against Floating
Example: A corporate has two years remaining on a six-month floating rate (six-
month LIBOR) loan of £5,000,000. The treasurer is concerned that interest rates
(and the company’s interest payments) may rise.
A bank is currently quoting the two-year swap as 6.2% – 6.3%. The treasurer
buys the swap at 6.3% on a notional of £5,000,000. The company has become
the payer in the swap (paying fixed rate).
6.3% Fixed
Bank/
Corporate
Dealer
6m
LIBOR LIBOR

Two-year
Loan

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4. Interest Rate Swaps (IRSs)
Example (cont.)
• On the six-monthly interest date the two parties to the swap will exchange
payments. These payments are calculated as follows:

Notional amount  Interest rate  Days in calculatio n period

100 Days in year

• The interest rate will be either fixed or floating

• Cash payments are netted
• Payments made at the end of each period (therefore no discounting required)

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 Further information
4. Interest Rate Swaps (IRSs) Other points to note about interest rate swaps:
• Payment frequency needs to be determined
Example (cont.)
• Standard market practice:
182
Bank : 0.065  5m 
365
 162,054.79 - Fixed on one side (paid annually), floating on other (paid semi-annually)
182
Company : 0.063  5m 
365
 157,068.49 - Possible to have fixed (paid annually), floating (paid monthly) if required
Net  4,986.30 (Bank pays company)
- Counterparties described as fixed rate payer or fixed rate receiver
Effective Termination
date (T) 182 days 183 days 182 days date

First payment Second payment Payment

date (settlement) date (settlement) date

Reset Reset
Reset
date date
date (T)
For second
For first payment
payment
LIBOR 6.5%
LIBOR 6.8%
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 Further information
4. Interest Rate Swaps (IRSs) 5.1 Overnight Index Swaps (OIS)
• An OIS is a fixed/floating swap where the floating index is an overnight
4.3 Basis swap interest rate. They are short-term swaps used in the money markets.
• Both payment streams based on variable rates (floating for floating) • Overnight benchmarks rates
• Difference lies in the term of the variable rate - SONIA (for GBP)
- E.g. three-month LIBOR vs. six-month LIBOR - EONIA (for EUR)
• Daily payment liabilities are compounded and settled periodically (e.g.
Three-month LIBOR Six-month LIBOR monthly rather than daily).
• Other uses:
Customer Customer
Bank
A B - Bank could borrow for one year then enter swap to receive one year
8.1% 8.3%
fixed and pay overnight rate (swap funding risk)
- Arbitrage gap between fixed term rates and OI rate
• Solution to exposure to change in three-month LIBOR vs. six-month LIBOR? - Reduce credit risk
- Asset swap (exchange long-term income for short-term rate)

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 Links
5. Currency Swaps Note: Currency swaps are different to FX forwards. Currency swaps
involve an exchange of principal at the beginning and at the end. It also
Definition locks in interest rates during the term of the swap protecting against
interest rate movements.
• A currency swap is an exchange of a series of cash flows in one currency for a
series of cash flows in another currency, at agreed intervals over an agreed Chapter 4, Section 14.4: FX Swaps
period, and based on agreed interest rates
Currency swaps are also different from FX swap. FX swap is an agreement
borrow one currency in exchange for lending another for a fixed period of
FX resettable swap time. The second exchange happens on maturity to return the borrowing so
there is only two exchange of cash flows at the beginning and the end.
• Settlement amounts are calculated by revaluing the swap (mark-to-market) on
a regular basis and paying/receiving the mark-to-market loss/profit since the
last settlement

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 Further information
5. Currency Swaps Illustration: USD 360,000

On every bond coupon date: US company Swap Counterparty

Illustration EUR 250,000
USD 360,000
• A US company wishes to expand into Europe
- It needs EUR 10m US company
bond holder
- European investment banks have quoted a high coupon to raise this money. The US
company is unknown in Europe.
At the end of the swap: USD 12m
- The US investment bank advising the company suggests issuing a dollar bond and US company Swap Counterparty
swapping the proceeds into euros EUR 10m

