1. Chapter 30 – Interest Rate Derivatives
BA 543 Financial Markets and Institutions

2. Forward Rate Agreement
An exchange traded future on short-term interest rates
Over the counter
Forward contract in that both parties are obligated to perform and contract is specific (not standardized – illiquid)
Seller agrees to “deliver” funds at the settlement date
Buyer agrees to “take delivery” of funds at settlement date

3. Forward Rate Agreement
Cash settle on difference at rate at settlement
Example – Notional amount at $10 million for three months delivery (91 Days) at 5%
At settle – current rate is 4.5% for money
FRA seller receives payment of discounted interest differential
Interest Differential
= (0.05 – 0.045) x ($10,000,000) x 91/360
Cash Compensation
= $12, / ( 1 + ( 0.045) x (91/360))
= $12,496.74

4. Chapter 30 – Swaps and More
Interest Rate Swaps
Objective: Control Interest Rate Risk
What is Interest Rate Risk?
It is the loss incurred by a company (i.e. bank) when interest rates change
Example, a bank is lending long term but borrowing short term
If short term rates increase over the set long-term rates, payment stream from loans is insufficient to meet interest promise to investors, loss $$$
This was the case in the 80s with many Savings and Loan Associations

5. Chapter 30 – Swaps and More
Mechanics of an Interest Rate Swap
Fixed Payment Stream “exchanged” with a Floating Payment Stream
Party A has a fixed stream (Savings and Loan with a set of Mortgages)
Party B has a floating stream (Insurance company with investment portfolio in floating rate bonds)
Party A and Party B swap payoff streams…
Only the difference changes hands

6. Chapter 30 – Swaps and More
Numbers of the mechanics of swap
Notional Amount of the Swap $50 Million
Fixed flow 8%
Floating flow LIBOR plus 2.5%
If LIBOR at 4%:
Fixed at $4,000,000
Floating at $3,250,000
If LIBOR at 7%
Floating at $4,750,000
Payment flow is $750,000 to counter-party

7. Chapter 30 – Swaps and More
Swap is series of Forward/Futures Contracts
Benefits of Swap over Forward
One time negotiation vs. negotiation of all forward contracts
Longer maturities than futures
Liquid Secondary Market
Lock in a spread profit against liability of the company
Why didn’t the two parties just contract correctly in the first place?
Availability of Contracts, Competition, and Arbitrage Across Markets

8. Chapter 30 – Swaps and More
Development of the Market
Bankers first were brokers
Bankers taking positions to finish swaps (difference in party notional amounts)
Bankers moving to dealers
Bankers acting solely as dealers as spreads narrow through competition
Bankers active dealers with standing quotes
Floating Rates matched with available Fixed Rates by Banks

9. Chapter 30 – Swaps and More
Secondary Markets for Swaps
Getting Out of the Contract – Finding a new counter party to assume your role
Swaptions
The option to swap
Interest Rate Caps and Floors
An options contract
Seller and Buyer Positions
Option on an Option
Captions and Flotions