Introduction to Derivatives

Definition and Uses of Derivatives

A derivative security is a financial contract whose value is derived from the value of the
underlying asset, such as a stock price, a commodity price, an exchange rate, an interest rate, or
even an index of prices.
Derivatives may be traded for a variety of reasons.
 A derivative enables a trader to hedge some pre-existing risk by taking positions in
derivatives markets that offset potential losses in the underlying or spot market.
 Another motive for derivatives trading is speculation (i.e. taking positions to profit from
anticipated price movements). In practice, it may be difficult to distinguish whether a
particular trade was for hedging or speculation, and active markets require the
participation of both hedgers and speculators.
 A third type of trader, called arbitrageurs. They profit from discrepancies in the
relationship of spot and derivatives prices, and thereby help to keep markets efficient.

Hedging
A hedge is an investment position intended to offset potential losses/gains that may be incurred
by a companion investment. In simple language, a hedge is used to reduce any substantial
losses/gains suffered by an individual or an organization.
A hedge can be constructed from many types of financial instruments,
including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many
types of over-the-counter and derivative products, and futures contracts.

Speculation
Derivatives can be used to acquire risk, rather than to hedge against risk. Thus, some individuals
and institutions will enter into a derivative contract to speculate on the value of the underlying
asset, betting that the party seeking insurance will be wrong about the future value of the
underlying asset. Speculators look to buy an asset in the future at a low price according to a
derivative contract when the future market price is high, or to sell an asset in the future at a high
price according to a derivative contract when the future market price is low.

Arbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference
between two or more markets: striking a combination of matching deals that capitalize upon the
imbalance, the profit being the difference between the market prices. When used by academics,
an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal

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state and a positive cash flow in at least one state; in simple terms, it is the possibility of a risk-
free profit at zero cost.
In principle and in academic use, an arbitrage is risk-free; in common use, as in statistical
arbitrage, it may refer to expected profit, though losses may occur, and in practice, there are
always risks in arbitrage, some minor (such as fluctuation of prices decreasing profit margins),
some major (such as devaluation of a currency or derivative). In academic use, an arbitrage
involves taking advantage of differences in price of a single asset or identical cash-flows; in
common use, it is also used to refer to differences between similar assets (relative
value or convergence trades), as in merger arbitrage.
People who engage in arbitrage are called arbitrageurs such as a bank or brokerage firm. The
term is mainly applied to trading in financial instruments, such as bonds,
stocks, derivatives, commodities and currencies.

Derivative Markets

These can be divided into Exchange traded markets and over the counter markets.

Exchange traded markets

Exchange traded markets provide a centralized place where all trades are conducted, exchanges
such as these also play the key role of acting as the counterparty to all trades. What this means
is that while you may be buying for example 100 shares of Google stock, at the same time
someone else is selling those shares, you do not buy those shares directly from the seller but
instead from the exchange.

The fact that the exchange stands on the other side of all trades in exchange traded markets is one
of their key advantages as this removes counterparty risk, or the chance that the person who you
are trading with will default on their obligations relating to the trade.

A second key advantage of exchange traded markets is that, as all trades flow through one
central place, the price that is quoted for a particular instrument is always the same regardless of
the size or sophistication of the person or entity making the trade. This in theory should create a
more level playing field which can be an advantage to the smaller and less sophisticated trader.

Lastly, because all firms that offer exchange traded products must be members and register with
the exchange, there is greater regulatory oversight which can make exchange traded markets a
much safer place for individuals to trade.
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The downside that is often cited about exchange traded markets is cost. As the firms who offer
exchange traded products must meet high regulatory requirements to do so, this makes it more
costly for them to offer these products, a cost that is inevitably passed along to the end user.
Secondly, as all trades in exchange traded products must flow through the exchange this gives
these for profit entities immense power when setting things such as exchange fees which can also
increase transaction costs for the end user.

Over the counter markets

With over the counter markets, there is no centralized place where trades are made; instead the
market is made up of all the participants in the market trading among themselves.

The biggest advantage to over the counter markets is that because there is no centralized
exchange and little regulation, you have heavy competition between different providers to attract
the most traders and trading volume to their firm. This being the case transaction costs are
normally lower in over the counter markets when compared to similar products that trade on an
exchange.