At the start of the swap: Eur10m USD 12m

US Company Swap
USD12m
Counterparty
US company
Bond holders
USD12m

Conclusion:
• The company has swapped a US dollar borrowing into a EUR
US Company
bond holders borrowing via a currency swap
• The company is protected against foreign exchange movements and
protected against interest rate movements in one contract
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• There is normally an exchange of principal at the beginning and end
of the term
• Payment streams cannot be netted because they are across different
currencies

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6. Users
Users
• Banks – speculation, arbitrage and structured products
• Mortgage lenders – hedge borrowing costs and income
• Fund managers – financial engineering
• Companies – hedge asset returns, foreign exchange exposure and borrowing
costs
• Governments – hedge borrowing costs

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 Further information
7. Settlement Details (Day Count) Other conventions:
In these, each month has 30 days regardless of leap years
• Two main day count conventions are actual/360 and actual/365 fixed
• 30E/360 – if the first or last day is 31, change to 30
(actual/365 bond market)
• 30/360 – if the first day is not 30/31 AND the last is 31,
GBP Actual/365 fixed do not change to 30 – keep date as 31

USD Actual/360
EUR Actual/360
CHF Actual/360
Keeping on target
JPY Actual/360
What is the number of days for the period 17th February to 17th April in a
leap year? Day count convention is 30/360.
• All day counts include the first day of the period but exclude the last
• How many days are in the period 15 October 2006 to 15 April 2007? A. 58
B. 59
• Actual/360 C. 60
• Actual/365 fixed D. 61
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Keeping on target
What is the number of days for the period 28th February to 31st March? Day
count convention is 30/360

A. 30
B. 31
C. 32
D. 33

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7. Settlement Details (Day Count)
Further Settlement Issues
• If payment date (settlement date) falls on a non-business day, then we need to
adjust.
• Example: A five-year swap paying LIBOR (receiving fixed) on 15 June/15
December. If the next scheduled payment is 15 June, but 15 June is a
Saturday, then use the next business day as the payment date.
- One exception to this rule is if the rescheduled date falls in the next month – then use
the business day before as the payment date.
• For the floating rate reset use the normal convention relative to the rescheduled
settlement date (always next business day).

IMM swaps
• Payments coincide with the settlement dates of futures trading on the IMM of
the CME (Chicago Mercantile Exchange)
• Quarterly this is the third Wednesday of September, December, March and
June
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Answer to the first question on previous slide:

C

Answer to the second question on previous slide

D

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 Hints
7. Settlement Details (Day Count) You may not always need this formula as sometimes the answer will be
intuitive.
Stub (Broken) Periods E.g. Libor is quoted as per below:
•Irregular non-standard period lengths are referred to as stubs 1 week: 2.9%
•To calculate the appropriate interest rate for a stub (stump) period, a weighted 1 month: 3%
combination of published standard period interest rates is used in accordance 2 month: 3.25%
with the following formula. This calculation is called interpolation.
Calculate the rate for a 38 days stub period:
 2nd rate - 1st rate 
Required rate  1st rate    Date required - 1st date  A. 0.25%
 2nd date - 1st date 
B. 3.00%
C. 3.06%
•Example: 61-day published LIBOR is 5.5% and 91-day LIBOR is 5.85%. What
D. 3.25%
is the appropriate rate for a 75-day stump period?
•Example: 31-day published LIBOR is 5.0% and 61-day LIBOR is 5.5%. What is
the appropriate rate for a 49-day stump period?

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 Further information
8. Operational Complexities (Compounding) Compound interest is the practice of adding accumulated interest to the
principal, so that interest is earned on interest from that moment on.
• In some swaps the interest payments on the leg of a swap may be Clearly, the more frequently income is added to the principal sum, the
compounded sooner it will earn further income.

