International Financial Management
P G Apte
1
Introduction
• Interest rate uncertainty poses a worrisome problem for
companies which borrow and invest in the international
money and capital markets
• The last decade of has seen a significant increase in
interest rate volatility.
• Fluctuations in interest rate affect a firm's cash flows by
affecting interest income on financial assets and interest
expenses on liabilities
• For non-financial firms with floating rate liabilities it poses
considerable uncertainty about cost of capital
• For financial institutions with large portfolios of debt
securities, interest rate movements can imply huge capital
gains or losses as well as fluctuations in income.
2
The Nature and Measurement of
Interest Rate Exposure
• Effective assessment and management of interest rate
exposure requires a clear statement of the firm's risk
objectives
– Primary Objectives
• Net interest income
• Net equity exposure
– Secondary Objectives
• Credit exposure
• Basis risk
• Liquidity risk
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The Nature and Measurement of
Interest Rate Exposure
• The most often used device to assess interest rate exposure
is Gap Analysis. It focuses on timing mismatches between
maturing assets and liabilities. During each time interval
the gap is the difference between assets and liabilities
which mature during that interval
• A more sophisticated approach uses the concept of
duration. This attempts to measure the sensitivity of the
market value of a debt security to changes in interest rates.
A large value of duration implies larger change in the
value of a debt instrument for a given change in yield.
Suffers from assumption of flat yield curve and parallel
movements in yield curve.
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Forward Rate Agreements (FRAs)
• A Forward Rate Agreement (FRA) is notionally an
agreement between two parties in which one of them (the
seller of the FRA), contracts to lend to the other (the
buyer), a specified amount of funds, in a specific currency,
for a specified period starting at a specified future date, at
an interest rate fixed at the time of agreement
• “Notional” because FRA will not normally involve actual
lending of the principal but only settlement of interest rate
difference.
• The underlying loan and FRA are separate contracts
generally with separate banks
• The seller of FRA essentially agrees to deposit funds at an
agreed upon rate with the buyer.
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Forward Rate Agreements (FRAs)
• Figure below is a schematic diagram of an FRA contracted
at t = 0, applicable for the period between t = S and t = L.
DS and DL are actual number of days from t=0 to t=S and
t=0 to t=L respectively. The period from t=S to t=L is the
contract period, t=S is the settlement date and DF is the
number of days in the contract period
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Forward Rate Agreements (FRAs)
• The important thing to note is that there is no exchange of
principal amount
• One of the following two formulas is used for calculating
settlement payment from the seller to the buyer (L>R) or
buyer to seller (R>L)
(L - R) x DF x A
P=
[(B x 100) + (DF x L)]
(R - L) x DF x A
P=
[(B x 100) + (DF x L)]
• L: Settlement Rate R: Contract Rate A: Notional Principal
• DF: No.of Days in FRA period B: Day Count Basis
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Forward Rate Agreements (FRAs)
• FRAs quotes: 6-9 FRA USD 5.50-6.00
• Bank will guarantee a “deposit rate” of 5.50% for a 3-
month deposit starting 6 months from now- Bank buys an
FRA; bank will guarantee a lending rate of 6.0% for a 3-
month loan starting 6 months from now- Bank sells an
FRA. Quotes based on forward rates implied by spot rates
• 3-month rate 6 months from today is implied by the 6 and
9 months actual – “spot” rates today
• (1+i0,6)180/360 (1+if6,9)90/360 = (1+i0,9)270/360
if6,9 denotes the 6-month forward 3-month rate. FRA quotes
will bracket this.