As there is no centralized exchange the firms that make prices in the instrument that is trading
over the counter can make whatever price they want, and the quality of execution varies from
firm to firm for the same instrument. While this is less of a problem in liquid markets such as
foreign exchange markets where there are multiple price reference sources, it can be a problem in
less highly traded instruments.

While the lack of regulation can be seen as an advantage in the above sense it can also be seen as
a disadvantage, as the low barriers to entry and lack of clear oversight also make it easier for
firms offering trading to operate in a dishonest or fraudulent way.

Lastly, as there is no centralized exchange, the firm that you trade with when you trade in an
over the counter market like forex, is the counterparty to your trade. So if something happens to
that firm you are in danger of losing not only the trades you have with that firm but also your

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account balance.

It is for these reasons that there is so much focus among forex traders as to which firm to trade
with, with special attention being paid to the financial stability of the firm and the execution that
they provide.

Differences between exchange traded markets and over the counter market

The primary difference is standardization versus customization. This leads to a crucial

distinction. When dealing in exchange traded products terms are standardized and the
clearinghouse guarantees that the other side of any transaction performs to its obligations. That
is, it assumes all contingent default risk so both sides do not need to know about each other’s
credit quality. This differs from customized OTC products where there is no clearinghouse to
guarantee performance. The differences between the Exchange traded contract and the over the
counter market can be summarised as follows:

Exchange Traded OTC Traded

Pricing Standardized Customized
Maturity Standardized Customized
Quantity Standardized Customized
Frequency Standardized Customized
Quality Standardized Customized
Documentation Standardized Customized
Regulatory Body One entity None

Types of derivative instruments

1. Forward Contract

It gives its holder both the right and full obligation to conduct a transaction involving another
security or commodity- the underlying asset- at a predetermined future date and a predetermined
price. NB They must always be two counterparties to a forward transaction. The eventual buyer

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(long position) who pays the contract price and receives the underlying security and the eventual
seller (short position) who delivers the security for the fixed price.

Pay offs on the forward contract.

The pay off from a long a position in a forward contract on one unit of an asset is equal to:

ST – K

The payoff from a shot position in a forward contract on one unit of an asset is equal to:

K-ST

Where

K= delivery price and ST = spot price at maturity of the contract.

The payoff diagrams for forward contracts are shown below:

2. Futures Contracts

A future is a derivative that is similar to the forward contract. It is used to transfer the price risk
of the underlying instrument from one party to another. A future is thus a contract between two
parties whereby the one party (the buyer) agrees to buy an underlying asset from the other party
to the contract on a specific future date, and at a price determined at the close of the contract.

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The underlying asset can be a financial asset such as a bond, a currency such as US dollars, a
commodity, etc. Because most futures are cash settled (which will be explained later in the text),
almost anything with a determinable value can be used as an underlying asset to a futures
contract.

A future is normally classified according to the underlying instrument. Where, for instance, two
parties agree to buy and sell a specific quantity of rice (of a certain quality) at a certain price on a
future date, the contract will be a commodity futures contract. Where two parties agree to buy
and sell bonds, this will be known as a financial futures contract, and where two parties agree to
buy and sell a certain amount of foreign currency, this is a currency futures contract.

A futures contract is thus

 an agreement between two parties

 to buy and sell
 a standardised type and quantity
 of a specified underlying asset
 with a certain quality
 at a price determined at the closing of the contract
 on a specified date
 Through a central exchange.

Futures contracts vs. forward contracts

Futures contracts and forward contracts are similar in that they are both contracts to buy and sell
an underlying instrument at a predetermined price on a future date. Futures contracts between
parties are closed with a futures exchange acting as intermediary, and are standardised in terms
of the type and quality of the underlying asset, the terms of the contract and the delivery date,
method of settlement and price determination.

Forward contracts, on the other hand, are closed between two parties independently from an
exchange (OTC), and the terms are structured to suit the specific needs of the two parties.

