Competency required for PV analyst.

1. PV analyst should be able to explain the movement in valuations based on market data
movement.
2. PV analyst should be able to explain basic concepts for pricing mentioned below. We will judge
the ability of the candidate via a quiz where passing marks will be 75%.

Options:
Introduction

Options are derivative contracts that give the holder the right, but not the obligation, to buy or sell the
underlying instrument at a specified price on or before a specified future date. Although the holder (also
called the buyer) of the option is not obligated to exercise the option, the option writer (known as the
seller) has an obligation to buy or sell the underlying instrument if the option is exercised.

Depending on the strategy, option trading can provide a variety of benefits including the security of limited
risk and the advantage of leverage. Options can protect or enhance an investor's portfolio in rising, falling
and neutral markets. Regardless of the reasons for trading options or the strategy employed, it is
important to understand the factors that determine the value of an option. This tutorial will explore the
factors that influence option pricing, as well as several popular option pricing models that are used to
determine the theoretical value of options.

Basics glossary for options

The following is intended as a review of basic option terminology, which can be used as a reference as
needed:

American Options - An option that can be at any point during the life of the contract. Most exchange-
traded options are American.

At-the-Money - An option whose strike price is equal to the market price of the underlying security.

Call - An option that gives the holder the right to buy the underlying security at a particular price for a
specified, fixed period of time.

Covered Call - An option strategy in which the writer of a call option holds a long position in the
underlying security on a share-for-share basis.

Covered Put - An option in which the writer of a put option holds a short position in the underlying
security on a share-for-share basis.

Covered Writer - An option seller who owns the option's underlying security as a hedge against the
option.

Derivative - An investment product that derives its value from an underlying asset. Options are
derivatives.
Early Exercise - The exercise of an option before its expiration date. Early exercise can occur with
American-style options.

European Options - An option that can only be exercised during a particular time period just before its
expiration.

Holder - An investor who purchases an option and who makes a premium payment to the writer.

In-the-Money - An option that has an intrinsic value. A call option is considered in-the-money if the
underlying security is higher than the strike price.

LEAPS (Long-term Equity Anticipation Securities) - LEAPS are publicly traded options that have
expiration dates longer than one year.

Listed Option - A put or call option that is traded on an options exchange. The terms of the option,
including strike price and expiration dates, are standardized by the exchange.

Naked Option - An option position in which the writer of the option does not have an offsetting position in
the underlying security, thereby having no protection against adverse prices moves.

Open Interest - The total number of outstanding option contracts in the exchange market on a particular
day.

Option - A financial derivative that gives the holder the right, but not the obligation, to either buy or sell a
fixed amount of a security or other financial asset at an agreed-upon price (the strike price) on or before a
specified date.

Out-of-the-Money - An option with no intrinsic value that would be worthless if it expired on that day. A
call option is out-of-the-money when the strike price is higher than the market price of the underlying
security. A put option is out-of-the-money when the strike price is lower than the market price of the
underlying security.

Over-the-Counter - An option that is not traded over an exchange. An over-the-counter option is not
subjected to the standardization of terms such as strike prices and expiration dates.

Premium - The total cost of the option. An option holder pays a premium to the option writer in exchange
for the right, but not the obligation, to exercise the option. In general, the option's premium is its intrinsic
value combined with its time value.

Put - An option that gives the holder the right to sell the underlying security at a particular price for a
specified, fixed period of time.

Strike Price - The agreed-upon price at which an option can be exercised. The strike price for a call
option is the price at which the security can be bought (prior to the expiration date); the strike price for a
put option is the price at which the security can be sold (before the expiration date). The strike price is
sometimes called the exercise price.

Terms - The collective conditions of an options contract that denote the strike price, expiration date and
the underlying security.

Underlying Security - The security that is subject to being bought or sold upon the exercise of an option.

Writer - An investor who sells an option and who collects the premium payment from the buyer. Writers
are obligated to buy or sell if the holder chooses to exercise the option.
Pricing an option

The price, or cost, of an option is an amount of money known as the premium. The buyer pays this
premium to the seller in exchange for the right granted by the option. For example, a buyer might pay a
seller for the right to purchase 100 shares of stock XYZ at a strike price of $60 on or before December 22.
If the position becomes profitable, the buyer will decide to exercise the option; if it does not become
profitable, the buyer will let the option expire worthless. The buyer pays the premium so that he or she
has the "option" or the choice to exercise or allow the option to expire worthless.

Premiums are priced per share. For example, the premium on an IBM option with a strike price of $205
might be quoted as $5.50, as shown in Figure 1. Since equity option contracts are based on 100 stock
shares, this particular contract would cost the buyer $5.50 X 100, or $550 dollars. The buyer pays the
premium whether or not the option is exercised and the premium is non-refundable. The seller gets to
keep the premium whether or not the option is exercised.

An option premium is its cost - how much the particular option is worth to the buyer and seller. While
supply and demand ultimately determine price, other factors, which will be discussed in this tutorial, do
play a role. Option traders apply these factors to mathematical models to help determine what an option
should be worth.

Time Value and Intrinsic value of option

The two components of an option premium are the intrinsic value and the time value. The intrinsic value is
the difference between the underlying's price and the strike price. Specifically, the intrinsic value for a call
option is equal to the underlying price minus the strike price; for a put option, the intrinsic value is the
strike price minus the underlying price

Intrinsic Value (Call) = Underlying Price – Strike Price

Intrinsic Value (Put) = Strike Price – Underlying Price

By definition, the only options that have intrinsic value are those that are in-the-money. For calls, in-the-
money refers to options where the exercise (or strike) price is less than the current underlying price. A put
option is in-the-money if its strike price is greater than the current underlying price.

In-the-Money (Call) = Strike Price < Underlying Price

In-the-Money (Put) = Strike Price > Underlying Price

Any premium that is in excess of the option's intrinsic value is referred to as time value. For example,
assume a call option has a total premium of $9.00 (this means that the buyer pays, and the seller
receives, $9.00 for each share of stock or $900 for the contract, which is equal to 100 shares). If the
option has an intrinsic value of $7.00, its time value would be $2.00 ($9.00 - $7.00 = $2.00).

Time Value = Premium – Intrinsic Value

In general, the more time to expiration, the greater the time value of the option. It represents the amount
of time that the option position has to become more profitable due to a favorable move in the underlying
price. In general, investors are willing to pay a higher premium for more time (assuming the different
options have the same exercise price), since time increases the likelihood that the position can become
profitable. Time value decreases over time and decays to zero at expiration. This phenomenon is known
as time decay.

An option premium, therefore, is equal to its intrinsic value plus its time value.

Option Premium = Intrinsic Value + Time Value

Factors impacting option pricing

There are six primary factors that influence option prices, as shown and discussed below.

Six factors that affect option prices are shown on the

top row. As indicated, the underlying price and strike
price determine the intrinsic value; the time until
expiration and volatility determine the probability of a
profitable move; the interest rates determine the cost
of money; and dividends can cause an adjustment to
share price.

Underlying Price
The most influential factor on an option premium is the current market price of the underlying asset. In
general, as the price of the underlying increases, call prices increase and put prices decrease.
Conversely, as the price of the underlying decreases, call prices decrease and put prices increase.

If underlying prices ... Call prices will ... Put prices will ...
Increase Increase Decrease
Decrease Decrease Increase

Expected Volatility
Volatility is the degree to which price moves, regardless of direction. It is a measure of the speed and
magnitude of the underlying's price changes. Historical volatility refers to the actual price changes that
have been observed over a specified time period. Option traders can evaluate historical volatility to
determine possible volatility in the future. Implied volatility, on the other hand, is a forecast of future
volatility and acts as an indicator of the current market sentiment. While implied volatility is often difficult
to quantify, option premiums will generally be higher if the underlying exhibits higher volatility, because it
will have higher expected price fluctuations.
 The greater the expected volatility, the higher the option value

Strike Price
The strike price determines if the option has any intrinsic value. Remember, intrinsic value is the
difference between the strike price of the option and the current price of the underlying. The premium
typically increases as the option becomes further in-the-money (where the strike price becomes more
favorable in relation to the current underlying price). The premium generally decreases as the option
becomes more out-of-the-money (when the strike price is less favorable in relation to the underlying).

Premiums increase as options become further in-the-money

Time Until Expiration

The longer an option has until expiration, the greater the chance that it will end up in-the-money, or
profitable. As expiration approaches, the option's time value decreases. In general, an option loses one-
third of its time value during the first half of its life and two-thirds of its value during the second half. The
underlying's volatility is a factor in time value; if the underlying is highly volatile, one could reasonably
expect a greater degree of price movement before expiration. The opposite holds true where the
underlying typically exhibits low volatility; the time value will be lower if the underlying price is not
expected to move much.

The longer the time until expiration, the higher the option
price
The shorter the time until expiration, the lower the option
price

Interest Rate and Dividends

Interest rates and dividends also have small, but measurable, effects on option prices. In general, as
interest rates rise, call premiums will increase and put premiums will decrease. This is because of the
costs associated with owning the underlying; the purchase will incur either interest expense (if the money
is borrowed) or lost interest income (if existing funds are used to purchase the shares). In either case, the
buyer will have interest costs.

If interest rates ... Call prices will ... Put prices will ...
Rise Increase Decrease
Fall Decrease Increase

Dividends can affect option prices because the underlying stock's price typically drops by the amount of
any cash dividend on the

ex-dividend date. As a result, if the underlying's dividend increases, call prices will decrease and put
prices will increase. Conversely, if the underlying's dividend decreases, call prices will increase and put
prices will decrease.

If dividends ... Call prices will ... Put prices will ...
Rise Decrease Increase
Fall Increase Decrease
Greeks:

Many option traders rely on the "Greeks" to evaluate option positions. The Greeks are a collection of
statistical values that measure the risk involved in an options contract in relation to certain underlying
variables. Popular Greeks include Delta, Vega, Gamma and Theta.

Δ Delta - Sensitivity to Underlying's Price

Delta, the most popular options Greek, measures an option's price sensitivity relative to changes in the
price of the underlying, and is the number of points that an option's price is expected to move for each
one point change in the underlying. Delta is important because it provides an indication of how the
option's value will change with respect to price fluctuations in the underlying instrument, assuming all
other variables remain the same.

