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Corporate Finance
Lecture 10
Corporate Finance
Lecture 10 :
Derivative Assets
Impact Consultancy & Training Pte Ltd
Derivative Assets
! Derivative asset is an asset whose pay-off or value depends
entirely on the value of an underlying asset
! Widely used for hedging purposes by financial institutions &
also for speculative purposes
! General types of derivatives
! Forwards
! Futures
! Options
! Swaps
Corporate Finance
Lecture 10
Forwards
! Tailored enforceable contract traded privately in a self
regulating OTC market with settlement usually only at
maturity
! A forward contract is an agreement between two parties
(called A & B) & has the following characteristics
! Party A agrees to supply to Party B a specified amount of a
specified asset on a specified date in the future
! Party B agrees to pay Party A a specified price (i.e.
forward price) when the goods are received
Forwards
! Party A is said to hold a short (sell) position while Party B a
long (buy) position
! Forward price vs Spot price
! Forward price
Price agreed today but settlement will be on a specified
future date
! Spot price (S0)
Todays price for immediate settlement
! Forward price (F0,k or Fk) is NOT EQUAL to future spot price
(Sk)
Corporate Finance
Lecture 10
Forwards : Example
Assume that a Singapore company needs to pay in 3 months time
USD200,000 for an American machine. The company can enter
into a contract to buy USD 3-month forward with the bank
assuming at a rate of USD1 = S$1.25
Agree today
F0,90 : USD 1 = S$1.25
Note : S0 NOT = F0,90
Exchange 90 days later

S$250,000 <-> USD200,000
S90 NOT = F0,90
Payoff Profile for Long Forward

! Payoff profile of a long forward position is shown below
St - Fo
Payoff
Fo
St
-Fo
!
!
!
Note :
Fo is the price agreed upon in the forward contract

St is the spot price of the asset at settlement date
Long party has unlimited upside potential but limited
downside @ -Fo
Pay-off profile is linear, positive for values of St > Fo &
negative when St < Fo
Corporate Finance
Lecture 10
Payoff Profile for Long Forward

! Understanding the forward pay-off
!
If St > F0, then the party that is long has gained

=> Can buy asset at lower price than cost in the spot
market
If St < F0, then the long pay-off is negative

=> Cheaper to buy asset in the spot market than at F0
Pay-off profile of a short forward position will be the

inverse of above figure
Payoff Profile for Short Forward

Payoff
Fo
0
Fo
St
Fo - St
Corporate Finance
Lecture 10
Pricing Forward Contracts

! Current spot asset price is S0
Riskless rate of interest is r
Value of a k-period forward contract

! To derive the above formula, consider the following 2
investment strategies
!
Long a forward contract maturing k periods later to buy the

underlying asset
No immediate cost
Will yield Sk Fk at maturity ie. k periods later
Buy the underlying asset at spot price (S0) by borrowing Fk

(1 + r)-k at the risk-free rate for k periods
Immediate net cost of [S0 Fk(1 + r)-k]
Need to repay Fk at maturity ie. Fk(1 + r)-k (1 + r)k
Will therefore yield Sk Fk at maturity ie. k periods later
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Corporate Finance
Lecture 10

! Since the maturity pay-off of the 2 strategies are identical,
they should also have identical costs hence
S0 Fk(1 + r)-k = 0
S0 = Fk(1 + r)-k
Fk = S0 / (1 + r)-k
Fk = S0 (1 + r)k
i.e. the no arbitrage price for k-period forward contract
11

! Alternatively, the following 2 investment strategies can be
considered
! Long a forward contract maturing k periods later to buy the
underlying asset
No immediate cost
Will yield Sk Fk at maturity ie. k periods later
! Buy the underlying asset at spot price (S0) by borrowing S0
at the risk-free rate for k periods
No immediate net cost as S0 S0 = 0
Need to repay S0(1 + r)k at maturity
Will yield Sk S0(1 + r)k at maturity ie. k periods later
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Corporate Finance
Lecture 10