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The following is a comparison of some of the characteristics of forward contracts and futures
contracts:

Futures Forwards
Method of trading Per electronic trading Over the counter or by
system through a central telephone
exchange
Contract size Standardised Negotiated to suit individual
needs
Delivery date Standardised on a specific Negotiated to suit individual
date for certain contracts needs
Integrity of system and Guaranteed by the clearing Dependent on the risk
payments house of the central relating to the individual
exchange parties to the contract
Regulation Regulated by law, statutory No formal regulation
body and exchange (SEC)
Tradability Traded in secondary No secondary market for
markets these contracts
Securities and protection of Security deposits to be No formal security unless
parties lodged with the exchange at agreed by parties to the
closing of contracts, and contract
daily cash settlements for
fluctuations in prices

The working and trading of a futures contract

In a futures contract, both parties have an obligation,

 one to buy the underlying instrument

 the other to sell the underlying instrument.

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Both the buyer and the seller can make a profit or suffer a loss, due to the fact that the contract
price (at which the underlying instrument is bought and sold) is determined at closing of the
contract. If the market price at the delivery date is lower than the futures contract price, the
buyer suffers a loss because he could have bought the instrument in the market at a lower price.
He is now obliged, according to the contract, to buy the underlying instrument at the higher price
specified in the contract. the opposite applies when the market value of the underlying
instrument is above the futures contract price. The buyer can now buy the underlying instrument
at the lower contract price, and sell the instrument immediately at the higher market price, thus
making an immediate profit.

An example of the working of a futures contract

Mr Dube is a farmer in Kezi, and one of his specialities is potatoes. Mr Dube has planted
potatoes and he knows that they will be ready for sale and delivery in three months' time. Due to
the good rains during the season, Mr Dube expects to harvest three tons of potatoes. He also
knows that the harvest countrywide will be a good one and is worried that he won't be able to sell
all his potatoes, or that he will be forced to sell them at a discounted price and suffer a loss.

The Lion Food Company in Victoria-Falls produces potato chips. The company expects an
influx of tourists to Victoria Falls due to a reduction in the Zimbabwean currency and the
sporting events taking place during the summer. The company has budgeted a huge increase in
production in three months' time, and is scared that there will not be sufficient potatoes available
in the market, or that the demand would increase, thus pushing up prices.

Mr Dube and the Lion Food Company close a contract whereby Mr Dube undertakes to supply
the company with three tons of potatoes in three months' time. The Lion Food company
undertakes to buy three tons of potatoes from Mr Dube at R1 000 per ton on delivery of the
potatoes. The market price of potatoes at the closing of the contract is R950 per ton.

The effect of the contract and the market price

The market price of potatoes at the closing of the contract has no direct effect on the contract
except that it acts as a guideline to the determination of the contract price (R1000).

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At the date of delivery determined in the contract (called the close-out date), Mr Dube has an
obligation to supply three tons of potatoes and the Lion Food Company has an obligation to take
delivery of the potatoes and pay Mr Dube R3000 (R1 000 x 3).

If the market price of potatoes on the day of delivery (the close-out day of the contract) is R1050,
the effect for the two parties will be as follows:

If Mr Dube did not close the contract, he could have sold his potatoes in the market at R1 050
(assuming the demand is high enough). The effect of the contract is thus:

Proceeds if sold in the market (R1 050 x 3) R3 150

Proceeds of futures contract (R1 000 x 3) R3 000
Financial loss (Loss of income) due to contract R 1 50
The Lion Food Company will buy the potatoes at R1 000 per ton whereas it would have paid
R1 050 per ton had the contract not been closed. The effect for the company is thus:
Costs of acquiring potatoes per contract R3 000
Costs if acquired in marked R3 150
Saving in costs due to futures contract R 150

Settlement and delivery of a futures contract

Due to the fact that Mr Dube lives in Kezi, and the Lion Food Company is in Vic-Falls, there are
further costs and the risks of transporting the potatoes to Vic-Falls. Instead of physical delivery
taking place, the parties agree to the following:

Mr Dube will sell his potatoes in the market at the market price (saving him the hassle of
delivery to Vic-Falls), and will pay to (or receive from) the Lion Food Company the difference
between the market value and the contract price.

