Management instruments interest rate risk

Management toolsrate riskVincent Lauwick Ines de Dinechin, Caroline Lorin Pierre and GourmetDeadline34Waiting periodIWarranty periodPayment rate differentialj, a consideration which borrowed the fixed rate is called the "buyer" of the FRA pays a fixed rate. " Consideration that lends the fixed rate is called seller "of the FRA or the receiver of the fixed rate."the date of recognition of variable-rate, two cases may arise: I_ if the reference rate is higher than the rate guaranteed by the FRA, the rate differential seller to the buyer,if the reference rate is lower than the rate guaranteed by the FRA is the achequi pays the interest rate differential to the seller.This article is devoted to traditional financial instruments that allow a company or an investor to manage their interest rate risk. We will not attempt to give an exhaustive coverage opportunities available on the market, but rather to present a range of products representative of the extraordinary diversity of solutions that canbe proposed today.For purposes of simplification, rate linked to a liability at floating rates. Most of the risk managementinstruments presented can be applied, thus consider in our examples to commitments at fixed rates. WeIf a borrower and a lender at floating rates. elst First, we define the firm products and texp ° ~ s0the origin of the market interest rate derivatives (swaps, caps and floors). havethen more complex structures derived products meet user needs ~ gradually been developed for liquefied t ~ Finally, we discuss the management instruments involving interest rate risktwo currencies.1. Classical instruments hedging interest rate risk
1.1. Forward rate agreements Forward Rate Agreements or yourThe Forward Rate Agreement is a guarantee operation of your â ~ e undertake to exchange aagreement between two counterparties in which r-model, the difference between fixed eenticonnue an AAR 1 ôlrigine France, diffél your ~ this date and rate tgaranti g TRVs preset and it is a refresh rate is applied to the FRA nominleur amount (either at the beginning of the P - is paid at the time of goingThe reference rate is higher than the rate guaranteed by the FRAThe reference rate is lower than the rate guaranteed by the FRABuyer SellerDifferential- The main characteristics of a contract of FRAeThe buyer and seller of the contract.Pibor references or Liber.Deadlines most common: 3, 6, 9, 12 months.This is the rate guaranteed by the contract. It is expressed in the same basis and with the same frequency as the variable rate (eg quarterly Actual/360 against a 3-month Pibor FRA).FRF 5 million against minimum or equivalent in foreign currency.The duration of the waiting period ("forward") is generally less than 2 years.The duration of the warranty period corresponds to the periodicity of the interest rate benchmark currency.t beat a Forward Rate Agreement érons example of a company that is currently indebted toFor ENEE e about 20 million francs. This is actually a disit finances by 3-month Pibor prints. In the context of a number of political uncertainties facingthat will be applied to the debt at that date. This rate is fixed ~, t, TNEMEtransaction to 5.85%.Overall, at the time of finding the next auction of Pih, r 3 months two cases can occur:- If the 3-month Pibor is greater than 5.85%, the seller pays the (lifférent1el rate to the buyer,- If instead the 3-month Pibor is less than 5.85%, the achetcur Verse ~ rate differential to the seller.The differential received or paid by the company at the date of determination of ~ FRA brings its overall debt at 5.85%, regardless of the level found. The company has fixed the rate of the next draw.Interest flows receivedTimeFlow of interest paymentsTable 33-month Pibor> 5.85%3-month Pibor G 5.85%Company <SellerDifferential1.1.2. The sale of a Forward Rate AgreementThe principle detailed above can be applied similarly to an underwriter cm which now wants to ensure the deposit rate at future date. Selling a FRA allows him to freeze the level of investment for a given maturity. Again, if the variable rate is less than the package level guaranteed by the FRA, the company perceives the different interests and, conversely, if the variable rate is found above your FRA, it pays the difference to the consideration. It is interesting to ntoin a configuration yield curve increasing the venteun that allows the distributor to receive a forward rate is higher than thatr not pro effect at the time of the transaction, and, if anything PARTICULARLY by the value date of the FRA, it will be cashed difference.1.2. Rate swapsThe interest rate swap is a transaction in which OTCagree to exchange streams of interest following a échéanc partiesià established. Two sets of cash flows are paid periodically as: prem of thethe soc0ncalculated by applying a rate to the nominal amount; L too "calculated by applying a different rate to the same montant.t swap is committed to pay a series of flow (first branch concluded swap) and receive a second series (second branch of sw'aP ~ 1 '• dti1e lot to me ~ comFigure 2 illustrates the definition of a swap t received in return a series of flow paid. In the case of a swap standân branches of the swap is indexed on a variable rate benchmarkvea the other is fixed. This fixed rate is the "swap rate" self '1,,,., .70-Insinn the RNNR I'r1TlPratlOn da.We discuss in this section the case of a swap with the simple structure