! Since the immediate investment costs of the 2 strategies are
identical, they should also have identical maturity payoff
hence
Sk Fk = Sk S0(1 + r)k
Fk = S0(1 + r)k
i.e. the no arbitrage price for k-period forward contract
13

! Illustration on pricing of currency forwards
!
Domestic investor in UK is quoted the spot & forward rates

S0 & Fk respectively indicating the domestic currency price
of one unit of foreign currency
The one-period domestic & foreign interest rate is denoted

rd & rf respectively
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Corporate Finance
Lecture 10

!
Compare 2 investment strategies assuming investor has S

which is the price of 1 USD
Deposit in a domestic account for k periods which will
yield S(1 + rd)k upon maturity
Alternatively, investor can convert for USD at S0 &
invest USD at the US rate rf
The investment will yield (1 + rf)k in USD in k
periods
Can sell USD proceeds for using forward contract
yielding Fk(1 + rf)k in
15

!
Both investments are riskless due to interest (rd & rf) &
exchange (S0 & Fk) rates being fixed & known
Hence, both cost S

=> S0(1 + rd)k = Fk(1 + rf)k
This is known as Covered Interest Rate Parity

Relationship
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Corporate Finance
Lecture 10
Futures
! Standardized enforceable contract traded on a centralized
regulated exchange with daily settlement of gains & losses
! Essentially futures are standardised forward contracts that are
exchange traded
! Futures give precise specifications for quality & quantity of
the assets to be exchanged on standardised maturities
=> Less flexible than forwards
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Futures
! Major difference between futures & forwards (apart from
those stated above) is in the exchange of monies
! Forward : Entire forward price is paid on settlement date
! Futures : Marked to market daily & the spot price (St) on
the settlement date will be paid
! Ways of settlement
! Physical delivery or
! Reversal of contracts
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Corporate Finance
Lecture 10
Futures
! Example
! Buy Future Contract for USD200,000 maturing on 31 Dec
@ S$1.25
! Possible Settlement
Physical Delivery : On 31 Dec (maturity), Long Party
take delivery of USD200,000 by paying the price at St
Reversal of Contract : Anytime before 31 Dec
(maturity), the party who longed the contract previously
now short another contract with same amount & same
maturity
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Futures
! Examples of exchanges on which futures are traded are
!
!
!
!
London International Financial Futures Exchange (LIFFE)

Chicago Board of Trade (CBOT)
Chicago Mercantile Exchange (CME)
Singapore Exchange (SGX)
! Contracts traded with high volumes include government

bonds, interest rates, currencies & stock indices
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Corporate Finance
Lecture 10
Forward & Futures Contracts

! Common features for both forward & futures
! Contractually binding on counterparties
! Contracts can involve buying or selling
! Specific amount/quantity
! Specific asset or underlying asset
! Specific future date
! Agreed price or rate
=> Strike or exercise price
Fixes price & conditions at origination for a transaction
that will take place in the future
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Comparison of Forward &

Futures Contracts
! Forward contract
! Futures contract
! Private contract between
! Traded on an exchange
two parties
! Standardized contract
! Not standardized on
with standard amounts &
amount & maturity date
maturity dates
! Settled at end of contract
! Range of delivery dates
! Delivery or final cash
! Contract usually closed
settlement usually takes
out prior to maturity
place
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Corporate Finance
Lecture 10
Options
! Options are contracts between 2 parties to buy or sell a
predetermined quantity of underlying asset on or before a
specified date in the future at a specified price known as
exercise price
! Call option : Contract to buy
! Put option : Contract to sell
! Buyers (Holders) of call or put options have the rights but
not obligations to buy or sell upon payment of premium
! Sellers (Writers) of call or put options have the obligations to
sell or buy after receipt of premium
! Options can be exercised either during a specified period
(American) or on a specified date (European)
23
Fundamentals of Options Mathematics