The Lion Food company will buy potatoes at the market in Vic-Falls, and will receive from Mr
Dube the difference between the market value and the contract price. The effect for the two
parties is as follows:

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Mr Dube:
Proceeds of sale in market R3 150
Payment to the Lion Food Company R 150
Net proceeds of potatoes R3 000
The Lion Food Company:
Costs of purchasing potatoes in the market R3 150
Payment received from Mr Dube R 150
Net cost of potatoes R3 000

This process is called cash settlement and has the same effect as physical delivery. A contract
can thus be honoured by cash settlement, which would be the difference between the market
value on close-out date and the contract price. This would also be the profit/loss to the
buyer/seller. Because physical delivery does not take place, a futures contract can be entered (as
seen previously) on almost anything with a determinable value, such as an index of prices.

6.3.4 Security measures of a futures contract

As seen in the above example, both the buyer and the seller can suffer a loss and be obliged to
pay to the other party the cash settlement amount. The risk is thus that the party in a loss
position cannot pay the amount owed to the other party at close-out of the contract. To ensure
that both parties can honour payments at close-out, they agree to put an amount on deposit (in the
case of futures, at an exchange) from which the settlement can be made at close-out, if
necessary. This initial security deposit is determined by the Exchange and is paid by both parties
at the closing of the contract, and is called an initial margin.

There is, however, the risk that the initial margin does not fully cover the loss suffered by one
party, because of an adverse movement in market prices. To cover this risk, the futures contract
further stipulates that the daily movement in market prices will be settled between the two parties
(through an exchange), as if the contract has expired (closed out) every day. This process is
called marking to market, which gives the effect of marking (valuing) the futures contract to its
market value at the end of each day.

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The pricing of futures contracts

Theoretically, the trading price of a futures contract should be equal to the current market value
of the underlying instrument plus interest on this value for the period up to close-out of the
contract. For instance, there is a future available on 10 ounces of gold on 1 January and the
following relates:

The market price of 10 ounces of gold on 1 January is $1 000.

The futures contract price on 10 ounces of gold, with a close-out of 31 December (thus one year
to settlement) is $1 160.

The following would be applicable:

If the short-term borrowing rate was 15%, an arbitrageur (a trader who makes money out of
differences in separate markets) could borrow R1 000 at 15% for one year. He would then buy
the gold immediately at R1 000 and sell a futures contract at R1 160.

On 31 December, he would deliver the gold (as seller in the futures contract) he bought and will
receive $1 160 for the gold according to the futures contract. He would then have to pay back his
loan, and in total he would have to pay back R1 150 ie (R1000 + 15% interest for a year).
Without taking risks, the arbitrageur would have made a profit of R10 on his transactions.

Theoretically, the value of a futures contract should thus be equal to the following:

FV = SP + (SP x i x d/365) (for simple interest as in above example)

Or

FV = SP(1 + 1)^(d/365) (for compound interest)

Where

FV = theoretical value of the futures contract expiring in d days

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SP = current spot value of the underlying instrument

i = short-term borrowing rate

d = number of days left to close-out of the contract.

In the above example with a simple interest rate of 15% the theoretical value should be:

FV = 1 000 + (1 000 x 15% x 365/365)

FV = R1 150.

Where income is received on the underlying instrument, such as interest on a bond or dividends
on shares, the future value of the income stream must be subtracted from the above calculation to
arrive at the theoretical fair value. This is because the income stream can be invested and
applied to repay the interest on the amount loaned to purchase the underlying instrument.

This calculation of the fair value of futures contracts is, however, a theoretical exercise to
determine, among other things, the possibility of arbitrage opportunities. The actual market price
is determined by supply and demand as is the case with other market products. The differences
in carrying costs are the main determinants that lead to differences in fair values and market
prices of futures.

The bid price by buyers and the offer price by sellers determine the final price at which futures
are bought and sold.

3. Options

An option contract has an exceptional characteristic distinguishing it from any other financial
instrument - the holder or owner of an option has the right, but does not have an obligation to
buy or sell an underlying instrument at a predetermined price during a specific period or at a
specific time.

There are two basic types of options:

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  An option to buy something. This is known as a call option.
 An option to sell something. This is called a put option.

The formal definition of a call option would be that it grants the buyer the right but does not
confer an obligation to purchase a certain quantity of the underlying asset at a predetermined
price. The price at which the purchase of the underlying asset will take place if the option is
exercised is called the strike price or the exercise price, and this is decided at the initial closing
of the option contract. The amount or-price paid for the option when the option is bought, is
called the option premium.