• A swap is where the fixed leg is paid annually and the floating leg of LIBOR is
re-fixed every month, three months or six months and these rates are Compounding a rate might in turn be complicated by a margin or spread
compounded and then paid as one annual payment over the interest rate as there is a difference between compounding, where
the margin is added to the rate before compounding, and compounding flat,
• For example where fixing occurs every six months but a floating payment is to where the margin is added after compounding.
be paid at the end of the year can be compounded and paid annually
• This can be complicated further by adding a spread to the LIBOR rates (Libor +
0.10%)

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 Further information
9. Interest Rate Protection Products 9.3 Swaption
• Payer swaption – right to enter into a fixed rate payer swap at an agreed
9.1 Caps strike price
• An OTC call on an interest rate • Receiver swaption – right to enter into a fixed rate receiver swap at an
agreed strike
• Useful for a borrower to protect against interest rates rising
• European or American style options are available
9.1 Floor • Flexibility of an option contract with protection benefits of a swap
• An OTC put on an interest rate
• Useful for a lender to protect against interest rates falling

9.2 Collars
• Borrower – buy a cap and sell a floor
• Lender – buy a floor and sell a cap
• Purpose is to set a range for interest rates at a lower cost than individual cap or
floor
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10. Other Interest Rate Products
10.1 Amortising, Accreting and Rollercoaster Swaps
• If an IRS swap is being used to change a borrowing, the swap can match the
loan pattern
- Amortising – the underlying loan is repaid in instalments so notional principal amount
reduces over time
- Accreting – notional principal is designed to increase rather than decrease
- Rollercoaster – notional principal oscillates in line with seasonal borrowing
requirements

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11. Credit Derivatives
Definition:

A credit derivative is a contract (derivative) that is used to transfer the risk of the
total return on a credit asset falling below an agreed level or going into default,
without transfer/ownership of the underlying asset. This is usually achieved by
transferring risk on a credit reference asset or entity.

Three most common ones:

• Credit default swap
• Total return swap
• Credit linked note

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 Further information
11. Credit Derivatives Physically settled
For physically settled contract, at the point of purchase certain criteria need
• 11.1 Credit default swap (a series of payments made by one party in return for to be met of the underlying asset:
compensation from another party, if reference asset is subject to a credit
event). There are three main types: 1. Specified currency: the obligation should be in a liquid currency and not
hampered by any exchange or governmental controls.
- Basic – reference asset is one company, government, security and the compensation
2. Transferable: each of these relate to the ability to get a good transfer of
relates to a credit event on that specific asset e.g. a particular corporate bond
ownership to the underlying.
- Index – compensation relates to movement of an index 3. Not contingent: the deliverable obligation must be free of
- Basket – compensation relates to a group of reference assets e.g. particular bonds in encumbrances, such as Issuer (puttable/callable/exchangeable) rights.
a sector 4. Not subordinated: there has to be an acceptance that what is being
• CDS can either be cash settled or physically settled
delivered ranks pari passu and is not subordinated to other debt
obligations of the Reference Entity.
Cost of
asset Swap
premium Cash Settled
Reference
asset Investor Investor does not receive the full value but receives bond value less
recovery rate.
Asset cash Cash payment
flows should default
occur

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 Further information
11. Credit Derivatives Z-Spread
The Z-spread looks at the spread between the considered bond and a
• 11.5 First to default CDS government bond over the term of the bond. The spread reflects the
- These are smaller baskets of credit default swaps but ones where the payoff is additional risk associated with the considered bond, including the option
triggered by the first reference entity to default risk on those bonds with embedded options. The option adjusted spread
- Can be second to default, third to default, etc. (OAS) removes the option risk from the spread.

