University of Hong Kong Trading Workshop

1. University of Hong Kong Trading Workshop Class 5 Treasury Workshop III Interest Rate Derivatives David Lo

2. Agenda • How to get the real-time and historical rates of FRA, IRS & Zero Coupon Rates • How to use 3000Xtra for pricing FRA from deposit rates, futures or zero curve • How to price IRS /Asset Swap from spot or historical zero coupon curve

3. What is a FRA? (FRA = Forward Rate Agreement) • An FRA (forward rate agreement) is a contract between two parties to lock in a forward interest rate, for a period, starting at a specific date in the future. For example, a 6 v 9 FRA is a contract that begins 6 months from now and ends after 9 months, i.e., lasts for 3 months. The two counterparties, one buyer and one seller, settle by cash payment at the start of the contract (in this example 6 months from now).

4. Example : 6X9 FRA • It begins in 6 months for a 3 month period • To hedge the risk of rising rates, you can buy a 6X9 FRA to protect yourself from a rise in interest rate you expected to occur in 6 months time.

5. FRA Pricing is via : • Interest Rate Futures • Cash Deposits • Zero Coupon Curve

6. FRA Pricing Model

7. How to use the Model ? • Choose Currency (eg. HKD, USD…..) • (type in command line, or drop down box on top left) • Choose FRAs from Deposit, Futures or Zero Coupon • Who will trade the FRA? • Ans : Money Dealer, Short-term IRD Desk...

8. Benefits • Automatic real-time update or you can input the value by yourself • Use hyperlinks to access relevant quotes • Able to calculate broken-dates by specific start and end dates • Have choice of Normal or IMM dates • Have choice of underlying instruments :deposit, futures or zero coupon

9. What is an IRS? (IRS = Interest Rate Swap) • Swap fixed rates with floating rates or vice versa • It can cover interest rate exposure risk • Plain Vanilla Swap – Fixed for Floating • Alter the structure of cash flows into a desired format • Quoted as fixed rate against standard floating rate (such as 3 month or 6 month LIBOR)

10. Floating Interest payments Spot Date 1Y 2Y 3Y Fixed Interest payments Interest Rate Swap • Two sides – receive & pay • No principal exchange, just swapping interests flows • Fixed interest • does not change throughout life of swap • Floating interest • changes every pre determined period

11. Terminology • 2 legs or sides • Receive side or offer side • ( Lend Money  receive interest) • Pay side or bid side • ( Borrow Money  pay interest) • Notional  not exchanged in IRS • Lend Money and Borrow Money  net off • Credit risk is lower

12. Spot Date 1Y 2Y 3Y Quoting Conventions • USD IRS • Annual Money against 3 month Libor Floating Payments = Principal x 3M Libor(%) x actual nos. days/360 Fixed Payments = Principal x Fixed Rate(%) x actual nos. days/360

13. IRS as a Hedge • Scenario • Corporate has an outstanding floating rate term loan with a remaining life of 3 years • Corporate feels that interest rates may rise in the future in tandem with economic recovery • Corporate wishes to lock the remaining life of the term loan into a Fixed Rate • Corporate seeks Bank for a strategy

14. IRS as a Hedge Interest payments on outstanding loan 6 month Libor + 150bps Corp receives 6 month Libor + 150bps Corporate Bank IRS Corp pays Fixed @ 4.875% To protect against rising interest rates

15. Reference Code • 0#IRS-HKD by institutions • 0#IRS-HKD-BRK by broker • 0#MARKETS

16. Swaps (Swaps.kob) >Go to Model

17. Benefits • Data display model for different currencies • Both institutions and broker contributions • Clients can see all related instruments • Eg. Swaptions, Basis Swap, ISDA FIXING, Treasury Swap Spread……. • Display benchmark yield curve and zero curve • Display related news

18. IRS Pricing (Interest Rate Swap) >Go to Model

19. Benefits • It can calculate specific structure and conventions, including amortization • Cash flow for the fixed and floating leg • Client can choose Reuters zero curve or their own zero curve • Use hyperlinks to access relevant quotes

20. Asset Swaps (Asset Swap.xls)

21. Purpose of the model • Swapping a Fixed Asset for a Floating Asset • (eg, 5 Years US Treasury for Libor) • Achieve cheap funding • Limited only to the same currency • Client can choose Reuters zero curve or their own zero curve • >Go to Model

22. Zero Coupon Builder (ZeroBuilder.xls)

23. Benefits • It allows you to calculate a real-time zero coupon yield curve from deposits, futures, swap and bond rates. • It can use either real-time update rates or input rates • Save the setup for a curve and re-use it either in this worksheet or other model • >Go to Model

24. Parameters • Deposits (D) • You can enter deposits, but not pre-spot deposits (eg ON or TN) • Futures (F) • If you include futures, you must include the 3 month deposit rate in the preceding instrument codes. • You may use any RICs, but best are continuation RICs or cm for contract month • You must enter futures contracts in one strip, with no more than one contract missing from the strip. • Interest Rate Swaps (S) • In the Structure field enter the Adfin structure code to determine the nature of the cashflows (see Settings/Style Management/IRS Styles) • Bonds (B) • In the Structure field add the Adfin structure code to determine the nature of the cashflows (see Settings/Style Management/Bond Styles) • Ins/Del buttons allow you to insert or delete rows in your instrument table (highlight the instrument to act on first)

25. Q & A DAVID_HKU@YAHOO.COM