Likewise, a put option would grant the buyer the right but does not impose an obligation to sell
the underlying instrument at a predetermined price.

A further parameter of an option is the period that the holder has to exercise the option.

 An American option can be exercised and settled at any time up to the expiry date.
 A European option can only be exercised using the market prices valid on expiry date and
is settled on or within a short time after the expiry date.

Parties and risks of option transactions

The party that transfers the risk and pays the premium for the option is the buyer and holder of
the option. The holder of an option can also sell this option to a new buyer, who becomes the
new holder of the option. The original seller of the option is called the writer or grantor of the
option and he stays liable to honour the option should the holder exercise the option. The writer
of a call option will receive the option premium at the first sale. If the option is sold by a holder
to a new buyer, a new premium will be determined, which is paid by the buyer to the seller.

Because the writer of an option is bound to the contract until expiry, there is a credit risk
attached to the option. An option written by a large corporate company will have less credit risk
attached to it than an option written by an individual, because there is more certainty that the
corporate company will perform if the option is exercised. The option with less credit risk will

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also trade more effectively in the secondary market. Options traded through exchanges are
normally guaranteed by the exchange in terms of settlement.

Call options

The holder of a call option pays a premium at acquisition of the option and the option gives him
the right to buy an underlying instrument at a price determined in the option contract (the strike
price) from the writer of the option. The holder of the option will only exercise the option if the
current market price of the underlying instrument is higher than the strike price, giving him the
opportunity to buy the instrument at the lower strike price, and sell the instrument at the higher
market price. If the market price of the underlying instrument is lower than the strike price, it
means that the instrument can be bought cheaper in the market than by exercising the option.
The maximum loss for the holder of an option is thus equal to the premium paid for the option.

The break-even point for the holder of an option is that point where the profit made on the
underlying instrument is equal to the option premium paid. If the market value of the
underlying instrument rises above the break-even point the holder starts making a profit on the
option transaction, and the writer of the option starts taking a loss. The holder of an option is
said to be long on a call option or to have a long position in a call option.

The following is a graph of the profit and loss profile of a long call option with a strike price of
A and a break-even price of B:

From this graph it can be seen that if the market value of the underlying asset is below price A,
the holder of the option will not exercise the option, and the loss will be limited to the premium
paid. Between the market price A and B, the loss of the holder will be the premium paid minus

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the profit on the underlying asset. Above market value B, the holder starts making a profit, and
this profit is in theory unlimited.

The writer of this call option has a different profit profile, opposite to that of the holder. The
maximum profit that the writer can make is equal to the premium that he received when he wrote
and sold the option. He will make this profit if the option is not exercised by the holder (in the
case where the market price of the underlying asset is less than the strike price as can be seen
from fig. 1). In the case where the market price of the underlying asset is more than the strike
price of the option, the holder will exercise the option, and the writer will suffer a loss on the
underlying asset. Where the loss on the underlying asset is equal to the option premium received
by the writer, the break-even point (B in fig. 2) for the writer is found. If the market value of the
underlying asset increases above the break-even point, the writer starts making a loss, as depicted
in fig. 2.

Put options

The holder of a put option has the right to sell an underlying instrument to the writer of the
option at a predetermined price, and for this right he pays a premium on acquisition of the
option. The holder of a put option will only exercise his option if the market value of the
underlying instrument is below the strike price of the option. If this is the case, he can buy the
underlying instrument in the market at the lower price, and sell the instrument to the writer of the
option at the higher strike price of the option. If the market value is above the strike price, the
holder can sell the underlying instrument in the market at a higher price, and will thus not
exercise the option. In this case the holder will suffer a loss equal to the premium paid. The

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profit profile for the holder of a put option is shown in figure 3, where it can be seen that the
break-even point (B) is the point where the profit on the underlying instrument is equal to the
premium paid (A). If the market value of the underlying instrument decreases beyond B, the
holder starts making a profit on the option.