! Call option
! Intrinsic Value = Max (S - X, 0)
where S = Market price of underlying asset
X = Exercise price
! If S > X, option is in-the-money or ITM
If S = X, option is at-the-money or ATM
If S < X, option is out-of-the-money or OTM
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Corporate Finance
Lecture 10

! Put option
! Intrinsic Value = Max (X - S, 0)
! If S < X, option is in-the-money or ITM
If S = X, option is at-the-money or ATM
If S > X, option is out-of-the-money or OTM
25

! Underlying Asset : SIA shares
! Exercise Price : $12.00
Call Option
Purchased Call Option for $0.80 during the life of the option
At maturity, the spot price (St) for SIA share is $12.50
Will the buyer exercise the option by purchasing SIA share @
the exercise price of $12? Why? Or why not?
Put Option
Purchased Put Option for $1 during the life of the option
At maturity, the spot price (St) for SIA share is $11.50
Will the buyer exercise the option by selling SIA share @ the
exercise price of $12? Why? Or why not?
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Corporate Finance
Lecture 10

! For both call & put options, holders will exercise upon expiry
if option is in-the-money regardless of premium paid for
option
! Options that are at-the-money or out-of-money are allowed
to lapse & have no retaining value
! In options, profits & losses are fully offset
! Buyers gain is sellers loss
! Buyers loss is sellers gain
=> Zero sum game
27

! Value of a call option depends on
! Exercise price
! Price of underlying asset
! Time to expiration
! Volatility in price of underlying asset
! Interest rate
All the above factors have positive relationships with value
of call option except for exercise price that has an inverse
relationship
! Think about how the above factors affect the value of a put
option
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Corporate Finance
Lecture 10
Payoff Profiles for Long Call

! Payoff profile to a holder of a European call option is shown
below
Payoff
0
!
[St - X]+
St
Options exercise price is labelled X
29
Payoff Profiles for Long Call

!
Call option gives the holder the right not the obligation to
purchase the asset therefore
If St > X (in-the-money), then cheaper to buy asset using
the option than in the spot market (Exercise the
option)
=> Call option holder makes a gain of St - X
If St X (at-the-money or out-of-the-money), then
cheaper to buy asset in the spot market (Dont exercise
the option)
=> Pay-off to the call option holder is zero
30
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Corporate Finance
Lecture 10
Payoff Profiles for Long Put

! Payoff profile to a holder of a European put option is shown
below
Payoff
X
0
!
[X - St]+
St
Put options exercise price is labelled X
31
Payoff Profiles for Long Put

!
Put option gives holder the right not the obligation to sell
the asset therefore
If X > St (in the money), then better to sell asset using
the option than in the spot market (Exercise the
option)
=> Put option holder makes a gain of X - St
If X St (at-the-money or out-of-the-money), then
better to sell asset in the spot market (Dont exercise
the option)
=> Pay-off to the put option holder is zero
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Corporate Finance
Lecture 10
Payoff Profiles for Short Call & Put

! Each option must have a long party & a short party with
payoffs to the long party as shown in the earlier 2 figures
! The short party is the writer (seller) of the option & the payoff
profiles are reverse of those who long (buy) the option
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Payoff Profiles for Short Call & Put

For call option
Payoff
0
St
[St - X]
For put option
Payoff
0
St
[X - St]
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Corporate Finance
Lecture 10
Profit & Loss Payoff Profile of Long Call

Profit from buying a XYZ European Call Option :
Option Price or Premium = $5, Strike Price = $100, Option Life = 2 months
30
Profit ($)
20
10
70
80
90
Terminal
asset price ($)
100
0
-5
110
120
130
35
Profit & Loss Payoff Profile of Short Call

Profit from writing a XYZ European Call Option :
Option Price or Premium = $5, Strike Price = $100
Profit ($)
5
0
110
70
80
90
120
100
-10
130
Terminal
asset price ($)
-20
-30
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Corporate Finance
Lecture 10
Profit & Loss Payoff Profile of Long Put