Delta is typically shown as a numerical value between 0.0 and 1.0 for call options and 0.0 and -1.0 for put
options. In other words, option delta will always be positive for calls and negative for puts. It should be
noted that delta values can also be represented as whole numbers between 0.0 and 100 for call options
and 0.0 to -100 for put options, rather than using decimals. Call options that are out-of-the-money will
have delta values approaching 0.0; in-the-money call options will have delta values that are close to 1.0.

ν Vega - Sensitivity to Underlying's Volatility

Vega measures an option's sensitivity to changes in the volatility of the underlying. Vega represents the
amount that an option's price changes in response to a 1% change in volatility of the underlying market.
The more time that there is until expiration, the more impact increased volatility will have on the option's
price.

Because increased volatility implies that the underlying instrument is more likely to experience extreme
values, a rise in volatility will correspondingly increase the value of an option and, conversely, a decrease
in volatility will negatively affect the value of the option.

Γ Gamma – Sensitivity to Delta

Gamma measures the sensitivity of delta in response to price changes in the underlying instrument.
Gamma indicates how delta will change relative to each one point price change in the underlying. Since
delta values change at different rates, gamma is used to measure and analyze delta. Gamma is used to
determine how stable an option's delta is; higher gamma values indicate that delta could change
dramatically in response to even small movements in the underlying's price.

Gamma increases as options become at-the-money and decrease as options become in- and out-of-the-
money. Gamma values are generally smaller the further away from the date of expiration; options with
longer expirations are less sensitive to delta changes. As expiration approaches, gamma values are
typically larger as delta changes have more impact.

Θ Theta – Sensitivity to Time Decay

Theta measures the time decay of an option - the theoretical dollar amount that an option loses every day
as time passes, assuming the price and volatility of the underlying remain the same. Theta increases
when options are at-the-money; theta decreases when options are in- and out-of-the money. Long calls
and long puts will usually have negative theta; short calls and short puts will have positive theta. By
comparison, an instrument's whose value is not eroded by time, such as a stock, would have zero theta.
Trading and analysis platforms, as well as online calculators, can provide options traders with current
Greek values for any options contract. Figure 12, for example, shows the Delta, Gamma, Theta, Vega
and Rho values for both call and put options. These values will change as other variables, such as strike
price, change.
CDS - Introduction
A swap designed to transfer the credit exposure of fixed income products between parties. A credit
default swap is also referred to as a credit derivative contract, where the purchaser of the swap makes
payments up until the maturity date of a contract. Payments are made to the seller of the swap. In return,
the seller agrees to pay off a third party debt if this party defaults on the loan. A CDS is considered
insurance against non-payment. A buyer of a CDS might be speculating on the possibility that the third
party will indeed default.

How CDS work

A CDS contract involves the transfer of the credit risk of municipal bonds, emerging market bonds,
mortgage-backed securities, or corporate debt between two parties. It is similar to insurance because it
provides the buyer of the contract, who often owns the underlying credit, with protection against default, a
credit rating downgrade, or another negative "credit event." The seller of the contract assumes the credit
risk that the buyer does not wish to shoulder in exchange for a periodic protection fee similar to an
insurance premium, and is obligated to pay only if a negative credit event occurs. It is important to note
that the CDS contract is not actually tied to a bond, but instead references it. For this reason, the bond
involved in the transaction is called the "reference obligation." A contract can reference a single credit, or
multiple credits.

As mentioned above, the buyer of a CDS will gain protection or earn a profit, depending on the purpose of
the transaction, when the reference entity (the issuer) has a negative credit event. If such an event
occurs, the party that sold the credit protection, and who has assumed the credit risk, must deliver the
value of principal and interest payments that the reference bond would have paid to the protection buyer.
With the reference bonds still having some depressed residual value, the protection buyer must, in turn,
deliver either the current cash value of the referenced bonds or the actual bonds to the protection seller,
depending on the terms agreed upon at the onset of the contract. If there is no credit event, the seller of
protection receives the periodic fee from the buyer, and profits if the reference entity's debt remains good
through the life of the contract and no payoff takes place. However, the contract seller is taking the risk of
big losses if a credit event occurs.

Hedging and Speculation

CDS have the following two uses.

 A CDS contract can be used as a hedge or insurance policy against the default of a bond or loan.
An individual or company that is exposed to a lot of credit risk can shift some of that risk by
buying protection in a CDS contract. This may be preferable to selling the security outright if the
investor wants to reduce exposure and not eliminate it, avoid taking a tax hit, or just eliminate
exposure for a certain period of time.

 The second use is for speculators to "place their bets" about the credit quality of a particular
reference entity. With the value of the CDS market, larger than the bonds and loans that the
contracts reference, it is obvious that speculation has grown to be the most common function for
a CDS contract. CDS provide a very efficient way to take a view on the credit of a reference
entity. An investor with a positive view on the credit quality of a company can sell protection and
collect the payments that go along with it rather than spend a lot of money to load up on the
company's bonds. An investor with a negative view of the company's credit can buy protection for
a relatively small periodic fee and receive a big payoff if the company defaults on its bonds or has
some other credit event. A CDS can also serve as a way to access maturity exposures that would
otherwise be unavailable, access credit risk when the supply of bonds is limited, or invest in
foreign credits without currency risk.

An investor can actually replicate the exposure of a bond or portfolio of bonds using CDS. This can be
very helpful in a situation where one or several bonds are difficult to obtain in the open market. Using a
portfolio of CDS contracts, an investor can create a synthetic portfolio of bonds that has the same credit
exposure and payoffs.

The Basics of Single-Name Credit Default Swaps

To understand the credit event auction default process, it is helpful to have a general understanding of
single-name credit default swaps. A single-name CDS is a derivative in which the underlying instrument is
a reference obligation, or a bond of a particular issuer or reference entity.

Credit default swaps have two sides to the trade: a buyer of protection and a seller of protection. The
buyer of protection is insuring against the loss of principal in case of default by the bond issuer.
Therefore, credit default swaps are structured so that if the reference entity experiences a credit event,
the buyer of protection receives payment from the seller of protection. (For more on credit default swaps,
see our article Credit Default Swaps.)
Credit Derivatives Glossary

Basis Point – 1/100 of 1%. 100 basis points = 1%. A common term in fixed income and credit derivative
markets.

Basket CDS – A CDS where a group of reference entities are specified in one contract. There are several
types of basket CDS including first or Nth -to-default swaps (where settlement is triggered when the first
or Nth entity defaults).

Big Bang Protocol - Protocol taking effect on April 8, 2009. The Protocol affects new trades and all
legacy trades to adherents. The changes include the hardwiring of the auction mechanism, the definition
of the ISDA Determination committee, and the Lookback Period (today minus 60 days for credit events,
and today minus 90 days for succession events).

Calculation Agent – The party responsible for determining when a credit event or succession event has
occurred, and for calculating the amount of payment required by the Protection Seller.

CDS Spread – Also called a premium. The amount paid by the Protection Buyer to the Protection Seller,
typically denominated in basis points and paid quarterly. For example if the spread for The Widget
Company is 200 basis points, the Protection Buyer will pay the Protection Seller 200 basis points
multiplied by the notional of the trade annually (typically paid quarterly, on an actual number of days per
period/360 basis).

Credit Event Auction – Industry standard mechanism designed to ease the settlement of credit
derivative trades following a credit event. The auction process determines the cash settlement price of a
CDS, with the compensation received by the protection buyer based on the final agreed auction price.
Markit and Creditex have jointly acted as administrators of the auctions since their inception in June 2005.

Credit Event – This is the event triggering settlement under the CDS contract. Since the original ISDA
Agreement in 1999, six categories of Credit Events have been defined:

•Bankruptcy – Although the ISDA 2003 Definitions refer to different ways a bankruptcy can occur,
the experience has been that the reference entity has filed for relief under bankruptcy law (or
equivalent law).

•Failure to pay - The reference entity fails to make interest or principal payments when due, after
the grace period expires (if grace period is applicable in the trading documentation).

•Debt restructuring - The configuration of debt obligations is changed in such a way that the credit
holder is unfavorably affected (maturity extended and/or coupon reduced).

•Obligation default, obligation acceleration, and repudiation/moratorium – The 2003 ISDA

definitions define these three credit events, but they are very rare.

ISDA – The International Swaps and Derivatives Association is the global trade association representing
participants in the privately negotiated derivatives industry, a business covering swaps and options across
all asset classes (interest rate, currency, commodity and energy, credit and equity). ISDA was chartered
in 1985.

LIBOR – London Interbank Offered Rate – An interest rate fixing in the interbank market, representing the
rate at which highly-rated banks will lend to one another. Also widely us ed as a floating rate reference on
interest rate and currency swaps, and floating rate notes. LIBOR is calculated daily for a variety of
currencies including USD and GBP.

The EUR equivalent is EURIBOR and the JPY equivalent is TIBOR.

Long Credit – Refers to the position of the CDS Protection Seller who is exposed to the credit risk and
who receives periodic payments from the Protection Buyer.

Markit CDX – Markit credit indices focused on North America. Investment Grade, High Yield, and
Emerging Markets are the three major sub-indices.

Markit iTraxx – European and Asian CDS indices owned by Markit. The Markit iTraxx represents the
most liquid part of the CDS market for Asia and Europe.

Markit RED™– Markit’s Reference Entity Database. Markit RED is the industry standard identifier for
reference

entities and reference obligations in the credit derivative market.

Notional Principal – The quantity of the underlying asset or benchmark to which the derivative contract
applies.

Off-the-run / On-the-run – Markit iTraxx and CDX indices ‘roll’ every six months when a new series of
the index is created with updated constituents. The previous series continues trading although liquidity is
concentrated on the new series. The new series is referred to as being on-the-run, with previous series
referred to as being off-the-run.

OTC – Over The Counter – Refers to trades negotiated and conducted directly between two parties. This
contrasts with trades conducted on exchanges, where the trades are defined by the rules of the particular
exchange. CDS are examples of an OTC-traded instrument.