For the writer of a put option, the income profile is opposite to that of the holder. The maximum
profit to the writer is the premium that he received at the first sale of the option. If the market
value of the underlying asset decreases beyond the strike price of the option, he will start making
a loss on the underlying asset position until eventually beyond break-even point B where he
starts to make a loss in total on the option. The writer is said to be short of a put option and his
income profile is shown in Figure 4.

7.4 Option pricing and value

The price of an option (called the premium paid for an option) is split into two different
determinants:

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7.4.1 Intrinsic value

The intrinsic value of an option is the profit or loss that will be made on an option if the option is
exercised immediately (ignoring the premium). This is the difference between the strike price of
an option and the market value of the underlying asset. The intrinsic value could be positive,
negative or equal to 0. Because an option premium cannot be negative, the effect of a negative
intrinsic value on an option premium is limited to the amount that will decrease the option
premium to 0.

If the holder of an option will make a profit on the underlying position by exercising the option
immediately, the option is said to be in-the-money and the intrinsic value is positive. This will
be the case if:

 the strike price is lower than the market value for a call option
 the strike price is higher than the market value for a put option

If the holder of an option will suffer a loss on the underlying position by exercising the option
immediately (ignoring the option premium), the option is said to be out-of-the-money and the
intrinsic value is negative. This will be the case where

 the strike price is higher than the market value for a call option
 the strike price is lower than the market value for a put option.

If the strike price is equal to the market value of the underlying instrument, the option is said to
be at-the-money and the intrinsic value is 0.

Specialised Interest Rate Derivatives

With the fluctuations in interest rates shown in recent years, investors in interest rate products
and lenders who pay interest on their loans have discovered that there are risks attached to their
investments/liabilities which they have not always anticipated. Large losses could be suffered
due to the movements in interest rates. This resulted in specialised interest rate derivatives being

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created in the market to hedge the risk of large financial losses due to movements in interest
rates. These derivatives, although developed to manage the risk of interest rate fluctuations, can
also in certain circumstances be used to hedge other risks, such as price risks, etc.

The interest rate derivatives that will be discussed in this chapter are:

 forward rate agreements

 interest rate swaps

Forward rate agreements (FRA)

A forward rate agreement can offer protection against unfavourable movements in interest rates
for future borrowings or investments. A forward rate agreement determines the interest rate for a
borrowing or an investment for a certain period, with the borrowing or investment starting at a
specified date in the future. The FRA is an agreement based on a notional principal amount, and
the settlement takes place in cash on a pre-specified date that is normally the starting date of the
underlying investment or borrowing.

An FRA will have two interest rates in the contract:

 A fixed rate, which is the rate that the buyer will pay to the seller on the specified loan.
The buyer thus fixes the interest rate that he will pay on a loan.
 A floating rate, which is the rate that the seller will pay to the buyer on the specified
loan. The seller can thus convert his fixed rate loans to a floating rate loan, and gain from
a fall in interest rates.

The fixed rate specified in the contract will be compared to the specific floating rate on the
starting date of the underlying investment/loan, and a net payment will be made by or to the
buyer/seller.

One of the common rates used as the floating rate is the 90-day BA rate converted to a yield.

8.2.2 The working of a FRA

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An FRA is quoted by using the fixed rate, the notional principal, the time until the start of the
underlying loan or investment and the time until expiry of the underlying loan or investment.

The following quote is given on an FRA: 16% on R10 million for 3 against 6 months.

This will fix the interest rate of a loan starting in three months' time and maturing in six months,
at 16%. The total period of the loan is thus 3 months (6-3).

The agreement further stipulates that settlement takes place on the date that the underlying loan
starts, and that the floating rate is the 90-day BA rate converted to a yield.

To calculate the settlement that has to take place under the FRA, the following formula is used:

SA = (Fi - Fli) x d/365 x N

Where

SA = settlement amount

Fi = fixed interest rate

Fli = floating interest rate

d = number of days from the start of the underlying loan/investment until the expiry of the
underlying loan/investment

N = notional principal amount of the agreement.

If the fixed rate is higher than the floating rate (which gives a positive answer to the formula),
the buyer has to pay the seller the settlement amount and vice versa.