Profit from buying an ABC European Put Option :
30
Profit ($)
20
10
0
-7
Terminal
asset price ($)
40
50
60
70
80
90
100
37
Profit & Loss Payoff Profile of Short Put

Profit from writing an ABC European Put Option :
Profit ($)
7
0
40
50
Terminal
asset price ($)
60
70
80
90
100
-10
-20
-30
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Corporate Finance
Lecture 10
Discrete Vs Continuous Compounding/

Discounting
!
!
!
!
!
Discrete Compounding :
FV = PV (1 + r)n
Discrete Discounting :
PV = FV (1 + r)-n
Continuous Compounding :
FV = PV x erT
Continuous Discounting :
PV = FV x e-rT
Both discrete or continuous can be used interchangeably as
proxy of each other in any calculation in exam depending of
what information is provided
39
Bounds on Option Prices

! Assumptions
! There exist a risk-free rate Rf where unlimited borrowing &
lending is possible
! No transaction costs or taxes
! The underlying asset does not pay out cash during the
option lifetime
=> For non-dividend or non-interest paying
underlying asset
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Corporate Finance
Lecture 10

! Upper bounds on call & put prices
! Calls can never be worth more than the underlying asset
cS
!
Puts can never be worth more than the exercise price

pX
(for European & American option)
(for American put)
For an European put, the value at maturity is at most X

implying (using PV argument) that
p Xe-rT
41

! Lower bounds for European call
! On the basis of no-arbitrage, the lower bound for an
European call option is
c S - Xe-rT
!
Rationale : Consider 2 portfolios

Portfolio A consists of an European call option with strike
price X plus cash of Xe-rT invested at the risk free rate
Portfolio B consists of the underlying asset
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Corporate Finance
Lecture 10

!
When the option in Portfolio A matures

If ST > X then will exercise with the cash which would
amount to X & the portfolio would be worth ST
If ST < X then will not exercise, option will be
worthless & the portfolio will be worth X i.e. cash in
hand
=> Value of Portfolio A = Max (ST , X)
At the maturity, Value of Portfolio B is ST
Hence, Value of Portfolio A Value of Portfolio B

43

!
Implication :
Price of investing in Portfolio A > Portfolio B
c + Xe-rT > S0
=> c > S0 - Xe-rT
As an option cannot be negatively valued, therefore

c Max [0, S0 - Xe-rT]
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Corporate Finance
Lecture 10

! Lower bounds for European put
! Lower bound for an European put is given as
p > Xe-rT - S0
!
Rationale : Consider 2 portfolios

Portfolio A consists of an European put option & an unit of
the underlying asset
Portfolio B consists of Xe-rT in cash invested at risk-free
rate
45

!
When the option in Portfolio A matures

Portfolio A is worth either X (if put is exercised) or ST
(if put is not exercised) i.e. Max (X, ST)
Portfolio B is always worth X at maturity
=> Value of Portfolio A > Value of Portfolio B
Implication :
Price of investing in Portfolio A > Portfolio B
p + S0 > Xe-rT
=> p > Xe-rT - S0
As an option cannot be negatively valued, therefore
p > Max [0, Xe-rT - S0]
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Corporate Finance
Lecture 10
Binomial Option Pricing

! Assumptions to derive model
!
All derivatives last only 1 period
Uncertainty is represented by the price of the underlying

asset taking 1 of the 2 possible values in the future
1-period risk-free return is rf

(i.e. a risk-free bond costing 1 unit of currency today will
pay 1 + rf units of currency 1-period from now)
47

! Illustration
! If the state of the world is good then future spot price is SH
else SL (where SH > SL)
! Current spot price of asset is S0
! A 1-period derivative assets exists with corresponding
prices of KH & KL ie. Maturity Payoff of Option
! 1-period risk-free interest rate is rf
! In pricing the derivative with absence of arbitrage, there is
a need to construct a portfolio consisting a units of the
underlying asset & b units of the risk-free asset
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Corporate Finance
Lecture 10

!
The replicating portfolio would have identical pay-off to

the derivative
Value of the portfolio will be either
depending whether the derivative pay-off is KH or KL