is us (structure called "plain vanilla"). Table 4 presents are the elements that define the standard plain-vanilla swap.The principal amount remains constant throughout the life of the transaction.The principal amount is used as the reference amount for the calculation of interest for the industry as a variable rate to fixed-rate branch. The principal amount is expressed in a single currency.The operation starts immediately after its conclusion (starting "spot"). Depending on the currency of the transaction, the first day of the swap will be the same day (j), the day of the conclusion (j + 1), or the day after (j + 2), in working days.Duration and maturity date of the transaction are set at inception.The fixed rate of the swap, also called the "swap rate" is determined initially and remains constant throughout the life of the operation.The reference rate variable used in a swap is a standard index (most often type Liber).There is no spread added to the index variable rate(The rate is said ~ (flat ").The frequency of findings of variable rate reflects the periodicity of the benchmark (eg, every 3 months in the case of a 3-month Libor).Interest payments and fixed interest variables are held at regular intervals to the observation dates floating reference rate.tion latt simplicity of this type of installation swapped srucureunUsability problems. Indeed, the situations are411SatPllroEnterprise SellerDifferentialStructure standard swapticks defined above. One example will suffice to illustrate this point. A enlre taken is fixed rate debt with an annual payment of interest and amortization of the nominal linear. She wants to turn this debt e debt to the 3-month Libor. We distinguish here anomaly-> ~ as the standard swap can not take into account: the amount of principal is not Consta, lt.This need for greater flexibility swaps is therefore made more sense alitant situations that end users - companies, investors, financial institutions - became more complex and more volatile markets. These factors have contributed to the development of non-standard structures swaps. These structures are described in the second section.To show the usefulness of swaps standard now consider two examples: a company that makes a swap borrower and that of a company that makes a swap lender.1.2.1. The borrower swapTherefore consider, first of all, a company that has signed a loan transaction in Pibor 3 months + 0.50%. This loan is spread over 3 years with a bullet repayment of principal and payment of quarterly interest. Treasurer wants to freeze the cost of the debt over the year ~ ENIR and know with certainty and financial expenses related to the debt over the next year. In addition, he fears a rise in short-term rates against which it seems important to be covered.He concludes to do a swap borrower perfectly backed debt and resuming financing conditions in terms of amount, timing and amortization (Figure 3). The swap rate is fixed at the time of the transaction at 6.00%. The original debt remains unchanged, indexed to the 3-month Pibor. Indeed, it is important to note that the swap contract is legally separate from the credit it protects.Figure 3 - Swap fixed rate payerquarterly exchange - no nominal exchangeThe swap works as follows:
- Quarterly floating rate (3-month Pibor) is found on the I ~ ~ rarché- At the end of the quarter, the company receives under the swap variables are inter ~ calculated from the observed level and debt:interest flows then offset the financial burden of the debt:interests- On the same dates and the same amount the company pays'S ThE determined from the fixed rate swap (6.00%).ncietOverall, as noted in Figure 1, the cost of the finathreadlïrrci a "nivt aii ~ ri >> fixed (Swad bed TAL1 ~ IIThe? NTE dE%''` j81.2.2. Swap AgentNow consider a company that has a structural surplus cash it up regularly T4M-x% (net interest margin). The amount invested varies each year between 15 and 45 million francs. It considers that the market is currently favorable rate freeze its assets. Indeed, the general trend anticipated by operators is that of a gradual decline in short rates, while the latter tend to come after a significant event that the Company believes to be punctual and ephemeral. The treasurer wants to enjoy these tensions to freeze the rate of its investments over the next 6 months for 20 million francs. Rateswap 6 months against T4M that is offered is 6.30% (interest paid monthly).Pphique ~ 1 - Profile debt ratio after completion of the transactionVariable rateFixed rate swapProtection rate increases6.00%Diagrammaticala 4 - Swap receiving fixed rate6.00%Bank6.30%BankBusinessVariable rateT4MBusiness, Loan~ Variable raterPibor 3 months + 0.50%Variable rate 3-month PiborPlacement}'Variable rateT4M-x%quarterly exchange - no nominal exchange19 ° e 2 - Profile placement rate after completion of the transactionVariable rateFixed rate swap6.30% - Protection rate cuts