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Forward Rate Agreements (FRAs)
•Given the spot interest rates for a short and a long
maturity, the rate expected to rule for the period
between the end of short maturity and the end of
long maturity is given by
• (1+i0,S)DS/B (1+ifS,L)DF/B = (1+i0,L)DL/B
B is the day count basis (360 or 365 days)
Interest rates i0,S, i0,L stated as fractions, (not percent)
are the spot interest rates at time t = 0 for maturities
S and L respectively
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Forward Rate Agreements (FRAs)
• The (if)S,L computed from above forms the basis for
quoting the bid and ask rates in an FRA DS/DL
• ifS,L = [(1+i0,L)DL/B/ (1+i0,S)DS/B]B/DF -1
• The rate so calculated will only serve as a benchmark for a
FRA quotation and the actual quote will be influenced by
demand-supply conditions in the market and the market's
expectations
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Forward Rate Agreements (FRAs)
• Applications of FRAs for borrowers and investors
• FRAs, like forward foreign exchange contracts are
a conservative way of hedging exposure
• The relationship between a FRA and an interest
rate futures contract is exactly analogous to that
between a forward foreign currency contract and a
currency futures contract
• Another product similar to a FRA for locking in
borrowing cost or the return on investment is
known as a "forward-forward" contract
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Forward Rate Agreements (FRAs)
• FRAs were introduced in the Indian money
market in 1999
• The benchmark rate may be any domestic money
market rate such as t-bill yield or relevant MIBOR
(Mumbai Interbank Offered Rate) though the
interbank term money market has not yet
developed sufficient liquidity
• RBI guidelines state that corporates are permitted
to do FRAs only to hedge underlying exposures
while market maker banks can take on uncovered
positions within limits specified by their boards
and vetted by RBI
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Example : A Typical FRA Deal
• Bank A sells to Bank B a 3 X 6 FRA at 10% against floating
91 day t-bill rate. Notional principal Rs10 crore
– Bank A receives fixed rate (10%) for a 3 month period
starting 3 months from trade date
– Bank B receives floating rate for the same period. The
floating rate would be the 91 day t-bill rate 3 months from
trade date
– though net amount is due on maturity (6 months from trade
date), settlement is done on start date (3 months from trade
date)
Trade date Fixing date FRA start date/ Maturity date
settlement date
t=0 t+3m1 t+3m t+6m
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• Bank A & Bank B enter into a 6 X 9 FRA. Bank A pays
fixed rate at 9.50%. Bank B pays floating rate based on
91 day T-bill yield. Additional details
– Notional principal = Rs 10 Crore
– FRA start & settlement date 10/12/99, Maturity date 10/3/00
– T bill yield on fixing date (say 9/12/99) = 8.50%
– Determine cash flow at settlement (assume discount rate as 10.0%)
• Working
– (a) Interest payable by bank A = 10 Cr * 9.50% * 91/365 = Rs 236,849
– (b) Interest payable by bank B = 10 Cr * 8.50% * 91/365 = Rs 211,918
– (c) Net payable by bank A on maturity date ((a)-(b)) = Rs 24,932
– (d) Discounting (c) to settlement date = (c)/(1+ discount rate*discount period)
= Rs 24,932/(1+10.0%*91/365) = Rs 24,325
Amount payable on settlement date = Rs 24,325 payable by Bank A
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Interest Rate Options
• A less conservative hedging device for
interest rate exposure is interest rate options
• A call option on interest rate gives the
holder the right to borrow funds for a
specified duration at a specified interest rate
without an obligation to do so
• A put option on interest rate gives the
holder the right to invest funds for a
specified duration at a specified return
without an obligation to do so
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Interest Rate Options
• An interest rate cap consists of a series of call
options on interest rate or a portfolio of calls
• A cap protects the borrower from increase in
interest rates at each reset date in a medium-to-
long term floating rate liability
• An interest rate floor is a series or portfolio of put
options on interest rate which protects a lender
against fall in interest rate on rate rest dates of a
floating rate asset
• An interest rate collar is a combination of a cap
and a floor
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Interest Rate Options
• A Call option on Interest Rate
– Payoff profile from the call option where the
payoff has been reckoned at option expiry.
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Interest Rate Options
– The breakeven rate is defined as that value of LIBOR at
option expiry at which the borrower would be
indifferent between having and not having the call
option. It is the value of i which satisfies the following
equality
A[1+i(M/360)] =A[1+R(M/360)]+C[1+it,T(T/360)][1+i(M/360)]
– A is the underlying principal, R is the strike rate, it,T is
the T-day LIBOR at time t when the option is bought, C
is the premium paid at time t, and, T and M are number
of days to option expiry and maturity of the underlying
interest rate
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Interest Rate Options
• A Put Option on Interest Rate
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Interest Rate Options
• A Put-Call Parity Relation
– A long position in a call option with strike rate
R and a short position in a put with the same
strike and same maturity, both on the same
underlying index are equivalent to a long
position in an FRA at R – If maturity rate is
higher than R, long call will be exercised; if
lower than R, the sold put will be exercised.