• 11.6 Sovereign CDS

- CDS on government bonds

• 11.7 Option Adjusted Spreads

- An adjustment applied to bonds with embedded options, e.g. callable/puttable bonds
- Allows comparison with vanilla bonds

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 Further information
11. Credit Derivatives 2009 ISDA Protocol Big Bang
• Aims to streamline and ensure efficient settlement of OTC credit
11.2 Credit event (defined by ISDA)
derivatives
• Bankruptcy • Protocol applies to existing and future CDS contracts
• Failure to pay (default) Main credit events • Affects physically settled CDS contracts as defined in ISDA 2003
• Restructuring
definition
• Firms who sign up agree that ISDA will establish a settlement price for
• Repudiation/Moratorium cash settlement that is binding in a credit event
• Obligation acceleration
11.10 Uniform settlement agreements (USA)
• Contracts signed after a credit event whereby participants agree that a
credit event notice has been delivered
• If a protocol is subsequently published in relation to that credit event, it
will supersede the USA

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 Further information
11. Credit Derivatives Tranches of debt whether in CDOs or directly on a major index are split into
the following groupings:
11.4 Collateralised Debt Obligations

Bonds secured by a pool of assets: • The Equity tranche is the riskiest and therefore the most akin to holding
the underlying equity.
• Bond portfolio
• The Mezzanine tranche which reflects debt that would rank between
• Loan obligation equity risk and senior unsecured debt – such as senior subordinated debt.
• Portfolio of bonds, equities and other assets (can be a fixed or managed • The Senior tranche – this is the accepted level of normal credit default
protection
portfolio)
• The Super Senior tranche (or Class A tranche) will account for the
• CDS on CDO remainder of the portfolio and is really not expected to be subject to a
credit event, at least on all past experience.

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 Further information
11. Credit Derivatives In the event of negative returns on the asset, the receiver is obligated not
just to pass the benchmark rate to the payer but also any negative returns
11.13 Total Return Swap on the asset.
• This is a swap in which one of the legs pays the ‘total’ return, the capital
changes and interest on an asset in return for a floating rate of interest e.g. Fixed or LIBOR spread
LIBOR
• The difference between a TRS and an IRS is that we are swapping all the
return on the asset when we use a TRS, whereas we are swapping only the Receiver Payer
interest when we use an IRS
Asset
Total
Purchase
Negative return on the asset
return
price
Fixed or Fixed or
LIBOR + LIBOR +
Spread Spread
Total return Total return
Swap payer
receiver
bank

Total return Total return

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12. Equity Market Considerations
12.1.1 Shareholder’s rights/benefits
• Reasons for investing in equities:
- Dividend income
• Covered – paid from this year’s profits
• Uncovered – paid from previous year’s profits
- Capital growth
- Shareholder benefits (perks)
- The right to purchase new shares, e.g. rights issues
- The right to vote at company meetings

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 Further information
12. Equity Market Considerations Preference shares make up part of the total share capital but not part of
the equity share capital of a company.
12.1 The Nature of Shares

Companies may issue more than just ordinary shares. In the UK cumulative preferred shares are the default. So unless stated to
the contrary, you have to assume that a preference share is cumulative.
Ordinary Shares Preferred Shares

Priority 2nd 1st

Dividends Variable Fixed

Voting Yes No

• Cumulative
• Redeemable
• Participating
Special Features • A shares/B shares
• Convertible
• Deferred
• Redeemable

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 Further information
12. Equity Market Considerations A corporate action is anything that happens to a security other than
secondary market trading. As well as the events on the opposite slide, it
12.2 Corporate Actions: Types would also include, for example: Issuing new securities; company
Mandatory liquidations; conversions of preference shares or bonds to ordinary.

• Bonus issues
Dividends Effect on share price: Increase on
• Mergers Cum date and decrease on ex date
• Dividends Bonus issues Effect on share price: Decrease
• Cash Stock splits/consolidations
Rights issues Effect on share price: Decrease
Voluntary
• Takeovers Stock split Effect on share price: Decrease

• Rights Issues
Consolidation Effect on share price: Increase
Mandatory with options
Takeover Effect on share price: Increase
• Dividend – cash or more shares?