Present Value – An asset valuation method, which maps future cash flows from an asset and discounts
the future cash flows by an appropriate discount rate.

Protection Buyer – This is the party to a CDS contract which pays a premium for protection in case a
credit event occurs. The Protection Buyer can also speculate that the cost of protection will rise and profit
from selling the CDS contract at a higher price than was paid.

Protection Seller – This is the party to a CDS contract receiving the premium payments, and who is
exposed to the credit risk of the reference entity.

Recovery Rate – Estimate of percentage of par value that bondholders will receive after a credit event.
CDS for

investment grade bonds generally assume a 40% recovery rate when valuing CDS trades. However, CDS
for lower rated bonds are more dynamic and often reflect lower estimated recovery rates.
Reference Entity– Refers to the legal entity that is the subject of a CDS contract. The reference entity
can be the issuer or the guarantor of the debt.

Reference Obligation – The specific bond (debt obligation) that is referenced in the CDS contract.

Restructuring Credit Event – One of the types of credit events (defined above). It is a “soft” event, in
which the loss to the owner of the reference obligation is not obvious. In addition, restructuring often
retains a complex maturity structure, so that debt of different maturities may remain outstanding with
significant differences in value.

Series -Term which identifies the series of a specific index, and its main characteristics. In September
2008, Markit rolled the Markit CDX IG index to series 11. Series 11 has a maturity of December 20, 2013,
and fixed coupon of 150 basis points. In March 2009, Markit will roll the Markit CDX IG index to series 12.

Settlement – What occurs in the case of a credit event. Settlement can be cash or physical delivery,
depending on the terms of the contract. Traditionally, CDS specified physical delivery but in the last three
years numerous auctions have been held to allow for cash settlement.

Short Credit – This is the credit risk position of the Protection Buyer, who sold the credit risk of a bond to
the Protection Seller.

SNAC (Standard North American Corporate Contract) - Defines trades confirmed on the new CDS
conventions, with full coupon, subject to the Big Bang Protocol (determination committee, auction
hardwiring, lookback period).

Swap – An agreement between two parties to exchange future cash flows or credit risk.

Tenor – Refers to the duration of a CDS contract. Most CDS are written with 5 year terms, and this
remains the most liquid and frequently quoted part of the credit curve; however other tenors, such as the
10 year, are becoming more common.

Tier – Refers to one of four levels of debt in the capital structure of the reference entities. Each tier
represents a different level of seniority or preference in liquidation or bankruptcy. There will generally be
different levels for CDS protection for each of the tiers.

 Senior
 Subordinated
 Junior
 Preferred

Upfront– Refers to the initial (i.e. upfront) lump sum payment made when entering a CDS transaction.
Upfront payments tend to apply to transactions where the credit quality of the entity referenced is poor –
in other words, where the perceived risk of the entity defaulting is high. It ensures the Protection Seller
receives a payment upon trade execution that reflects the riskiness of the contract.

Version -Each index series is identified by a version number. After an index rolls, the initial version will be
one. To represent removal of constituents because of credit events and early termination (for LCDX), a
new version of the index is published. For example Markit CDX HY 11 v1 was the version of the Markit
CDX HY index launched at the roll of September 2008. After the removal of Tribune Company because of
bankruptcy, a new version Markit CDX HY 11 v2 was published. After the removal of Nortel Networks
Corporation, a new version was published, Markit CDX HY 11 v3.

Doc clause

Doc Clause Abbreviation Description

CR Cum- Restructuring or Old Restructuring
MR Modified Restructuring
MM Mod Restructuring (Introduced in June 2003)
XR Ex- Restructuring

Seniority Levels

Tier Abbreviation Description

JRSUBUT2 Junior Subordinated or Upper Tier 2 Debt (Banks)
PREFT1 Preference Shares, or Tier 1 Capital (Banks)
SECDOM Secured Debt (Corporate/Financial) or Domestic Currency Sovereign Debt (Government)
Senior Unsecured Debt (Corporate/Financial),Foreign Currency Sovereign Debt
SNRFOR (government)
SUBLT2 Subordinated or Lower Tier 2 Debt (Banks)

Credit Event

Defining ‘financial difficulty’ is more problematic, and indeed has led to several lawsuits already. We don’t
usually call it ‘financial difficulty’, by the way. It’s referred to as a ‘credit event’, or a ‘default’. We say a
credit default swap contract is ‘triggered’ if a credit event occurs, meaning the Big Bank has to pay up in
our example.

There are three broad categories of credit events that are put into the documentation of credit default
swap contracts:

1. Bankruptcy
If a company goes into Chapter 11 (in the US) then that is a clear indicator that the company is in
serious financial difficulty and that the bondholders may not get all their money back. This is an
obvious thing to have trigger the payment in a CDS contract.
2. Failure to Pay
If a company fails to make payments it should be making, including coupon payments on the
bonds, then this can be documented as a credit event.
3. Restructuring
This is where a company changes the payment schedules it makes on its bonds, usually with the
agreement of the bondholders. It’s usually not to the bondholders advantage when this happens,
and hence CDS contracts can be documented to cover this kind of restructuring as a credit event.

Of these, restructuring is the one that has proved the most problematic for the market. There are now four
separate standard definitions for restructuring that can be used in CDS contracts.
Physical vs. Cash Settlement

When a credit event occurs, settlement of the CDS contract can be either physical or in cash. In the past,
credit events were settled via physical settlement. This means that buyers of protection actually delivered
a bond to the seller of protection for par. This worked fine if the CDS contract holder actually held the
underlying bond.

As CDSs grew in popularity, they were used less as a hedging tool, and more as a way to make a bet on
certain credits. In fact, the number of CDS contracts written outstrips the number of cash bonds they are
based on. This would create an operational nightmare if all CDS buyers of protection chose to physically
settle the bonds. A more efficient way of settling CDS contracts needed to be considered.

To that end, cash settlement was introduced to more efficiently settle single-name CDS contracts when
credit events occurred. Cash settlement better reflects the intent of the majority of participants in the
single-name CDS market, as the instrument moved from a hedging tool to a speculation, or credit-view,
tool.

CDS Settlement Process Evolves

As CDSs had evolved into a credit trading tool, the default settlement process needed to evolve as well.
The volume of CDS contracts written is much larger than the number of physical bonds. In this
environment, cash settlement is superior to physical settlement.

In an effort to make cash settlement even more transparent, the credit event auction was developed.
Credit event auctions set a price for all market participants that choose to cash settle.

The credit event auction under the International Swaps and Derivatives Association (ISDA) global
protocol was initiated in 2005. When buyers and sellers of protection submit to adhere to the protocol of a
particular bankrupt entity, they are formally agreeing to settle their credit derivative contracts via the
auction process.

Credit Default Auctions

Buyers and sellers of protection participating in the credit event auction have a choice between cash
settlement and what is effectively physical settlement. Physical settlement in the auction process means
you settle on your net buy or sell position - not every contract. This is superior to the previous method as
it reduces the amount of bond trading needed to settle all of the contracts.

There are two consecutive parts to the auction process. The first stage involves requests for physical
settlement and the dealer market process where the inside market midpoint (IMM) is set. Dealers place
orders for the debt of the company that has undergone a credit event. The range of prices received is
used to calculate the IMM (for the exact calculation used, visit http://www.creditex.com/).

In addition to the IMM being set, the dealer market is used to determine the size and direction of the open
interest (net buy or net sell). The IMM is published for viewing and then used in the second stage of the
auction.
After the IMM is published, along with the size and direction of the open interest, participants can decide if
they would like to submit limit orders for the auction. Limit orders submitted are then matched to open
interest orders. This is the second stage of the process.

The Lehman Brothers Auction

The Lehman Brothers failure in September 2008 provided a true test of the procedures and systems
developed to settle credit derivatives. The auction, which occurred on October 10, 2008, set a price of
8.625 cents on the dollar for Lehman Brothers debt. It was estimated that between $6 billion and $8 billion
changed hands during the cash settlement of the CDS auction. Recoveries for Fannie Mae and Freddie
Mac (NYSE:FRE) were 91.51 and 94.00, respectively. (To learn more, read How Fannie Mae And
Freddie Mac Were Saved.)

Recoveries were much higher for the mortgage-finance companies placed into conservatorship, as the
U.S. government backed the debt of these companies.

What does the price of 8.625 mean? It means that the sellers of protection on Lehman CDS will have to
pay 91.375 cents on the dollar to buyers of protection to settle and terminate the contracts via the
Lehman Protocol auction process.

In other words, if you had held Lehman Brothers bonds and had bought protection via a CDS contract,
you would have received 91.375 cents on the dollar. This would offset your losses on the cash bonds you
held. You would have expected to receive par, or 100, when they matured, but would have only received
their recovery value after the bankruptcy process concluded. Instead, since you bought protection with a
CDS contract, you receive 91.375.

The CDS "Big Bang"

Further improvements and standardization of CDS contracts continue to be made. Together, the various
changes being implemented have been called the "Big Bang".

In 2009, new CDS contracts will begin trading with a fixed coupon of 100 or 500 basis points, with the
upfront payment differing based on the perceived credit risk of the underlying bond issuer.

Another improvement is to make the auction process a standard part of the new CDS contract. Under
current contracts, the auction process is voluntary or an "opt-in" and investors have to sign up for each
protocol individually, increasing administration costs. Investors will now have to "opt-out" of the protocol if
they would like to settle their contracts outside of the auction process (using a preapproved list of
deliverable obligations)
Pricing CDS
As with any swap, valuing credit default swaps (CDS) involves calculating the present value of the
two legs of the transaction. In the case of CDS, these are the premium leg (the regular fee payments) and
the contingent leg (the payment at the time of default). The basic inputs to the model are: the credit curve,
which is the term structure of the CDS spread curve ranging across the standard maturity points, i.e. 6M,
1Y, 2Y, 3Y, 4Y, 5Y, 7Y, 10Y, 15Y, 20Y and 30Y; the recovery rate assumption, meaning if a default
occurs, how much of their money bond investors will recover; a discount rate for calculating a present
value, typically the zero-coupon swap curve for the trade currency; and the traded spread of the CDS.