Equating the value of the portfolio with the derivative payoff results in 2 equations with 2 unknown variables
aSH + b(1+ rf ) = K H (Eqn 1)
aSL + b(1+ rf ) = K L
(Eqn 2)
49

!
Taking Eqn 1 minus Eqn 2 to solve for the simultaneous

equations would provide us the portfolio weights as follows
K H " KL
S H " SL
Then substitute the value of a into either Eqn 1 or Eqn 2 to
solve for the value of b
Hence,
! the cost of the replicating portfolio is
a=
!
!
aS0 + b
=> The no-arbitrage price of the derivative
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Corporate Finance
Lecture 10
Binomial Option Pricing Example

(Subject Guide)
A one-period European call option on ABC stock has an

exercise price of 120. The current price of ABC stock is 100, &
if things go well, the price in the following period will be 150.
If things go badly over the coming period, the future price will
be 90. The risk-free rate is 10%. What is the no-arbitrage price
of this option?
Using the above information, price an European put option on
ABC stock with a strike price of 100.
51

(Subject Guide)
SH > X : KH = 150 120 = 30
SL < X : KL = 0
150a + 1.1b = 30 (Eqn 1)
90a + 1.1b = 0 (Eqn 2)
60a = 30 (Eqn 1 Eqn 2)
a = 0.5 (Substitute into Eqn 2)
b = (-0.5 x 90)/1.1 = -40.91
Cost of Replicating Portfolio = aS0 + b
= (0.5 x 100) + (-40.91) = 9.09
52
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Corporate Finance
Lecture 10

(Subject Guide)
Using the above information, price an European put option on

ABC stock with a strike price of 100.
SH > X : KH = 0
SL < X : KL = 100 90 = 10
150a + 1.1b = 0 (Eqn 1)
90a + 1.1b = 10 (Eqn 2)
60a = -10 (Eqn 1 Eqn 2)
a = -1/6 (Substitute into Eqn 1)
b = (150/6)/(1.1) = 22.73
Cost of Replicating Portfolio = aS0 + b
= (-1/6 x 100) + 22.73 = 6.06
53

! Extending the model to more than 1 period allows longer
maturity instruments to be priced
! One period could represent one day, one hour or one minute
! Using a multi-period derivative valuation, we could price a
one-month option from a binomial model of hourly stock
returns
54
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Corporate Finance
Lecture 10
Risk-Neutral Option Valuation Method

! Under the previous portfolio replicating method, the current
price of the derivative asset does not depend on the probability
of the state of nature on the underlying asset
! Information about probabilities or risk would have been
captured by the current price of the underlying asset
! Pre-requisite information for Risk Neutral Valuation Method
! 1 + u = eT
! 1 d = e-T
! SH + S0(1 + u)
! SL = S0(1 d)
55

! Steps of Risk-Neutral Option Valuation Method
! Identifying the risk-neutral probabilities ie. Probabilities
which are consistent with investors being risk-neutral
Probabilities where the current price of the underlying
asset is the present value of tomorrows asset prices
S0 = [qSH + (1 q)SL]/(1 + rf)
S0(1 + rf) = q(SH SL) + SL
q = [S0(1 + rf) SL]/(SH SL)
= [S0 + rfS0 S0(1 d)]/[S0(1 + u) S0(1 d)]
= (S0 + rfS0 S0 + dS0)/(S0 + uS0 S0 + dS0)
= S0(rf + d)/S0(u + d) = (rf + d)/(u + d)
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Corporate Finance
Lecture 10

!
Calculating the current price of the derivative asset

which can be expressed as the present value of tomorrows
derivative values using the risk-neutral possibilities
K0 = [qKH + (1 q)KL]/(1 + rf)
= {(rf + d)/(u + d)KH + [1 - (rf + d)/(u + d)]KL}/(1 + rf)
= [(rf + d)KH + (u + d)]KL- (rf + d)KL]/[(u + d)(1 + rf)]
= [(rf + d)KH + uKL + dKL- rfKL dKL]/[(u + d)(1 + rf)]
= [(rf + d)KH + (u - rf)KL]/[(u + d)(1 + rf)]
57
Black-Scholes Option Pricing