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 Further information
12. Equity Market Considerations Trading Disruption

12.4 Market Disruption Events

Any event which prevents market participants filling orders on the
exchange because trading in a share has been limited by the exchange.
• To value instruments traded on an exchange is fairly straightforward This may be due to excessive movements in the price of that share on that
day, or because there is only a bid up/ offer down quote available in the
• Can be much harder to value OTC instruments due to the illiquid nature e.g.
market.
private equity, property, exotic derivatives
• Multiple price sources should be used along with pricing models
Exchange Disruption
• Should also take into account market disruption events such as: Any event which prevents market participants trading on the exchange
- Trading disruption generally. The most notable occasion of this type is the disruption of the
- Exchange disruption American stock exchanges caused by 9/11.
- Early closure
Early Closure
An unannounced early closure by the exchange, or an early closure with
less than 60 minutes notice. An early closure does not exist when the
exchange is scheduled to close early (e.g. 24 December).

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12. Equity Market Considerations
12.5 Share Indices

Introduction
• A simple way of summarising market movements
• Role in performance analysis
- Helps determine whether portfolio manager is more successful at stock selection or
sector allocation

Construction – index may reflect:

• Asset class
• Geographic region
• Stock exchange
• Securities selected from target market
- Fixed number, e.g. S&P 500
- Varying number to represent % of target market, e.g. FTSE All Share
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 Further information
12. Equity Market Considerations Total return index

Share indices
An index that calculates the performance of a group of stocks, assuming
that dividends are reinvested into the index constituents. For the purposes
Construction of indices and weighting of index calculation, the value of the dividends is reinvested in the index on
the ex-dividend date. Total return index data is not available at the stock
• Price weighted
level.
- The sum of the market price per shares / Number of companies
- Biased towards higher priced shares

• Value weighting
- The sum of market cap / Number of companies
• Market cap = Market price of share x Number of shares
- Biased towards the performance of larger companies

• Float-adjusted market-capitalisation weighting

- Market float (free float)
• Number of shares of the constituent security available to investing public
- Most indices are float adjusted

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 Keeping on target
13. Equity Forwards and Options A fund manager believes the FTSE 100 will increase in value and enters
into an equity index swap. During the term of the swap the index falls in
13.3 Equity Swaps value. Which of the following will the fund manager have to do?
• Definition: One party pays a floating interest rate e.g. LIBOR, in return for the A. Make interest payments to the swap dealer
change in value of an equity index all settled against a notional principal B. Make interest payments to the swap dealer and additional payments
amount for the decrease in the value of the index
• Switch from one asset type to another without trading the underlying (achieves C. Make increased interest payments until the index increases in value
synthetic exposure at a lower cost) D. Make payments based on the value of the index only to the swap
‘Equity leg’ dealer
Index/Basket/Individual
equity:
gains (losses)
dividends

‘Payer’ ‘Receiver’
Further information
Equity return
Bank Client A 13.4 Variance swap
LIBOR+ One leg linked to a realised variance of any asset. This is usually based
‘Interest leg’ on the price of the asset at the end of each day. The other leg is
Knowledge | Skills | Conduct generally a fixed amount based on the expected or implied volatility.

13.5 Correlation swap

Correlation swaps provide a straightforward means of taking a position
on correlation. Correlation swaps are one of the only means of gaining
direct exposure to longer-dated correlation.

13.6 Dividend swap

One leg based on the actual dividends paid within an index or basket of
shares, the other a fixed rate based on interest rates or expected
dividend returns.

13.7 Contracts for Differences

A cash settled agreement to buy the long or short exposure to equity
without having to physically own the shares.