For a fair market trade, the present value of the two legs should be equal, so the present value of all
future fee payments should be exactly equal to the present value of the contingent payment at the time of
default. Consider the following example CDS trade:

The mark-to-market CDS spreads for Ford as at September 13 were 100bp for 6M and 150bp for 1Y. Let
us assume: a 5% constant annual interest rate for discounting; a recovery rate of 40% on default; that if a
default occurs, it takes place in the middle of a coupon period; and default probabilities of P1 and P2 for
the two periods of the CDS.

For the six-month CDS, value of the premium leg is made up of two parts: the case where there is a
default (at three months), plus the case where there isn't a default (payment at six months), appropriately
discounted:

P1*100bp*/(1+5%)(1/4)+(1-P1)*100bp*1/2/(1+5%)(1/2)

The value of the contingent leg is the payment on default multiplied by the probability of default and
discounted:

(1-40%)*P1/(1+5%)(1/4)

Setting these equal and solving for P1, we see it is about 0.82%.

The equations for the 1Y swap are a little more complicated. On the premium leg we consider the cases
of default in period 1, default in period 2 and no default in either period. For the contingent leg we
consider default in both the first two periods. The algebra is a little more complex, but solving for P2, we
obtain a value of about 1.64%.

The common way of quoting these probabilities is as a survival function S(t), which is the probability of no
default. For the six-month period this is:

S(6M)=1-P1=99.18%

And for one year:

S(1Y)=(1-P1)(1-P2)=97.55

Once the survival function has been determined from current market spreads, both the fee and contingent
legs may be valued using similar principles. For example, if we are valuing a one-year trade on Ford
where we traded at 200bp, we use the same equations for each leg but replace the market rate of 150bp
with the traded rate of 200bp in the fee leg and use the values of P1 and P2 we deduced above.
Substituting the values of P1 and P2, this gives a present value of approximately 0.47%. Intuitively this
number 'feels' about right: if we traded at 200bp and the market is now 150, we would expect the present
value to be approximately equal to the discounted value of 50bp, which it is.

Factors impacting CDS valuations

Credit Default Swaps (CDS)

Suppose that we have invested in the General Motors bond mentioned above. Suppose our investment is
$10,000,000. Suppose also that we have become worried that General Motors may be getting into
financial trouble. What can we do about it? Obviously we could just sell our bond position in the
secondary market. However, we can also enter into a credit default swap. The easiest way to think of a
credit default swap is as an insurance contract. We are insuring against the possibility that a company
might get into financial trouble and cause us to lose money on our bond position.

To enter into this insurance contract we have to find someone prepared to insure us. Note that this is
NOT General Motors. The big banks are usually the people to go to.

What we can do is to pay the bank a periodic small amount of money known as a ‘premium’ (which is like
an insurance premium). This is calculated as a percentage of the face value of the bond we are insuring
against, which is $10m in our case. This amount (the $10m) is known as the ‘notional principal’. The
premium is paid every few months (usually every three or six months) throughout the life of the contract.

In return for the premium the bank does nothing unless General Motors gets into financial difficulty. In that
case the bank will pay us an amount equal to the amount we have lost on our bond position. This is likely
to be a big sum relative to the small premiums that we will pay. Once this happens the contract will
terminate. Otherwise the contract carries on for an agreed period (usually five years). In picture form this
looks a bit as below:

Here the Big Bank is the ‘protection seller’: it’s receiving money in return for providing protection against
our bonds falling in value. Similarly we are ‘protection buyers’.

Clearly there are a few things that need to be sorted out before we enter into this contract. Since the Big
Bank is going to make us a large payment if General Motors gets into financial difficulty we’d better define
what ‘financial difficulty’ means very clearly. We’d also better sort out exactly how we’re going to calculate
the amount that will be paid.
Size of Premium Payment is Bigger if the Company is more Likely to Default

One question that has been asked is how large the premium will be in general (see the comments).

The Big Bank in our example is providing us with protection against the default of a company (General
Motors). We are paying them the premium for this protection. Clearly if the company being referred to is
more likely to default the Big Bank will want us to pay them more money. So the premium rate is higher
for riskier companies than for safe ones.

The Big Bank will decide which companies it thinks are risky, and hence what premium it should charge,
based on a number of factors. However, there’s already a market that reflects how risky a company is.
This is the bond market as described earlier in this article. In the example there General Motors had to
pay a higher interest rate on its bonds than the US Government because of the risk that the investor
wouldn’t get their money back if General Motors defaulted.

Size of Premium Payment and How it Relates to Bond Prices

Now consider the case where we buy a General Motors bond. We then enter into a credit default swap to
the maturity of the bond as well. This acts as insurance against General Motors defaulting on the bond.
We receive interest from the General Motors bond, but pay some of it away in insurance on the credit
default swap.

In simple terms we now have overall a bond position where we don’t lose anything if General Motors
defaults. If a default occurs we get our money back from the credit default swap. We can then invest in
another bond.

We can think of this as a risk-free bond position. This is in many ways equivalent to a position in US
Government bonds (which we can assume won’t default at all). We’d expect our overall interest rate to
be similar to that of a US Government bond. Our overall interest rate is the rate on the General Motors
bond less the premium on the credit default swap.

Now suppose the interest rate on a US Government bond is 5% and the interest rate on a General Motors
bond of the same maturity is 8%. We’d expect the premium on a credit default swap on General Motors
for the same period to be about 3%. Note that the 3% premium is also called the ‘spread’ on a credit
default swap, since it is the spread between the government bond and the corporate bond interest rates.

Note that this is a very simplistic analysis. It is broadly accurate but there are reasons why it doesn’t work
exactly in practice.

Some Other Terminology Relating to Credit Default Swaps

(i) Reference Entity and Reference Obligation

Note above that General Motors is not directly involved in the credit default swap contract. General
Motors as a company will not even know the contract exists. The contract is between us and the Big
Bank. General Motors is just an entity that is referred to in the contract, and hence is known as the
‘reference entity’.

Similarly the contract refers to the specific bond we are insuring (General Motors 8.375% maturing 15th
July 2033 in our example). However the bond isn’t directly involved in the contract. Indeed if the contract
is cash settled we don’t even have to be holding the bond at any time: we can just enter into the CDS
contract without it. The bond is just an obligation being referred to in the contract, and hence is known as
the ‘reference obligation’.
You should know that, at least in technology, everyone’s favourite interview question about credit default
swaps is ‘what’s the difference between a reference entity and a reference obligation?’

(ii) Bond Seniority

Bonds have a hierarchy of importance when a company is unable to pay its debts. Some bondholders will
get their money back before others. (They ALL get their money back before the shareholders.) The exact
place in the pecking order depends on the documentation of the bonds. Typically bonds are classified
according to ‘seniority’. They are assigned to one of senior secured, senior unsecured, senior
subordinated, subordinated and junior subordinated seniority categories. The list is in order of seniority:
senior secured is the highest, junior subordinated the lowest. This means if we hold a senior secured
bond we are more likely to get our money back if the company goes bankrupt than if we hold a junior
subordinated bond.

When a company is being wound up the bondholders get paid in seniority order out of the cash that is
remaining to the company. The bondholders with the highest seniority debt get paid first, then the
bondholders with the next level of seniority debt, and so on. Bondholders will get paid in full in each
seniority category until the money runs out. If at any stage the money is insufficient to pay the current
seniority of bondholder in full, every bondholder of that seniority gets paid the same percentage of the
face value of their bond. So, for example, the most senior bondholders may get paid in full, one category
of more junior bondholders will only get a percentage payout, and the most junior bondholders may get
nothing.

(iii) Recovery Rates

The ‘recovery rate’ is the percentage of the face value of our bond that we get back if there’s a credit
event. For example, suppose we hold $10m of bonds in a company, and it goes bankrupt. Assume we get
$4m back for our bonds from the company after the bankruptcy. We would say our ‘recovery rate’ is 40%
(4m/10m as a percentage).

Recovery rates are also one of the inputs into pricing a CDS contract (working out its value to either
counterparty) prior to maturity. To price a CDS one of the things we need to know is how much the bond
we are insuring will reduce in value if a credit event occurs. This is obviously important since it determines
the size of the payment made as a result of the credit event. Clearly we can’t know exactly how much the
bond will be worth after a credit event before the credit event has happened, so we estimate a recovery
rate.

Most pricing methodologies estimate recovery rates in a very simplistic way: a percentage is assigned to
the seniority of the debt of a company. So we might say General Motors Senior Unsecured debt has a
recovery rate of 40%, and then use that number for pricing all GM senior unsecured credit default swaps.

Uses of Credit Default Swaps

As described above it sounds like the credit default swap is a very niche product since its primary use is
to hedge bond positions against default. However, the credit default swap market has taken off and is
huge. The reason is that there is a wide range of ways CDS can be used. In recent years pure
speculation, largely by hedge funds, seems to have been the main driver of the market.

Geoff Chaplin’s excellent book ‘Credit Derivatives: Risk Management, Trading and Investing’ cites the
following uses of CDS:

 Directional Trading/Relative Trades (speculation on individual companies)

 Debt Hedging (hedging bond positions as described above)
  Sector/Portfolio Trades (speculation on groups of companies)
 Income Generation (we can just sell protection and receive premium, provided we’re confident we
won’t face defaults (credit events))
 Regulatory Capital Reduction (if a bank has lent to a company that uses regulatory capital which
can be reduced by buying CDS protection)

Issues

Below are a few further issues relating to credit default swaps?

