LUDHIANA COLLEGE OF
ENGINEERING AND
TECHNOLOGY
Katani Kalan, Ludhiana – 141113
LECTURE NOTES (UNIT-4)
Course Name: International Finance and
Financial Derivatives (MBA 915-18)
Contact:
Mail: info@[Link],
ludhianalcet@[Link]
international@[Link]
Phone: 0161-2834307 Mobile: 94785-03999,94785-03666
Website: [Link]
SWAPS AND SWAPATIONS
What is a Swaption?
A swaption (also known as a swap option) is an option contract that grants its holder the right but not
the obligation to enter into a predetermined swap contract. In return for the right, the holder of the
swaption must pay a premium to the issuer of the contract. Swaptions typically provide the rights to
enter into interest rate swaps, but swaptions with other types of swaps can also be created.
Understanding Swaptions
In terms of their trading characteristics, swaptions are closer to swaps than to options. For example,
swaptions are over-the-counter securities similar to swaps. In other words, the derivative contracts are
traded over-the-counter, not on centralized exchanges. Also, the swaptions benefit from a great degree
of flexibility since the contracts do not come in a standardized form.
Before the transaction, the counterparties in a swaption must agree on the various features of the
contract. For example, the parties determine the price of the swaption (also known as the swaption’s
premium) and the length of the option.
In addition, the counterparties must decide on the features of the underlying swap. The features
generally include the notional amount, swap’s legs (fixed vs. float), and frequency of adjustment for
the variable leg. Also, the counterparties determine the benchmark for the floating leg of a swap.
Applications of Swaptions
Swaptions come with numerous applications in the investment industry. For example, they are
frequently used in hedging various macroeconomic risks such as interest rate risk. A company
anticipating an interest rate increase may purchase a payer swaption to protect itself from the interest
rate risk. Additionally, the swaption may allow hedging the risks associated with financial securities
such as bonds. Also, financial institutions commonly employ swaptions to change their payoff profile.
Swaptions are primarily employed by large corporations and financial institutions,
including investment banks, commercial banks, and hedge funds.
Types of Swaptions
The classification of swaptions is based on the types of legs involved in the anticipating swap
contract. Based on such a classification, there are two primary types of swaption: payer
swaption and receiver swaption.
With the purchase of a payer swaption, the purchaser obtains the right to enter into a swap contract,
which implies that he or she receives the floating swap leg in exchange for the fixed swap leg.
Conversely, the receiver swaption delivers the right but not an obligation to enter into a swap contract,
in which the holder of a swap must pay the floating swap in exchange for the fixed swap leg.
Execution Styles
Similar to plain-vanilla options, swaption contracts come with different execution styles. In other
words, different swaptions contain different clauses that determine the exercise dates. The most
common swaption styles include European, American, and Bermudian styles.
European swaption: A swaption that can be exercised only on the exercise date.
American swaption: A swaption that can be exercised on any date between the origination
and exercise dates, as well as on the exercise date.
Bermudian swaption: A swaption that can be exercised on several predetermined dates in
between the origination and exercise dates.
The swaptions styles are crucial in selecting the appropriate valuation method. For example, European
style swaptions are typically valued using the Black valuation model. On the other hand, American
and Bermudian swaptions, which are considered to be more complex relative to European options, are
usually priced using Black-Derman-Toy or Hull-White models.
Credit Derivatives
Credit derivatives (CDs) are derivative contracts that enable a lender to transfer a debt
instrument’s credit risk to a third party in exchange for a payment. However, there is no actual
transfer of ownership of the instrument. They protect the lender against the loss associated with the
risk of default by the borrower.
CDs are extensively used in the commercial banking sector across the US. The banks use them to
mitigate credit risk exposure and expand their credit portfolio. In addition, insurance companies also
use them to improve returns on their asset portfolio. CDs are traded over the counter, and their price
depends on the borrower’s credit rating.
Lenders or investors possess varying degrees of risk tolerance. Debt securities come with several
types of risk: interest rate, liquidity, credit, prepayment, etc. To hedge them, investors enter into
a derivative contract. Derivatives are financial instruments that confer the same value as their
underlying financial assets to the holder without the right of ownership over them.