Borrowing/lending will take place at R like in
an FRA.
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Interest Rate Caps, Floors and Collars
• Interest Rate Caps
– A portfolio of call options on interest rate.
– Provides protection against rising rates on a floating
rate debt.
– Depending upon the evolution of the underlying
interest rate, some of the options in the cap will be
exercised while some will lapse.
– Borrowing cost capped at a rate which equals the strike
rate plus a margin representing the amortization of the
premium paid.
– The effective cost of a floating rate loan plus a long cap
will depend upon the evolution of the underlying rate.
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Interest Rate Caps, Floors and Collars
• Interest Rate Floors
• A portfolio of put options on the underlying rate.
• Protection against falling rates on a floating rate
asset.
• The return on the asset floored at a rate equal to
the strike rate minus an Vallowance for amortization
of the premium.
• Effective return on a floating rate note plus a long
floor depends on the evolution of the underlying
rate
22
Interest Rate Caps, Floors and Collars
• An Interest Rate Collar
• A long cap with strike R1 plus a short floor with strike R2
, R2 < R1 is a long collar.
• Protection against rising rates, cost of protection reduced
by sacrificing some of the benefit of lower rates.
Borrowing cost capped at R1 plus a margin but will not
fall below R2 plus a margin.VThe margin represents
annualized cost of the premium for the collar.
• R1 and R2 can be chosen so that the collar is a “zero cost”
collar. The premium paid for the cap cancelled by the
premium received for the floor. The borrowing cost would
vary between a low of R2 and a high of R1.
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Interest Rate Caps, Floors and Collars
Payoff Diagram of a Zero-Cost Collar
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Valuation of Interest Rate Options
• The risk-neutral binomial model can be applied to
simple interest rate options
• Since caps and floors are portfolios of simple
options, they can be valued by simply valuing
each of the embedded options separately and
adding together the values
• Options on interest rates can be treated as options
on corresponding debt instruments and
approximately valued using the Black-Scholes
model.
• More accurate valuation requires term structure
models
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Options on Interest Rate Futures
• The underlying asset is a futures contract such as T-bill or
Eurodollar futures contract
• The holder of a call has the right to establish a long
position in a futures contract while a put holder has the
right to establish a short position
• Payoffs from a long call (put) on futures are similar to a
long put (call) on the underlying interest rate itself.
– E.g. Hedging against a rise in interest rate
– Buy a put on an interest rate futures. If rates rise,
futures price will fall, put will be in the money. Same
as buying a call on the underlying rate.
• To hedge against a fall in rates, go long a call on an
interest rate futures.
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Options on Interest Rate Futures
Payoff from a Put on Eurodollar Futures
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Options on Interest Rate Futures
– Alternatively, if rates are expected to rise, the firm can
write a call option on futures and collect an up-front
premium; if rates rise, futures price would fall, call
would lapse. Premium income would partly
compensate for increased interest cost.
– Comparison of a number of alternative strategies for an
investor to cope with interest rate risk
– The available instruments allow the investor a lot of
flexibility in designing a package with the preferred
risk-return profile given his views about future
movement in rates
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Some Recent Innovations
• An interest rate cap can be designed that provides
protection contingent upon the price of some
commodity or asset
• Average rate or Asian interest rate options have
payoffs based on the average value of the
underlying index during a specified period
• Look-back options give payoffs determined by the
most favorable value
• In a cumulative option the buyer can obtain
protection such that cumulative interest expense
over a period does not exceed a specific level
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Summary and Conclusion
• Interest rate volatility is a major source of
uncertainty particularly for financial institutions
• Use of gap analysis and duration
• A single-period interest rate exposure can be
hedged using FRAs, interest rate futures, simple
interest rate options and options on interest rate
futures
• Multi-period risk can be managed with interest
rate caps and floors
• Valuation of interest rate derivatives must take
account of the stochastic evolution of the entire
term structure and in certain cases, simpler
approaches using binomial lattice or modifications
of Black-Scholes model may be adequate
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