Interest flows discounted to T4M on the investment outweigh those of the interest rate swap. The financial performance of the investment is then frozen, 11 corresponds to fixed rate swap - 6.30 or 1/0 net of the bank margin, and that whatever the level of T4M recorded each month.A final remark should be made. A swap contract is legally separate from the operation it covers, it is not necessary that a loan or an underlying investment is for a swap.1.3. Caps and floorsCaps and floors are optional instruments that allow their buyer to be hedged against an unfavorable interest rate given reference. Unlike products that are firm swaps and FRAs, interest rate options can also benefit from Evolt ~ tions favorable benchmark, the payment of a premium. We will examine successively in this paragraph headings (ceiling) and floors (floor rate).1.3.1. CapsThe course is an option, upon payment of a premium, allows the buyer to hedge against a rise in money market rates beyond a ceiling level (the exercise price or strike the cap). At each setting of the variable rate reference rate level found is compared to the maximum rate guaranteed: if the rate is found to exceed the guaranteed rate, the seller pays an interest rate differential to the purchaser of the cap (the exercise option is automatic).This instrument thus enables the buyer to receive a lower rate money while being guarded against an increase beyond the strike price of the course.To illustrate the use of a cap, consider the example discussed in Section 1.2.1., A company that has signed opf tune 'borrowing ration • 3 years 3-month Pibor + 0, 50% wishing to be covered in the event of rising interest rates. Treasurer of the company may this time i sp ~ c ° 'p> knows that his company would be heavily penalized if its debt ratio exceeded 7.00% (breakeven). He therefore sought a means of insurance, gp capping its overall debt ratio, while maintaining ossibilité take advantage of favorable changes in short rates.He enters into a transaction to purchase cap to 3 years exercise price 6.50%. for that, it pays a premium to the seller of the cap (payment two days near the conclusion of the transaction). This premium is estimated at 1.50% of the notional amount of origin.The cap works as follows: each quarter, the variable rate (3-month Pibor) is found on the market, two cases can occur:- The 3-month Pibor is greater than 6.50%, the seller of course the company then pays the difference between the 3-month Pibor and found 6.50%- The 3-month Pibor is less than 6.50%, the cap does not generates flows between the buyer and the seller.Table 53-month Pibor> 6.50% 3-month Pibor <6.50%
Company SellerDifference between the 3-month Pibor foundand 6.50%
 Company Seller
 No flow under the headingThe payment of a premium, the company has capped its funding rate at 6.50% initially selected.It is interesting to determine an "equivalent period" of the premium, which'Corresponds to the spread of the premium on each of the maturities couverfRi
 equivalent period is expressed in the same basis as the floating ratereference. In our example this is equivalent to 056% of the dead,. ~ Ap is 7.06% (6.50% + 0.56%).34 Instruments ide management of interest rate risk ∎ 661`'Ter enjoy its relaxing expectations of short rates, which`' has resulted in a reduction of financial charges. However,Figure 3 - Profile debt ratio after completion of the transactionBorrowing ratesiVariable rate */ii/CeilingIt
 • The two floorsfloor is an option for the payment of a premium allows, n buyer to hedge against a decline in money market rates below the level of the floor (the floor or strike the prixexercice) Each holder. ~ Variable reference rate level is compared to the observed rate guaranteed ber: if tttét iféii ldWater devoted esnreur rate guarantee, e Huntsman differential interest to the buyer of the floor (the exercise of the option atic). lnstrurment thus enables the buyer to receive higher nétaires
Figure 4 - Profile placement rate after completion of the transactionPlacement rateFigure 5i iiVariable rate *Variable rateExercise price of the purchased floorThe floor is not exercised,placement rate = variable rate.Floor rateiiThe floor is exercised,placement rate = strike price of the floor.0Exercise price of the floor rate monetary 'Given the spread of the premiuma structural surplus cash of 20 million francs that place T4M. In this example, we made the assumption of a general context of expectations of lower short-term rates, with rates occasionally strained due to a particular event. Here, the Treasurer anticipates that these tensions should not disappear quickly and T4M rates could remain at high levels for a few months or even a few new tips about levels above 7.50%. In this case, rather than freeze the level of its next T4M through a swap - which would not allow him to enjoy his new tensions expectations - he can buy a floor of 6 months for example, one Exercise of 5.50%. Buying a floor guarantees a placement rate floor equal to 5.50% and allows it to be covered in the event of market expectations (relaxation short rates) to be realized against its own forecasts. In addition, occasional tensions observed in short-term rates when it completes the purchase of floor do help in gaining more favorable terms on the premium (premium less expensive). The premiumHere 80,000 francs (0.40% of the principal amount). TNU ~The floor works as follows: each trimesira. the: variable (T4M) is found on the market, two cases can then P'' ° dtirise- The T4M is less than 5.50% 0, the vendor has the floor then poured t'titrE'p the difference between 5.50% and T4M found11ttS- The T4M is greater than or equal to 5.50%, no fluorine generates <+ ui ~ tttbetween the buyer and the seller of the option. tt ~ tin titi Upon payment of the initial premium, the company is i? <t titiere low of 5.50% for its investment. Fluorine leaves himl ~ 'yopportunity to benefit from an increase in the T4M though. - pt'echain months, as illustrated in Figure 5.