 The description of CDS as ‘insurance’ is not technically accurate. Insurance contracts are
regulated in a different way, the documentation is different, and usually an insurance contract
would require us to actually own the bond to be valid for a claim, which is not the case for a CDS.
 As mentioned above, there’s no reason for either party to a CDS contract to actually be holding a
bond (reference obligation) of the reference entity. CDS can be entered into purely as speculative
positions. Even with physical settlement the buyer of protection can just go into the market and
buy the appropriate bond at the time of a credit event, and doesn’t need to hold it through the life
of the contract.
 CDS contracts are usually not entered into with retail investors. You or I couldn’t actually execute
a CDS on our bond position; we don’t have big enough positions to make it worthwhile in general.
Hedge funds, pension funds, fund managers and insurance companies tend to be the
counterparties to the banks on these contracts (as well as other banks).
 Credit default swaps are usually documented such that a range of bonds can be ‘delivered’
(handed over in physical settlement or used to calculate losses in cash settlement). The text
above implied that only one bond was ever relevant. The reference obligation cited in the contract
simply defines the type of bond that can be delivered (its seniority). Usually any bond of the same
seniority or higher seniority can be delivered. CDS can be traded without any reference obligation
being cited: usually this means that any senior unsecured debt can be delivered.
 This is a zero-cost instrument. The two parties to the contract just agree the details up front, and
the contract starts without any initial payment being necessary. If you are a seller of protection
you just get premium in without having to do anything, which can be attractive.

Since that time we have seen what many are calling the greatest financial crisis since the Great
Depression, and a global recession.

Rightly or wrongly, some of the blame for the crisis has been attributed to credit derivatives and
speculation in them. This has led to calls for a more transparent and better regulated credit default swap
(CDS) market. Furthermore the CDS market has grown very quickly, and by 2009 it had become clear
that some simple changes to operational procedures would benefit everyone.

As a result many changes in the market have already been implemented, and more are on the way. This
article will discuss these changes. It will focus primarily on how the mechanics of trading a credit default
swap have changed, rather than the history of how we got here or why these changes have been made.
I’ll also briefly discuss the further changes that are on the way.
Overview of the Changes

The first thing to note is that nothing has fundamentally changed from the description of a credit default
swap in part 1. A credit default swap is still a contract that provides a kind of insurance against a company
defaulting on its bonds. If you have read and understood part one then you should understand how a
credit default swap works.

The main change that has happened is that credit default swap contracts have been standardized. This
standardization falls into three broad categories:

1. Changes to the premium, premium and maturity dates, and premium payments that simplify the
mechanics of CDS trading.
2. Changes to the processes around identifying whether a credit event has occurred.
3. Changes to the processes around what happens when a credit event has occurred.

Items 2 and 3 are extremely important, and have removed many of the problems that were discussed in
part 1 relating to credit events. However, they don’t affect the way credit default swaps are traded as
fundamentally as item 1, and are arguably more boring, so we’ll start with item 1.

The Non-Standard Nature of Credit Default Swaps Previously

If I buy 100 IBM shares and then buy 100 more I know that I have a position of 200 IBM shares. I can go
to a broker and sell 200 IBM shares to get rid of (close out) this position.

One of the problems with credit default swaps (CDS) as described in part 1 of this series of articles is that
you couldn’t do this. Every CDS trade was different, and it was consequently difficult to close out
positions.

Using the description in part 1, consider the case where I have some senior IBM bonds. I have bought
protection against IBM default using a five year CDS. Now I decide to sell the bonds and want to close
out my CDS. It’s difficult to do this by selling a five year CDS as described previously. Even if I can get
the bonds being covered, the definition of default, the maturity date and all the premium payment dates to
match exactly it’s likely that the premiums to be paid will be different from those on the original CDS. This
means a calculation has to be done for both trades separately at each premium payment date.

Standardization

To address this issue a standard contract has been introduced that has:

Standard Maturity Dates

There are four dates per year, the ‘IMM dates’ that can be the maturity date of a standard contract: 20th
March, 20th June, 20th September, and 20th December. This means that if today is 5th July 2011 and I
want to trade a standard five-year CDS I will normally enter into a contract that ends 20th September
2016. It won’t be a standard CDS if I insist my maturity date has to be 5th July 2016.
Standard Premium Payment Dates

The same four dates per year are the dates on which premiums are paid (and none other). As a result
three months of premium are paid at every premium payment date.

Note that the use of IMM dates for CDS maturity and premium payment dates was already common when
I wrote part 1 of the article.

Standard Premiums

In North America, standard contracts ONLY have premiums of 100 or 500 basis points per annum (1% or
5%). In Europe, Asia and elsewhere a wider range of premiums is traded on standard contracts, although
this is still restricted. How this works in practice will be explained in part 3.

Payment of Full First Coupon

Standard contracts pay a ‘full first coupon’. What this means is that if I buy a CDS midway between the
standard premium payment dates I still have to pay a full three months’ worth of premium at the next
premium date. Note that ‘coupon’ here means ‘premium payment’.

For example, if I enter into a CDS with face value $100m on 5th July 2011 with a premium of 5% I will
have to pay 3 months x 5% x 100m on the 20th September. This is in spite of the fact that I have not
been protected against default for the full three months.

Note that for the standard premiums and the payment of full first coupon to work we now have upfront
fees for CDS. Again this will be explained in more detail in part 3.

Impact of these Changes

What all this means is that we have fewer contract variations in the market. The last item in particular
means that a position in any given contract always pays the same amount at every premium date: we
don’t need to make any adjustments for when the contract was traded.

In fact, in terms of the amount paid EVERY contract with the same premium (e.g. 500 bps) pays the same
percentage of face value at a premium date, regardless of reference entity. This clearly simplifies coupon
processing. It also allows us to more easily net positions in credit default swaps in our systems.

Effect of recovery rate on CDS pricing

If recovery goes up CDS spread will go down as in case of default we should be able to recover higher
amount and hence less premium for protection. If recovery goes down CDS spread will go up as in case
of default we should be able to recover lower amount and hence higher premium for protection.

Effect of CDS spread on CDS pricing

If CDS spread goes up it is beneficial for CDS buyer as CDS buyer has agreed to pay a predetermined
premium to CDS seller which is lower and hence CDS buyer will have a positive MTM. If CDS spread
goes down CDS seller will have positive MTM.
Relation between CDS spread and probability of default

For a given recovery rate higher the probability of default higher will be the CDS spread.

RED code – 6 digit and 9 digit

The RED code for the reference entity/obligation - 6 characters to specify the entity only, and 9 to specify
the entity as well as the tier and currency of the obligation. Please choose ONLY ONE of the three
options below to specify the entity, tier and currency of the CDS:

1. 6 character RED code, Tier and Currency

2. 9 character RED code
3. 6 character RED code, Bond ID and Bond ID Type

When more than one option is specified, the precedence will follow the order above

Upfront – Refers to the initial (i.e. upfront) lump sum payment made when entering a CDS transaction.
Upfront payments tend to apply to transactions where the credit quality of the entity referenced is poor –
in other words, where the perceived risk of the entity defaulting is high. It ensures the Protection Seller
receives a payment upon trade execution that reflects the riskiness of the contract.

Recovery rate for single name CDS and LCDS, Markit uses the composite recovery rate. If a composite
recovery cannot be built due to insufficient contributions that pass the cleaning tests, then the following
default recovery rates are used for the different seniority tiers:

1. 40% for senior corporate debt

2. 20% for subordinate debt
3. 25% for emerging market entities
4. 35% for senior Japanese names
5. 70% for first lien loans
6. 40% for second lien loans
7. 20% for third lien loans.

For indices, the following recovery rates are used:

1. 40% for IG (investment grade) indices

2. 30% for HY (high yield) indices
3. 25% for EM (emerging market) indices
4. 35% for Japanese indices.
Basic swap structure
Interest rate swaps are simply the exchange of one set of cash flows (based on interest rate
specifications) for another. Because they trade OTC, they are really just contracts set up between two or
more parties, and thus can be customized in any number of ways.

An interest rate swap is a contractual agreement entered into between two counterparties under which
each agrees to make periodic payment to the other for an agreed period of time based upon a notional
amount of principal. The principal amount is notional because there is no need to exchange actual
amounts of principal in a single currency transaction: there is no foreign exchange component to be taken
account of. Equally, however, a notional amount of principal is required in order to compute the actual
cash amounts that will be periodically exchanged.

Under the commonest form of interest rate swap, a series of payments calculated by applying a fixed rate
of interest to a notional principal amount is exchanged for a stream of payments similarly calculated but
using a floating rate of interest. This is a fixed-for-floating interest rate swap. Alternatively, both series of
cashflows to be exchanged could be calculated using floating rates of interest but floating rates that are
based upon different underlying indices. Examples might be Libor and commercial paper or Treasury bills
and Libor and this form of interest rate swap is known as a basis or money market swap.

Interest Rate Swaps

If we consider the generic fixed-to-floating interest rate swap, the most obvious difficulty to be overcome
in pricing such a swap would seem to be the fact that the future stream of floating rate payments to be
made by one counterparty is unknown at the time the swap is being priced. This must be literally true: no
one can know with absolute certainty what the 6 month US dollar Libor rate will be in 12 months time or
18 months time. However, if the capital markets do not possess an infallible crystal ball in which the
precise trend of future interest rates can be observed, the markets do possess a considerable body of
information about the relationship between interest rates and future periods of time.

In many countries, for example, there is a deep and liquid market in interest bearing securities issued by
the government. These securities pay interest on a periodic basis, they are issued with a wide range of
maturities, principal is repaid only at maturity and at any given point in time the market values these
securities to yield whatever rate of interest is necessary to make the securities trade at their par value.

It is possible, therefore, to plot a graph of the yields of such securities having regard to their varying
maturities. This graph is known generally as a yield curve -- i.e.: the relationship between future interest
rates and time -- and a graph showing the yield of securities displaying the same characteristics as
government securities is known as the par coupon yield curve. The classic example of a par coupon yield
curve is the US Treasury yield curve. A different kind of security to a government security or similar
interest bearing note is the zero-coupon bond. The zero-coupon bond does not pay interest at periodic
intervals. Instead it is issued at a discount from its par or face value but is redeemed at par, the
accumulated discount which is then repaid representing compounded or "rolled-up" interest. A graph of
the internal rate of return (IRR) of zero-coupon bonds over a range of maturities is known as the zero-
coupon yield curve.