! While Binomial Pricing Model is based on discrete time,
Black-Scholes model is based on continuous time process
! The model is able to give the exact prices for European calls &
puts
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Corporate Finance
Lecture 10

! The following parameters are needed to price a European call
on a stock that never pays a dividend
S
X
T
r
:
:
:
:
:
Current stock price

Exercise price of the option
Number of periods to maturity
Compounded risk-free rate
Instantaneous volatility of the stock price ie.
Standard deviation of the change in the logarithm of
the stock price
59

! The Black-Scholes formula for the price of a European call
option is given below
60
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Corporate Finance
Lecture 10

! N(x) represents the cumulative normal distribution function
! N(x) is the probability that a normally distributed variable
with a mean of zero & a standard deviation of 1 is less than x
! Value can be obtained from
! A table for cumulative distribution function or
! Using a polynomial approximation
61
Black-Scholes Option Pricing - Example

(Subject Guide)
The current price of Glaxo Wellcome shares is $2.88. An

investor writes a 2-year call option on Glaxo with exercise
price $3. If the annualised, continuously compounded interest
rate is 8% & the volatility of Glaxos stock price is 25%, what
is the Black-Scholes option price?
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Corporate Finance
Lecture 10
Black-Scholes Option Pricing - Example

(Subject Guide)
Using the above formulas, the values for d1 & d2 can be derived
as 0.5139 & 0.1603 respectively.
The values of the cumulative normal distribution function are
0.696 & 0.564 respectively.
Plugging in all available data, a call price of
c = (2.88)(0.696) - [(3)( e-0.08 x 2)(0.564)]
= $0.5644
63

! The Black-Scholes formula would suggest the
following determinants of call prices
! Current stock price
! Exercise price
! Volatility
! Time to maturity
! Riskless interest rates
All the above are positively correlated with the call price
except exercise price & the last 2 caused the PV of exercise
price to fall
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Corporate Finance
Lecture 10
Put-Call Parity
! Enables the pricing of a put
! Assume options have same
! Strike price (X)
! Time to maturity (T) &
! Underlying stock
! Consider 2 portfolios
! Portfolio A consisting of a long position in the underlying
asset & a put option costing (S0 + p)
!
Portfolio B consisting a long position in a call option &

lending Xe-rT costing (c + Xe-rT)
65
Put-Call Parity
!
The pay-offs on the portfolios on maturity are

Portfolio A : Max [X - ST, 0] or ST = Max [X, ST]
Portfolio B : Max [0, ST - X] or X = Max [X, ST]
Both portfolios always pay identical amounts & must cost

the same
=> S0 + p = c + Xe-rT
Implication :
Given the price of a call (put), value of the underlying asset
& risk-free rate, the price of a put (call) can be deduced
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Corporate Finance
Lecture 10
Put-Call Parity - Example

A call option on BAC stock, with an exercise price of 3.75,
costs 0.25 & expires in 3 years. The current price of BAC stock
is 2.00. Assuming the continuously compounded annual riskfree rate to be 10%, calculate the price of a put option with 3
years to expiry & exercise price of 3.75
Solution
S0 + p = c + Xe-rT
p = c + Xe-rT - S0
p = 0.25 + (3.75)e(-0.10)(3) - 2
= 1.03
67
Put-Call Parity : Deriving Arbitrage