1.4. Swaptions
A swaption is an option that gives the holder the right to set up a swap at a future date and at a predetermined rate. Two types of swaptions will be considered successively: first swaptions lending, borrowing then swaptions.1.4.1. The swaption lendingThe lender swaption is an option, subject to immediate payment of a premium, allows the buyer to establish, if desired, to the maturity of the option, an interest rate swap of receiver fixed rate (swap lender) whose characteristics are defined at the conclusion of the swaption. The fixed rate of the swap future is known at the conclusion of the transaction.At the maturity of the option, the fixed rate swap banks found reference is compared to the level guaranteed by the swaption (the exercise price of the swaption). Two cases can then arise.1) The fixed rate swap market is higher than the guaranteed fixed in aption: it is better to enter into a swap market conditions rather than implementing the underlying swap. The buyer of the swaption does not exercise its option and can benefit from higher swap rates qW occurred since the conclusion of the swaption.2) The fixed rate swap market is lower than the fixed rate guaranteed by ~ aption: the buyer exercises his option and, according to his choice or swapLace-to stiilspace is wapon ms (choice of swap settlement) Soffe, Tial rate, discounted at the swap shall be paid immediatelyoice of u, cash settlt) emen.Figure 5 summarizes the various possibilities that may arise in Eancé ofe lati swaption.product is primarily intended to counterparties who wish r the rate of an investment transaction variable rate, which will be January 1st ed dh eate future known. ACAT a SwaptionManagement instruments interest rate risk ∎ 665The fixed rate swapmarket is higherrate guaranteed by the swaption.The fixed rate of the swap market is lower than guaranteed by the swaption.The option is exercised.Cash sett / ement:BankDiscounted incrementalpoured at onceBusinessThe option is not exercised.Swap settlement:BankGuaranteed fixed rateVariable rateBusinessperiodic exchange - no nominal exchangeLe tauxmarchéfixe duestswapinférieur partauxlafixe ​​The swap market is higher than the guaranteed
 swaptionprate guaranteed by the swaption. The option is exercised.
 Cash settlement:
  Differential updated Bank Company
  The option is not exercised. poured at once
  Guaranteed fixed rate swap settlement Company
  :
  Bank
   ________ -
 Variable rate
 periodic exchange - no nominal exchange
1.4.2. The swaption borrowing
The borrower swaption is an option, subject to immediate payment of a premium, allows the buyer to establish, if desired, to the maturity of the option, swap interest rate payer fixed rate (swap borrower) whose characteristics are defined at the conclusion of the swaption. The fixed rate of the swap future is known at the conclusion of the transaction.At the maturity of the option, the fixed rate of the swap is recorded with banks and compared to the reference level guaranteed by the swaption (the exercise price of the swaption). Two cases may arise.1) The fixed rate swap market is lower than the fixed rate guaranteed by the swaption: it is better to enter into a swap market conditions rather than implementing the underlying swap. The buyer of the do s ~ aption not exercise its option and can benefit from the lower rate swap that has occurred since the conclusion of the swaption.2) The fixed rate swap market is higher than the fixed rate guaranteedthe swaption: the purchaser exercising the option and, depending on his choice tial or swap underlying the swaption is implemented (choice ~ `° S ui1 lapsettlement), or the interest rate differential, discounted at the swap, it ~ 'erse immediately (choice of cash settlement).Figure 6 summarizes the various possibilities at maturity.This product is primarily intended to counterparties who wish to ensure the rate of operation of floating rate debt, which sc, ra eflcctuee known at a future date. Buying a swaption borrowing the leu prlx to ensure that the rate of funding of the operation did not exceed P exercise of the swaption.
2. Structured Products
ment that have been made to these simple structures. Instrumentsincreasingly sophisticated and are appearing on the market. It is importantnote that it is the end users who have driven this trend. Inalongside the development of derivatives markets and the emergenceadvanced technology, banks have proposed solutions,,,,, Businesses and investors increasingly demanding. Two kindsNnovations .. can be distinguished: the first resulting in modifica'ons appoté lt dresa sructure'un standard swap (amortization of theominal Det difféé idi d, Parr, ncese atypical rate ...), the second resulting from theMI; diffét bination of ierensnstruments conventional (tunnel, participatory swap ...).s many examples queétidwe prsenons c-Essous allow ill ustrerflexible products covering interest rates and explainif the great CEHE spin (ls marks.1. Structures of non-standard swapThe term "non-standard swap" refers to any structure swaprant swap standard (as was défiian in Section 1.2.) aul'is by one of its characteristics. Depending on the nature of the change brought
structure is standard ditilisngue, puseurs structures atyues categories, including: swaps the depreciable sw TBD delegates, apsparca are zero-coupon swaps.Da "s lal dpupartes cases, non-standard swap has no one but several atypical features In order to silifiti. Mpcaon weenterons mainly here where a seliti ue varaon compared to standard lacture was apportée.e Table 7 presents several cases of transformation of the structureill swap standdiar, that further serontustrés some examples