Finally, at any time the market is prepared to quote an investor forward interest rates. If, for example, an
investor wishes to place a sum of money on deposit for six months and then reinvest that deposit once it
has matured for a further six months, then the market will quote today a rate at which the investor can re-
invest his deposit in six months time. This is not an exercise in "crystal ball gazing" by the market. On the
contrary, the six month forward deposit rate is a mathematically derived rate which reflects an arbitrage
relationship between current (or spot) interest rates and forward interest rates. In other words, the six
month forward interest rate will always be the precise rate of interest which eliminates any arbitrage profit.
The forward interest rate will leave the investor indifferent as to whether he invests for six months and
then re-invests for a further six months at the six month forward interest rate or whether he invests for a
twelve month period at today's twelve month deposit rate.

The graphical relationship of forward interest rates is known as the forward yield curve. One must
conclude, therefore, that even if -- literally -- future interest rates cannot be known in advance, the market
does possess a great deal of information concerning the yield generated by existing instruments over
future periods of time and it does have the ability to calculate forward interest rates which will always be
at such a level as to eliminate any arbitrage profit with spot interest rates. Future floating rates of interest
can be calculated, therefore, using the forward yield curve but this in itself is not sufficient to let us
calculate the fixed rate payments due under the swap. A further piece of the puzzle is missing and this
relates to the fact that the net present value of the aggregate set of cashflows due under any swap is -- at
inception -- zero. The truth of this statement will become clear if we reflect on the fact that the net present
value of any fixed rate or floating rate loan must be zero when that loan is granted, provided, of course,
that the loan has been priced according to prevailing market terms. This must be true, since otherwise it
would be possible to make money simply by borrowing money, a nonsensical result However, we have
already seen that a fixed to floating interest rate swap is no more than the combination of a fixed rate loan
and a floating rate loan without the initial borrowing and subsequent repayment of a principal amount. The
net present value of both the fixed rate stream of payments and the floating rate stream of payments in a
fixed to floating interest rate swap is zero, therefore, and the net present value of the complete swap must
be zero, since it involves the exchange of one zero net present value stream of payments for a second
net present value stream of payments.

The pricing picture is now complete. Since the floating rate payments due under the swap can be
calculated as explained above, the fixed rate payments will be of such an amount that when they are
deducted from the floating rate payments and the net cash flow for each period is discounted at the
appropriate rate given by the zero coupon yield curve, the net present value of the swap will be zero. It
might also be noted that the actual fixed rate produced by the above calculation represents the par
coupon rate payable for that maturity if the stream of fixed rate payments due under the swap are viewed
as being a hypothetical fixed rate security. This could be proved by using standard fixed rate bond
valuation techniques.

Financial Benefits Created By Swap Transactions

Consider the following statements:

1. A company with the highest credit rating, AAA, will pay less to raise funds under identical
terms and conditions than a less creditworthy company with a lower rating, say BBB. The
incremental borrowing premium paid by a BBB company, which it will be convenient to refer
to as a "credit quality spread", is greater in relation to fixed interest rate borrowings than it is
for floating rate borrowings and this spread increases with maturity.
2. The counterparty making fixed rate payments in a swap is predominantly the less
creditworthy participant.
3. Companies have been able to lower their nominal funding costs by using swaps in
conjunction with credit quality spreads.

These statements are, I submit, fully consistent with the objective data provided by swap transactions and
they help to explain the "too good to be true" feeling that is sometimes expressed regarding swaps. Can it
really be true, outside of "Alice in Wonderland", that everyone can be a winner and that no one is a loser?
If so, why does this happy state of affairs exist?
The Theory of Comparative Advantage

When we begin to seek an answer to the questions raised above, the response we are most likely to meet
from both market participants and commentators alike is that each of the counterparties in a swap has a
"comparative advantage" in a particular and different credit market and that an advantage in one market
is used to obtain an equivalent advantage in a different market to which access was otherwise denied.
The AAA company therefore raises funds in the floating rate market where it has an advantage, an
advantage which is also possessed by company BBB in the fixed rate market.

The mechanism of an interest rate swap allows each company to exploit their privileged access to one
market in order to produce interest rate savings in a different market. This argument is an attractive one
because of its relative simplicity and because it is fully consistent with data provided by the swap market
itself. However, as Clifford Smith, Charles Smithson and Sykes Wilford point out in their book MANAGING
FINANCIAL RISK, it ignores the fact that the concept of comparative advantage is used in international
trade theory, the discipline from which it is derived, to explain why a natural or other immobile benefit is a
stimulus to international trade flows. As the authors point out: The United States has a comparative
advantage in wheat because the United States has wheat producing acreage not available in Japan. If
land could be moved -- if land in Kansas could be relocated outside Tokyo -- the comparative advantage
would disappear. The international capital markets are, however, fully mobile. In the absence of barriers
to capital flows, arbitrage will eliminate any comparative advantage that exists within such markets and
this rationale for the creation of the swap transactions would be eliminated over time leading to the
disappearance of the swap as a financial instrument. This conclusion clearly conflicts with the continued
and expanding existence of the swap market.

It would seem, therefore, that even if the theory of comparative advantage does retain some force -- not
withstanding the effect of arbitrage -- which it almost certainly does, it cannot constitute the sole
explanation for the value created by swap transactions. The source of that value may lie in part in at least
two other areas.

Information Asymmetries

The much- vaunted economic efficiency of the capital markets may nevertheless co- exist with certain
information asymmetries. Four authors from a major US money centre bank have argued that a company
will -- and should -- choose to issue short term floating rate debt and swap this debt into fixed rate funding
as compared with its other financing options if:

- It had information -- not available to the market generally -- which would suggest that its own
credit quality spread (the difference, you will recall, between the cost of fixed and floating rate
debt) would be lower in the future than the market expectation.
- It anticipates higher risk- free interest rates in the future than does the market and is more
sensitive (i.e. averse) to such changes than the market generally.

In this situation a company is able to exploit its information asymmetry by issuing short term floating rate
debt and to protect itself against future interest rate risk by swapping such floating rate debt into fixed rate
debt.

Fixed Rate Debt and Embedded Options

Fixed rate debt typically includes either a prepayment option or, in the case of publicly traded debt, a call
provision. In substance this right is no more and no less than a put option on interest rates and a right
which becomes more valuable the further interest rates fall. By way of contrast, swap agreements do not
contain a prepayment option. The early termination of a swap contract will involve the payment, in some
form or other, of the value of the remaining contract period to maturity.
Returning, therefore, to our initial question as to why an interest rate swap can produce apparent financial
benefits for both counterparties the true explanation is, I would suggest, a more complicated one than can
be provided by the concept of comparative advantage alone. Information asymmetries may well be a
factor, together with the fact that the fixed rate payer in an interest rate swap -- reflecting the fact that he
has no early termination right -- is not paying a premium for the implicit interest rate option embedded
within a fixed rate loan that does contain a pre-payment rights. This saving is divided between both
counterparties to the swap.

Reversing or Terminating Interest Rate Swaps

The point has been made above that at inception the net present value of the aggregate cashflows that
comprise an interest rate swap will be zero. As time passes, however, this will cease to be the case, the
reason for this being that the shape of the yield curves used to price the swap initially will change over
time. Assume, for example, that shortly after an interest rate swap has been completed there is an
increase in forward interest rates: the forward yield curve steepens. Since the fixed rate payments due
under the swap are, by definition, fixed, this change in the prevailing interest rate environment will affect
future floating rate payments only: current market expectations are that the future floating rate payments
due under the swap will be higher than those originally expected when the swap was priced. This benefit
will accrue to the fixed rate payer under the swap and will represent a cost to the floating rate payer. If the
new net cashflows due under the swap are computed and if these are discounted at the appropriate new
zero coupon rate for each future period (i.e. reflecting the current zero coupon yield curve and not the
original zero coupon yield curve), the positive net present value result reflects how the value of the swap
to the fixed rate payer has risen from zero at inception. Correspondingly, it demonstrates how the value of
the swap to the floating rate payer has declined from zero to a negative amount.

What we have done in the above example is mark the interest rate swap to market. If, having done this,
the floating rate payer wishes to terminate the swap with the fixed rate payer's agreement, then the
positive net present value figure we have calculated represents the termination payment that will have to
be paid to the fixed rate payer. Alternatively, if the floating rate payer wishes to cancel the swap by
entering into a reverse swap with a new counterparty for the remaining term of the original swap, the net
present value figure represents the payment that the floating rate payer will have to make to the new
counterparty in order for him to enter into a swap which precisely mirrors the terms and conditions of the
original swap.

Credit Risk Implicit in Interest Rate Swaps

To the extent that any interest rate swap involves mutual obligations to exchange cashflows, a degree of
credit risk must be implicit in the swap. Note however, that because a swap is a notional principal
contract, no credit risk arises in respect of an amount of principal advanced by a lender to a borrower
which would be the case with a loan. Further, because the cashflows to be exchanged under an interest
rate swap on each settlement date are typically "netted" (or offset) what is paid or received represents
simply the difference between fixed and floating rates of interest. Contrast this again with a loan where
what is due is an absolute amount of interest representing either a fixed or a floating rate of interest
applied to the outstanding principal balance. The periodic cashflows under a swap will, by definition, be
smaller therefore than the periodic cashflows due under a comparable loan.

An interest rate swap is in essence a series of forward contracts on interest rates.. In distinction to a
forward contract, the periodic exchange of payment flows provided for under an interest rate swap does
provide for a partial periodic settlement of the contract but it is important to appreciate that the net present
value of the swap does not reduce to zero once a periodic exchange has taken place. This will not be the
case because -- as discussed in the context of reversing or terminating interest rate swaps -- the shape of
the yield curve used to price the swap initially will change over time giving the swap a positive net present
value for either the fixed rate payer or the floating rate payer notwithstanding that a periodic exchange of
payments is being made.

Users and Uses of Interest Rate Swaps

Interest rate swaps are used by a wide range of commercial banks, investment banks, non-financial
operating companies, insurance companies, mortgage companies, investment vehicles and trusts,
government agencies and sovereign states for one or more of the following reasons:

1. To obtain lower cost funding

2. To hedge interest rate exposure

3. To obtain higher yielding investment assets

4. To create types of investment asset not otherwise obtainable

5. To implement overall asset or liability management strategies

6. To take speculative positions in relation to future movements in interest rates.

The advantages of interest rate swaps include the following:

1. A floating-to-fixed swap increases the certainty of an issuer's future obligations.

2. Swapping from fixed-to-floating rate may save the issuer money if interest rates decline.

3. Swapping allows issuers to revise their debt profile to take advantage of current or expected
future market conditions.