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 Further information
14. Foreign Exchange The US Dollar is the reserve currency of the world. As a result most
commodities are quoted in USD. Most currencies are quoted against
Introduction each other via the dollar. This is the ‘cross rate’.
• OTC market
• Major international banks
• London largest centre
• Quotes
- Currencies are quoted in pairs such as:
Keeping on target
• USD/JPY: E.g. USD1.00/JPY 116.15 A company wishes to exchange $250,000 into GBP at a spot rate of
• GBP/USD: E.g. GBP1.00/1.63 1.4505/15USD. How much will the company receive?
- The first currency is the ‘base’ currency
- The second currency is the ‘counter’ or ‘quoted’ currency
- Quoted – American Style
- Quoted – European Style

• Spot market and forward market

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Answer to the question on the previous slide:

B

Make interest payments to the swap dealer and additional payments for
the decrease in the value of the index.

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14. Foreign Exchange
Forward FX

Forward rate pip adjustment

Generally:
• Pips are either added to or subtracted from the spot rate:
Spot GBP = USD 1.5110
Forward adjustment +40
Outright forward rate GBP 1 = USD 1.5150

Spot GBP= USD 1.5110

Forward adjustment -28
Outright forward rate GBP 1 = USD 1.5083

• Forward rates can expressed as a two way pip adjustment to the spot’s bid and
offer
Knowledge | Skills | Conduct

Answer to the question on the previous slide:

Buying or selling base? Buying, therefore offer rate.
$250,000 / 1.4515 = 172,235.18 GBP

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 Further information
14. Foreign Exchange Non-deliverable forwards
If we look at the following two scenarios:
14.3 Non-deliverable forwards
Scenario 1:
• Counterparties pay/receive the difference between the spot and forward rates • TWD (spot rate) in three months’ time is 47.06; therefore to purchase
in a pre-agreed convertible currency (GBP, USD etc.) 50,000,000/47.06 is $1,062,473 in the spot market
• Useful where underlying currency is not freely convertible (so unable to buy the • We have agreed through the NDF to sell $1,019,160 and therefore we will
currency for forward delivery) be paid the difference through the NDF
Scenario 2:
Example:
• TWD (spot rate) in three months’ time is 51.06; 50,000,000/51.06 is
• US corporate hedging a payment of 50,000,000 Taiwanese dollars in three $979,240 in the spot market
months’ time
• We have agreed through the NDF to sell $1,019,160 so we pay the
• Buy a three-month TWD49.06($) NDF difference through the NDF contract
• We have contracted to buy TWD (50m) in three months and pay (sell)
TWD50,000,000/49.06 TWD($) which is USD1,019,160 In both scenarios, we have secured the purchase of 50m TWD for the agreed
49.06, which means we are selling (it is costing US corporate) $1,019,160.

Knowledge | Skills | Conduct

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 Further information
15. Asset Swaps The use of an IRS from an investor’s perspective can be to change the
interest rate/currency on an asset (e.g. bond) that they are holding. This is
5% Fixed referred to as an asset swap.
The term is used to denote the reason for the swap (asset swap changes
Fund manager Swap bank income stream).
LIBOR Investor is free to choose the underlying asset according to credit quality,
Term deposit liquidity, pricing and then swap for fixed or floating rate or different currency
(Cash) as required.
5% fixed
coupon bond

Overall:
• Investor has achieved floating exposure
• Investor has created a synthetic floating rate note yielding LIBOR

Knowledge | Skills | Conduct

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 Further information
16. Other Products
Fixed-for-floating:
16.1 Commodity Swaps • One party pays cash value of an agreed quantity of the underlying
commodity multiplied by a fixed price
Payment of • Other party pays cash value of an agreed quantity of the underlying
commodity index price commodity multiplied by a floating price (variable price)
Swap
Producer
institution
• No exchange of the commodity
Fixed price
’ • Used with bullion/precious metals/energy.
• Price for interest: Value of a fixed amount of a commodity is exchanged for
Commodity market floating or fixed rate of interest.
price

16.2 Hybrid derivatives

Fixed for floating
commodity swap • A contract that combines features and risks of two different markets in a
Commodity single contract
Market • Example: A trade involving the price of oil and a transport company, a
commodity and an equity

Knowledge | Skills | Conduct

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