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Interest Rate Derivatives

Interest Rate Derivatives. Interest Rate Derivatives. Swaps Forward Rate Agreements (FRAs): A one-period, future swap EuroDollar Futures Bond Options (Black-76) Caps/Floors/Collars(Cap&Floor Combo.) Buy Cap: Get CFs if Mkt Rate>Cap Rate Buy Floor: Get CFs if Mkt Rate<Floor Rate

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Interest Rate Derivatives

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  1. Interest Rate Derivatives

  2. Interest Rate Derivatives • Swaps • Forward Rate Agreements (FRAs): • A one-period, future swap • EuroDollar Futures • Bond Options (Black-76) • Caps/Floors/Collars(Cap&Floor Combo.) • Buy Cap: Get CFs if Mkt Rate>Cap Rate • Buy Floor: Get CFs if Mkt Rate<Floor Rate • Swaptions: Get/Give CF on both sides of Mkt Chg

  3. All-In-Cost • Lay out cash-flows on a timeline and solve for IRR. Looking for least cost. • Exercise 1: Fixed Bond at 7% annual, 3yrs: 0 1 2 3 +100 -7 -7 -107 IRR = 7% ==> All-in-Cost

  4. All-In-Cost • Issue Fltg Rate Note and Swap • Swap: Fixed(T-Note, 4.5%+0.3%+2%) for Floating (LIBOR+2%) • 0 1 2 3 +100 -6.8 -6.8 -106.8 IRR = 6.8% ==> All-in-Cost

  5. All-In-Cost • FRAs: • (12/24 has 1 year (in 1 year) at 5% vs. LIBOR, or 7% vs. LIBOR+2%) • (24/36 has 1 year (in 2 years) at 8% vs. LIBOR+2%) • Issue Fltg Rate Note and FRAs • 0 1 2 3 +100 -5.7 -7 -108 First year CF=5.7 as known at FRA contract. IRR = 6.85% ==> All-in-Cost

  6. All-In-Cost • Cap/Floor Strikes vs LIBOR so add 2% • Buy Cap (-Prem), Sell Floor (+Prem), Net combined with $100 t=0, borrowing: • 0 1 2 3 +97.95 -6 -6 -106 +100 -6.8 -6.8 -106.8 +100.41 -7 -7 -107 +103.14 -8 -8 -108 AICs = 6.78, 6.80, 6.84, 6.81%

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