4. Interest rate swaps are a financial tool that potentially can help issuers lower the amount of
debt service.

Typical transactions would certainly include the following, although the range of possible permutations is
almost endless.

1. Reduce Funding Costs. A US industrial corporation with a single A credit rating wants to raise
US$100 million of seven year fixed rate debt that would be callable at par after three years. In
order to reduce its funding cost it actually issues six month commercial paper and
simultaneously enters into a seven year, nonamortising swap under which it receives a six
month floating rate of interest (Libor Flat) and pays a series of fixed semi- annual swap
payments. The cost saving is 110 basis points.
2. Liability Management. A company actually issues seven year fixed rate debt which is callable
after three years and which carries a coupon of 7%. It enters into a fixed- to- floating interest
rate swap for three years only under the terms of which it pays a floating rate of Libor + 185
bps and receives a fixed rate of 7%. At the end of three years the company has the flexibility
of calling its fixed rate loan -- in which case it will have actually borrowed on a synthetic
floating rate basis for three years -- or it can keep its loan obligation outstanding and pay a
7% fixed rate for a further four years. As a further variation, the company's fixed- to- floating
interest rate swap could be an "arrears reset swap" in which -- unlike a conventional swap --
the swap rate is set at the end and not at the beginning of each period. This effectively
extends the company's exposure to Libor by one additional interest period which will improve
the economics of the transaction.
3. Speculative Position. The same company described in (b) above may be willing to take a
position on short term interest rates and lower its cost of borrowing even further (provided
that its judgment as to the level of future interest rates is correct). The company enters into a
three year "yield curve arbitrage swap" in which the floating rate payments it makes under the
swap are calculated by reference to a formula. For each basis point that Libor rises, the
company's floating rate swap payments rise by two basis points. The company's spread over
Libor, however, falls from 185 bps to 144 bps. In exchange, therefore, for significantly
increasing its exposure to short term rates, the company can generate powerful savings.
4. Hedging Interest Rate Exposure. A financial institution providing fixed rate mortgages is
exposed in a period of falling interest rates if homeowners choose to pre- pay their mortgages
and re- finance at a lower rate. It protects against this risk by entering into an "index-
amortising rate swap" with, for example, a US regional bank. Under the terms of this swap
the US regional bank will receive fixed rate payments of 100 bps to as much as 150 bps
above the fixed rate payable under a straightforward interest rate swap. In exchange, the
bank accepts that the notional principal amount of the swap will amortize as rates fall and that
the faster rates fall, the faster the notional principal will be amortized.
5. A less aggressive version of the same structure is the "indexed principal swap". Here the
notional principal amount continually amortizes in line with a mortgage pre- payment index
such as PSA but the amortization rate increases when interest rates fall and the rate
decreases when interest rates rise.
6. Creation of New Investment Assets. A UK corporate treasurer whose company has
substantial business in Spain feels that the current short term yield curves for sterling and the
peseta which show absolute interest rates converging in the two countries is exaggerated.
Consequently he takes cash currently invested in the short term sterling money markets and
invests this cash in a "differential swap". A differential swap is a swap under which the UK
company will pay a floating rate of interest in sterling (6 mth. Libor) and receive, also in
sterling, a stream of floating rate payments reflecting Spanish interest rates plus or minus a
spread. The flows might be: UK corporation pays six month sterling Libor flat and receives six
month Peseta Mibor less 210 bps paid in sterling. Assuming a two year transaction and
assuming sterling interest rates remained at their initial level of 5.25%, peseta Mibor would
have to fall by 80 bps every six months in order for the treasurer to earn a lower return on his
investment than would have been received from a conventional sterling money market
deposit.
7. Asset Management. A German based fund manager has a view that the sterling yield curve
will steepen (i.e. rates will increase) in the range two to five years during the next three years
he enters into a "yield curve swap "with a German bank whereby the fund manager pays
semi- annual fixed rate payments in DM based on the two year sterling swap rate plus 50
bps. Every six months the rate is re- set to reflect the new two year sterling swap rate. He
receives six monthly fixed rate payments calculated by reference to the five year sterling
swap rate and re- priced every six months. The fund manager will profit if the yield curve
steepens more than 50 bps between two and five years.
Interest rate swaps pricing

To price a swap, we need to determine the present value of cash flows of each leg of the transaction. In
an interest rate swap, the fixed leg is fairly straightforward since the cash flows are specified by the
coupon rate set at the time of the agreement. Pricing the floating leg is more complex since, by definition,
the cash flows change with future changes in the interest rates. The pricing both legs of the swap is
examined in detail below.

Fixed Leg of a Swap

where

Pfix = present value of cash flows for the fixed leg,

N = notional principal amount,
R = fixed coupon rate,
n = number of coupons payable between value date and maturity date,
αi- 1,i = accrual factor between dates i - 1 and i based on the specified accrual method, and
Di = discount factor on cash flow date i.

Floating Leg of a swap

and

where

Pfix = present values of cash flows for floating leg,

N = notional principal amount,
Fi-1, i = (implied) forward rate from date i - 1 to date i,
αi- 1,i = accrual factor from date i - 1 to date i based on the specified accrual method, and
n = number of cash flows from settlement date to the maturity date, and
Di = discount factor on cash flow date i.
Interest Rate Swap

A swap is a contractual agreement to exchange net cash flows for a specified pay leg and receive leg,
each of which may be either fixed or floating. The present value of cash flows of the swap is the
difference between the values of the two streams of cash flows. In other words,

pay floating, receive fixed

Pswap = Pfix - Pflt,

pay fixed, receive floating

Pswap = Pflt - Pfix.

Effect of yield curve movement on IRS

Fixed leg – As yield increases DF (discount factor) decrease and hence valuation of fixed leg goes down
and if yield decrease DF increase and hence valuation goes up.

Floating leg – Floating legs are also impacted in a same manner as fixed leg but there will be two
opposing factors DF affects inversely and coupon will increase if yield increase cancelling out each other
and net impact is lower as compared to Fixed leg.

Cash flow prediction

To determine the net pay position of the counterparties, it is first necessary to determine the future
payments for the Fixed Payer as well as for the Floating Payer.

 Fixed Payments: The projected fixed payments are based on the fixed interest rate established
upon consummation of the initial swap contract. This interest rate is typically set such that the net
present value of the anticipated payments from the Floating Payer and Fixed Payer is zero at the
contract’s initiation.
 Floating Payments: The projected variable payments are based on the estimated LIBOR forward
(i.e., future) yield curve as of the measurement date, which is derived by bootstrapping the LIBOR
spot yield curve. Bootstrapping is a method utilized to construct a fixed-income yield curve using
forward substitution whereby quoted periodic spot rates are used to estimate future spot rates
based on a “no arbitrage” principal. For example, the six-month and nine-month spot rates are
used to estimate the three-month spot rate in six months
 After the applicable interest rates have been determined, the payments are calculated based on the
notional amount on an Act/360 basis. Only the net amount due from the Fixed Payer or Floating
Payer is remitted at each payment date.

Date schedules
Date schedules are used extensively in trade definitions. They are used to define payment dates, accrual
dates, fixing dates and exercise schedules. There are four types of schedules used in interest rate swap
valuations; payment schedules, fixing schedules, compounding schedules and amortization schedules. If
a fixing schedule is not populated then the system defaults to the payment schedule.

Tag Description
startdate The start date for this schedule.
freq The frequency of dates in this schedule e.g. the payment frequency.
enddate The end date for this schedule.
rolldate A date from which other dates should roll. The rolldate can appear outside of the
range between start and end dates, in which case only dates between start and
end will be used. In order to set a long or short stub at the start or end of the
swap, the roll date needs to be set to the date of that stub
 rolldayofweek A day on which the trade should roll (e.g. Wednesday). If this field, along with
the rollweekofmonth, is populated then rolldate should not be used.
rollweekofmonth The week within a month on which the trade should roll (e.g. 3). If this field,
along with the rolldayofweek, is populated then rolldate should not be used.
rollcode Adjustment to make on dates which fall on non business days. May be one of:
‘MODFOLL’, ‘FOLL’, ‘MODPREV’ or ‘PREV’.
adjust Indicates whether the accrual periods are adjusted for holidays. Payment dates
are always adjusted for holidays.
eom Indicates whether the scheduled dates fall on the last day of each month. This
rule is not applied to the start and end dates.
holidays The list of holiday codes used when adjusting payment dates. This is a list of
<code> elements, e.g., LON, NYC, TARGET, TOKYO, HKG, SYDNEY. The
XML schema should be consulted for the complete list.
Rule The rule used to aggregate fixing rates up to either the payment period or
compounding period, or already aggregated rates from the compounding period
to the payment period. Chosen from: ‘Compound’ or ‘Straight Compounding’,
‘Flat Compounding’, ‘Spread Exclusive Compounding’, ‘Average’, ‘Weighted
Average’, ‘Power’, ‘Annualized’ and ‘Annualized Product’; the default is
‘Compound’. See §5.1 for further details.

Leg information
There are various properties that are common to all trade legs. These are listed below:
Tag Description
Leg A numerical identifier for each leg of a multi-leg trade.
Currency The currency of the leg.
Type Indicates the type of leg. For interest rate derivatives it will be one of ‘FIXED’,
‘FLOAT’, ‘RETURN’ or ‘RATIORETURN’
Daycount The day count code, selected from: ‘A360’, ‘AA’, ‘A365’, ‘30360’, ‘3E360’,
‘A365F’, ‘AM12’, ‘1’ or ‘B252’. See Appendix A.1 for an explanation of day
count conventions.
Notional The notional; negative for paying and positive for receiving.
FutureValueNotional The notional on the termination date of the contract. Negative for paying and
positive for receiving. For a BRL-CDI zero-coupon swap the Notional (N) and
the FutureValueNotional (FVN) are related as FVN = N * [(1 + R)^(i/252)],
where R is the fixed rate and i is the number of business days between the
effective date and termination date of the swap. This is only an appropriate field
to use for BRL zero-coupon swaps
notionalxg Indicates whether there is an exchange of principal at either end of the swap.
Chosen from: 'BOTH', 'NEITHER', 'FRONT' or 'BACK'.