Strategies
! Based on the market prices of put or call option, if the LHS is
not = to the RHS then a arbitrage strategy can be formulated
! If RHS > LHS then sell/short RHS & buy/long LHS else
! If RHS < LHS then buy/long RHS & sell/short LHS
! Analyse the cash flows from the short & long strategies would
result in either
! Immediate positive net cash flows with fully nullified
maturity cash flows or
! Positive maturity net cash flows with fully nullified
immediate investment costs
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Corporate Finance
Lecture 10
Put-Call Parity
! The determinants of put prices are similar to the call prices as
the prices are derived from the Black-Scholes model as well
!
Underlying Price
Inverse relationship
Exercise Price
Positive relationship
Volatility
Positive relationship
69
Put-Call Parity
!
Time to maturity
Longer period will lead to a greater volatility but as
holder receives the exercise price, discounting at higher
rates makes put prices less valuable resulting in
ambiguous combined effect
Risk-free rate
Puts are less valuable as rate rises due to greater
discounting of cash received i.e. exercise price
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Corporate Finance
Lecture 10
What is a Swap?
! Definition : Contracts specifying exchange of cash flows
between 2 counter parties over a period of time
! A risk management product
! Common examples of swaps
! Interest Rate Swap : Exchange of interest payments
based on a market-determined floating rate such as
LIBOR or SIBOR for those calculated on a fixed rate
basis
! Currency Swap : Exchange of principal & interest
payments in different currencies such as fixed EUR
interest payments for fixed USD interest payments
71
Interest Rate Swaps

! An agreement between 2 parties in which each party makes a
series of interest payments to the other at predetermined dates
at different rates
! One party pays fixed interest rate on a notional principal while
another party pays floating interest rate on the same notional
principal
! Only the net amount owed by one party is to be made, principal
is not exchanged
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Corporate Finance
Lecture 10
Interest Rate Swaps

! Swap Buyer : Fixed rate payer = Floating rate receiver
! Position equivalent to
! Sold fixed rate bond &
! Bought floating rate note
! Position value increases if
! Yield rise
! Swap spread widen
73
Interest Rate Swaps

! Swap Seller : Fixed rate receiver = Floating rate payer
! Position equivalent to
! Sold floating rate note &
! Bought fixed rate bond
! Position value increases if
! Yield fall
! Swap spread narrow
74
37
Corporate Finance
Lecture 10
Interest Rate Swaps

Payer of fixed rate is buyer
Fixed rate payer buys floating rate (LIBOR), the
fixed rate is the price
Fixed-Rate
Payer
Swap
Buyer
Floating Rate (LIBOR)

6.75% Fixed
Fixed-Rate
Receiver
Swap
Seller
75
Interest Rate Swaps - Structure

! Company XYZ borrows at floating rate LIBOR but would
prefer fixed rate
! Enter a swap for XYZ to receive LIBOR & pay fixed rate
(LIBOR is determined for the period ahead)
! Net cash flow at each interest payment date (from XYZs
perspective) is given as follows
76
38
Corporate Finance
Lecture 10

! If LIBOR > fixed rate, then XYZ receives the net amount
based on the formula given earlier
! If LIBOR < fixed rate, then XYZ will have to pay the net
amount to the other party
77

! P & L Effects Based on Original Liability for XYZ
Year 1
Year 2
Year 3
LIBOR
7.5% p.a
6.75%p.a
5% p.a
Int Expense ($750k)
($675k)
($500k)
! P & L Effects with Swap Contract (Fixed Rate = 6.75%p.a)
Year 1
Year 2
Year 3
LIBOR Int
($750k)
($675k)
($500k)
NCF fr Swap
75k
($175k)
Final Int Exp ($675k)
($675k)
($675k)
78
39
Corporate Finance
Lecture 10
Interest Rate Swaps : Liability

Restructuring
Fixed Rate
Swap
Counterparty
Borrower
Floating Rate
Floating Rate
Lender
79
Interest Rate Swap Caselet

! AA Bank
! Wants cheapest floating rate funding
! Can borrow at 12% fixed or LIBOR + 0.4%
! BBB Company
! Wants cheapest fixed rate funding
! Can borrow at 14% fixed or LIBOR + 0.8%
Questions
! How to tell whether it is possible to have an Interest Rate
Swap deal that make sense? How much is the potential interest
savings that can accrue from the Swap?
80
40
Corporate Finance
Lecture 10
Interest Rate Swap Caselet