If, in the above example, the 90-day BA rate converted to a yield on settlement date (three
months after the closing of the contract) is 16,5%, the settlement amount will be:

SA = (16% - 16,5%) x 91/365 x R10 000 000

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 = (R12 466) to be paid by the seller to the buyer on settlement date.

Interest rate swap agreement

8.3.1 Introduction

An interest rate swap agreement is an agreement between two parties to swap a fixed rate and a
floating rate paid on loans of a certain notional principal for a certain period. If a company, for
instance, pays a floating rate on a loan, and the company is of the opinion that the market rates
and the floating rate will increase, it could swap its floating rate with another company paying a
fixed rate on a loan but with a different opinion about interest rates. In the case of an interest
rate swap (as with an FRA), both parties are exposed to the upside (interest rates moving as
anticipated) and the downside (interest rates moving in the opposite direction from the
anticipated direction).

8.3.2 The working of an interest rate swap agreement

No exchange of principal amounts takes place. The agreement will stipulate:

 a floating rate, which will be paid by one party to the other

 a fixed rate, paid in the opposite direction
 the term of the agreement
 the dates at which recalculations will be made in terms of the difference between the
fixed and floating rates (called reset dates)
 payment or settlement dates as explained in the following example:

ABC Limited borrowed R3 million to build a new shopping complex in a suburb business is
booming. ABC borrowed this amount from BankA over a period of 10 years at a fixed rate of
15%. The company is of the opinion that interest rates will decrease over the next period, and
would rather be paying a floating rate on the loan. The following swap agreement is closed with
XYZ Limited on 1 January 2010.

Principal amount: R3 million

Term of the agreement: 12months

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Fixed-rate payer: XYZ
Floating-rate payer: ABC Limited
Fixed interest rate: 15%
Floating interest rate: 90-day TB rate converted to a yield
Reset dates: Every three months
Settlement dates: Three months after reset date

The spot floating rate on the reset date will be compared to the fixed rate, and a calculation made
for the period from the last reset date (or the starting date if it is the first reset date). The net
payment (settlement amount for that reset period) made on settlement date will be calculated as
follows:

SA = (Fi - Fli) x d/365 x N

where

SA = settlement amount for that reset period

Fi = fixed interest rate

Fli = floating interest rate

d = number of days in relevant reset period

N = notional principal amount

If the fixed rate is higher than the floating rate (which would give a positive answer to the
formula), the fixed-rate payer would make a net payment to the floating-rate payer of the amount
calculated, and vice versa.

If on 1 April 2010 the 90-day TB rate was 14,9%. The following calculations would now be
made:

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Firstly the BA rate must be converted to a yield using the formular:

365 × TBrate
BEY =
365−90∗TB rate

The 90-day BA rate of 14,9% converts to a yield of 15,47%

SA = (15% - 15,46%) x 90/365 x R3 million

= (R3 403) that ABC ltd pays to XYZ on 1 July 2010 (the settlement date for this reset).

On the next reset date, which is 1 July 2010, the same calculation will take place, and the
payment date for this second reset date is 1 October 2010.

Any merchant banks which deal in derivatives will normally give quotes on swaps. They will,
however, also manage their own exposure to swaps from a risk and cash flow point of view. A
bank would try either to cover each swap transaction with another swap agreement which
counter the effects of the first, or take a view on interest rates so that the exposure to floating
interest rates reflects the view of the bank. In the following example, the bank has two swap
agreements:

 The first is on a notional principle of R10 million, where the bank pays a fixed rate of
16% and receives a floating rate of LIBOR plus 2%
 The second is on a notional principle of R8 million, where the bank receives a fixed rate
of 16% and pays a floating rate of LIBOR plus 2%

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The bank in the above situation has an open position in swaps of R2 million. The movement of
rates in the market will not affect the fixed rate payments, but will affect the floating rate
payments. Because the bank receives the floating rate (prime plus 2%) on R2 million more than
it pays on the floating rate, the bank is exposed to floating rates decreasing. In net terms, if the
floating rate decreases, the bank will lose money and if the floating rate increases the bank will
gain. This is similar to a short position in the bond market.

An offset such as the one illustrated above can be done with any two swaps where the same basic
floating rate is used (such as the BA rate or the prime rate, etc.) and where the spread between
the fixed rate and the floating rate is the same.

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