Payment schedule

Payment schedule can be defined as the set of dates on which counterparties of an interest rate swap
exchange payments. It can have various frequencies such as monthly, quarterly, semiannually, annually
or single payment at the end of swap.
Day count convention

A system used to determine the number of days between two coupon dates, which is important in
calculating accrued interest and present value when the next coupon payment is less than a full coupon
period away. Each bond market has its own day-count convention.

The need for day count conventions is a direct consequence of interest-earning investments. Different
conventions were developed to address often conflicting requirements, including ease of calculation,
constancy of time period (day, month, or year) and the needs of the Accounting department. This
development occurred long before the advent of computers.

There is no central authority defining day count conventions, so there is no standard terminology. Certain
terms, such as "30/360", "Actual/Actual", and "money market basis" must be understood in the context of
the particular market.

30/360 US

Date adjustment rules (more than one may take effect; apply them in order, and if a date is changed in
one rule the changed value is used in the following rules):

 If the investment is EOM and (Date1 is the last day of February) and (Date2 is the last day of
February), then change D2 to 30.
 If the investment is EOM and (Date1 is the last day of February), then change D1 to 30.
 If D2 is 31 and D1 is 30 or 31, then change D2 to 30.
 If D1 is 31, then change D1 to 30.

This convention is used for US corporate bonds and many US agency issues. It is most commonly
referred to as "30/360", but the term "30/360" may also refer to any of the other conventions of this class,
depending on the context.

Other names:

 30U/360 - 30U/360 is NOT strictly the same as 30/360, it is used for the Euribor (Euro
denominated Libor) curve and Euro denominated swaps, with the distinction that under 30/360,
each day in a 31 day month accrues 30/31 of interest, whereas in 30U/360 payment occurs on
the 30th and the 31st is considered to be part of the next month. - Bloomberg
 Bond basis
 360/360
Actual methods

The conventions of this class calculate the number of days between two dates (e.g., between Date1 and
Date2). This is the function Days (StartDate, EndDate).

The conventions are distinguished primarily by the amount of the Coupon Rate they assign to each day of
the accrual period.

Actual/Actual ICMA

Formulas:

For regular coupon periods:

For irregular coupon periods, the period has to be divided into one or more quasi-coupon periods (also
called notional periods) that match the normal frequency of payment dates. The interest in each such
period (or partial period) is then computed, and then the amounts are summed over the number of quasi-
coupon periods.

This method ensures that all coupon payments are always for the same amount.

It also ensures that all days in a coupon period are valued equally. However, the coupon periods
themselves may be of different lengths; in the case of semi-annual payment on a 365 day year, one
period can be 182 days and the other 183 days. In that case, all the days in one period will be valued
1/182nd of the payment amount and all the days in the other period will be valued 1/183rd of the payment
amount.

This is the convention used for US Treasury bonds and notes, among other securities.

Other names:

 Actual/Actual
 Act/Act ICMA
 ISMA-99
 Act/Act ISMA
Actual/Actual ISDA

Formulas:

This convention accounts for days in the period based on the portion in a leap year and the portion in a
non-leap year.

The days in the numerators are calculated on a Julian day difference basis. In this convention the first day
of the period is included and the last day is excluded.

The CouponFactor uses the same formula, replacing Date2 by Date3. In general, coupon payments will
vary from period to period, due to the differing number of days in the periods. The formula applies to both
regular and irregular coupon periods.

Other names are:

 Actual/Actual
 Act/Act
 Actual/365
 Act/365

Actual/365 Fixed

Formulas:

Each month is treated normally and the year is assumed to be 365 days. For example, in a period from
February 1, 2005 to April 1, 2005, the Factor is considered to be 59 days divided by 365.

The Coupon Factor uses the same formula, replacing Date2 by Date3. In general, coupon payments will
vary from period to period, due to the differing number of days in the periods. The formula applies to both
regular and irregular coupon periods.

Other names:

 Act/365 Fixed
 A/365 Fixed
 A/365F
 English
Actual/360

Formulas:

This convention is used in money markets for short-term lending of currencies, including the US dollar
and Euro, and is applied in ESCB monetary policy operations. It is the convention used with Repurchase
agreements. Each month is treated normally and the year is assumed to be 360 days. For example, in a
period from February 1, 2005 to April 1, 2005, the Factor is 59 days divided by 360 days.

The CouponFactor uses the same formula, replacing Date2 by Date3. In general, coupon payments will
vary from period to period, due to the differing number of days in the periods. The formula applies to both
regular and irregular coupon periods.

Other names:

 Act/360
 A/360
 French

Actual/364

Formulas:

Each month is treated normally and the year is assumed to be 364 days. For example, in a period from
February 1, 2005 to April 1, 2005, the Factor is considered to be 59 days divided by 364.

The CouponFactor uses the same formula, replacing Date2 by Date3. In general, coupon payments will
vary from period to period, due to the differing number of days in the periods. The formula applies to both
regular and irregular coupon periods.

Actual/365L

Formulas:

This convention requires a set of rules in order to determine the days in the year (DiY).

 If Freq = 1 (annual coupons):

 o If February 29 is in the range from Date1 (exclusive) to Date3 (inclusive), then DiY = 366,
else DiY = 365.
 If Freq <> 1:
o If Date3 is in a leap year, then DiY = 366, else DiY = 365.

The CouponFactor uses the same formula, replacing Date2 by Date3. In general, coupon payments will
vary from period to period, due to the differing number of days in the periods. The formula applies to both
regular and irregular coupon periods.

Actual/Actual AFB

Formulas:

"Actual/Actual AFB/FBF Master Agreement" has the DiY equal to 365 (if the calculation period does not
contain 29 February) or 366 (if 29 February falls within the Calculation Period or Compounding Period).

If the Calculation Period or Compounding Period is a term of more than one year, the basis shall be
calculated as follows:

 the number of complete years shall be counted back from the last day of the Calculation Period or
Compounding Period; and
 this number shall be increased by the fraction for the relevant period calculated.

When counting backwards for this purpose, if the last day of the relevant period is 28 February, the full
year should be counted back to the previous 28 February unless 29 February exists, in which case, 29
February should be used.
Stubs

There are 4 stubs in e.g. an interest rate swap, interest rate cap, or swaption transaction, which are:

1. Short first stub: the first interest period of e.g. a swap is shorter than the following interest
periods, e.g. a swap that starts at (mm/dd/yy) 04/01/04 and ends at 01/01/07. The first
interest period is from 04/01/04-01/01/05 and the next are from 01/01/05-01/01/06, 01/01/06-
01/01/07.
2. Long first stub: the first interest period is longer than the following interest periods, e.g. a
swap that starts at 04/01/04 and ends at 06/01/07. The first interest period is from 04/01/04-
06/01/05 and the next are from 06/01/05-06/01/06, 06/01/06-06/01/07.
3. Short end stub: the last interest period is shorter than the previous ones, e.g. a swap that
starts at 04/01/04 and ends at 06/01/07. The first interest period is from 04/01/04-04/01/05,
the 2nd from 04/01/05-04/01/06, the 3rd from 04/01/06-04/01/07, and the last period is from
04/01/07-06/01/07.
4. Long end stub: the last interest period is longer than the previous ones, e.g. a swap that
starts at 04/01/04-06/01/07. The first interest period is from 04/01/04-04/01/05, the 2nd from
04/01/05-04/01/06, and the last period from 04/01/06-06/01/07.

Pay accrued means paying the interest that has accrued so far since the last interest payment date.

Fixing name and fixing term

Floating rate fixing

For a Sterling swap this would be something like “3M GBP-LIBOR-BBA”.
Tag Description
name The reference name of the floating rate, e.g. ‘USD-LIBOR-BBA’. These
references must be specified as they appear in the “ISDA Currency Definitions
Guide 2006” (and its annexes). The few commonly referenced rates that are not
defined by ISDA are listed in appendix A.3.
term The designated maturity of the floating rate.
arrears Indicates whether fixings are in advance or arrears. If fixings are in arrears then
appropriate convexity adjustments shall be used.
spread The spread to be applied to the fixing.
fixingdate and Optional series of currently applicable fixing rates; if not provided then Markit will
fixingrate pairs source these. Each fixing consists of a pair of fixingdate and fixingrate. A series
of these can be specified so that, for example, all daily fixings since the last
compounding date can be supplied by the customer.

Fixed rate
Tag Description
rate The rate of the fixed leg of a swap.

The vanilla case can be enhanced by adding the following features:

 Fixing and compounding schedules that do not match the payment schedule;
 Notional amortization schedules; and
 Coupon step-up schedules.
Forwards
A customized contract between two parties to buy or sell an asset at a specified price on a future date. A
forward contract can be used for hedging or speculation, although its non-standardized nature makes it
particularly apt for hedging. Unlike standard futures contracts, a forward contract can be customized to
any commodity, amount and delivery date. A forward contract settlement can occur on a cash or delivery
basis. Forward contracts do not trade on a centralized exchange and are therefore regarded as over-the-
counter (OTC) instruments. While their OTC nature makes it easier to customize terms, the lack of a
centralized clearinghouse also gives rise to a higher degree of default risk. As a result, forward contracts
are not as easily available to the retail investor as futures contracts.

Forward pricing

The predetermined delivery price for an underlying commodity, currency or financial asset decided upon
by the long (the buyer) and the short (the seller) to be paid at predetermined date in the future.

At the inception of a forward contract, the forward price makes the value of the contract zero.

The Forward Price can be determined by the following formula:

where:
S0 represents the current spot price of the asset
F0 represents the forward price of the asset at time T
er represents a mathematical exponential function

As evident from above equation that forward price is directly proportional to spot.