! Assuming each party will share any potential interest saving
equally, how do you structure the interest rate swap deal?
! What if AA Bank wants to have 1% savings, how do you
restructure the interest rate swap deal?
81
Interest Rate Swap Solution

AA has absolute advantage in both fixed & floating
but there exist comparative advantage if
BBB borrows at LIBOR + 0.8% floating
AA borrows at 12% fixed
Preferred Positions : If BBB at 14% fixed & AA at LIBOR +
0.4%
Total cost = LIBOR + 14.4%
Swapped Positions : If BBB at LIBOR + 0.8% & AA at 12%
fixed
Total cost = LIBOR + 12.8%
Hence, savings of 1.6%
82
41
Corporate Finance
Lecture 10

! Original Liabilities of Both Counterparties
AA Bank
BBB Company
12%
L + 0.8%
83

Restructured Liabilities of Both Counterparties with Swap
! BBB Company is Swap Buyer paying fixed rate & receiving
floating rate
! AA Bank is Swap Seller paying floating rate & receiving fixed
rate
Floating Rate
AA Bank
BBB Company
Fixed Rate
12%
L + 0.8%
84
42
Corporate Finance
Lecture 10

They swap to give BBB fixed rate funding & AA floating rate
funding
After swap, with equal savings of 0.8% each, both counterparties
positions will be
BBB Companys net position will be
-14% + 0.8% Savings = -13.2%
-(L + 0.8%) + (Floating Rate Fixed Rate) = -13.2%
AA Banks net position will be
- (L + 0.4%) + 0.8% Savings = - (L - 0.4%)
-12% - (Floating Rate Fixed Rate) = - (L - 0.4%)
Swap Spread = (Floating Rate Fixed Rate) = L 12.4%
85

L
AA Bank
BBB Company
12.4%
12%
L + 0.8%
86
43
Corporate Finance
Lecture 10

After swap, with savings of 1% to AA Bank & 0.6% to BBB
Company, both counterparties positions will be
BBB Companys net position will be
-14% + 0.6% Savings = -13.4%
-(L + 0.8%) + (Floating Rate Fixed Rate) = -13.4%
AA Banks net position will be
- (L + 0.4%) + 1% Savings = - (L - 0.6%)
-12% - (Floating Rate Fixed Rate) = - (L - 0.6%)
Swap Spread = (Floating Rate Fixed Rate) = L 12.6%
87

L
AA Bank
BBB Company
12.6%
12%
L + 0.8%
88
44
Corporate Finance
Lecture 10
Currency Swaps
US$ Fixed Rate (P+I)
Swap Payments
IBM
World
Bank
DEM/SFr Fixed Rate (P+I)
DEM / SFr
P+I
Payments
Swap Payments
DEM & SFr

Bond Holders
US$ P+I
Payments
$ Eurobond
Holders
89
Pricing Interest Rate Swaps

! Review definition :
Counterparty A contracts to give fixed interest payments on a
notional principal to Counterparty B & in return receives
interest payments on the same principal based on an agreed
floating interest rate
! The frequency & duration of the interest payments are to be
agreed between the counterparties
! The London Inter-Bank Offer Rate (LIBOR) is a common
choice of floating interest rate used in such contracts
90
45
Corporate Finance
Lecture 10
Pricing Interest Rate Swaps - Example

Counterparty A agrees to pay Counterparty B payments on a $1
million principal at a fixed rate of 8% p.a. annually for 10 years
in return for interest payments of LIBOR + 0.25% p.a.
Payments by Counterparty A at every payment date till maturity
are fixed BUT the receipts are uncertain.
On a particular payment date, Counterparty A pays $80,000 &
receives LIBOR + 0.25%.
91
Pricing Interest Rate Swaps - Example

This is identical to the cash flows from a forward contract &
every payment date can be regarded as a forward transaction
Hence, the interest rate swap can be considered as a package of
forwards & priced using the forward pricing equations
92
46

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