Therefore, a credit derivative is a type of derivative contract that derives its value from the
underlying debt instrument and is used to protect the lender against credit risk. Credit risk means the
risk that borrowers may default on their loan or debt obligations.
To reduce the potential credit risk exposure related to risky borrowers, lenders enter into a CD with a
third party (counterparty) for selling debt securities without the transfer of their ownership. The
counterparty guarantees to cover the default on a loan or debt on behalf of the borrower in return for a
certain sum.
Thus, if the loan account defaults, the lender gets the securities’ value repaid as per the credit
derivative agreement. But if the loan account comes to a successful closure, the counterparty gets to
keep the exorbitant fees it charges for providing the insurance to the loan.
How do the Credit Derivatives Function?
A CD involves mainly three participants:
The borrower who needs credit (reference entity)
The lender who needs insurance for the loan (protection buyer)
The third party or the guarantor who wants to profit by covering the risk of a loan default (protection
seller/counterparty)
Let us suppose that the borrower, an XYZ Coffee Shop, needs a credit line of $100000 for developing
its business. However, the firm has an unhealthy credit rating amongst financial institutions.
Now, suppose the XYZ Coffee Shop applies for the credit of $100000 from the ABX Bank. In that
case, it will face a hurdle in securing the loan from the bank owing to its bad credit record.
In this case, the bank will issue the loan. However, it will enter into a contract with a third party to
mitigate the credit risk associated with the loan. Such a contract is referred to as a credit derivative.
Here, ABX Bank is the protection buyer, the third party is the protection seller, and XYZ is the
reference entity. ABX will have to pay a certain fee to the third party in lieu of covering the risk of
loan default for the term of the CD contract.
The value of the CD will depend on the creditworthiness of the reference entity and the third party.
The CD will enable the bank to transfer the entire loan default risk to the guarantor or the third party.
Therefore, if the XYZ coffee shop defaults on its loan, the third party will pay the remaining amount
or the interest of the loan to the bank and close the loan. However, if the XYZ Coffee shop doesn’t
default upon its loan, the third party retains the fees on the CD contract.
Hence, in the light of the above explanation, we can see that the CD has:
Enabled the credit line to the XYZ Coffee Shop
Covered the credit risk of the loan account of the ABX bank and
Benefitted the third party in terms of fees received from the ABX bank
Types of Credit Derivatives
CDs are useful instruments for offloading a lender’s credit risk to a third party and securing its credit
asset. There are two main categories of CDs: Unfunded and Funded.
1 – Unfunded Credit Derivatives
Unfunded CDs are instruments where the protection buyer (lender) does not receive any initial
payment from the protection seller (counterparty) for covering the credit risk. Under such a contract,
the counterparty pays only when the borrower defaults. Therefore, unfunded CDs expose the lender to
the risk of default from the counterparty.
There are different types of unfunded CDs.
Credit Default Swap (CDS)
In this type of contract, both the protection seller as well as the protection buyer of the credit asset
negotiate a deal where:
The buyer undertakes to make regular payments (swap spread or premium) to the seller over the term
of the contract, and
The seller makes good the loan in the event of default by the borrower or reference entity.
It is the most popular derivate product, widely used in the commercial banking sector.
Credit default swap option
It is a contract that offers its buyer a right, without obligation, to enter into a CDS agreement on a
future date at a specific strike price.
Credit spread option
This type of CD involves simultaneously buying and selling an option of the same class (with the
same underlying asset and expiry date) at a different strike price. The difference in the strike prices
yields profit.
Total-rate-of-return swap
It involves the transfer of both credit and interest rate risks associated with the underlying financial
asset to a third party. Here also, the transfer of risk is without the transfer of the ownership of the
underlying asset.
2 – Funded Credit Derivatives
Funded CDs are instruments where the lender is not exposed to the credit risk from the counterparty.
This is because the counterparty pays an appropriate sum to the lender to cover any loan default in the
future. Now, let’s discuss the different types of funded CDs.
Credit linked note (CLN)
It is a type of funded CD that allows the protection seller to transfer a specific set of its credit risk to a
third party (investor in the note). If the borrower doesn’t default, the note is redeemed at par at
maturity. However, if the default occurs, it is redeemed at less than the par value.
Constant Proportion Debt Obligation (CPDO)
It is a type of CD that allows the investors exposure to credit risk through a note that has the credit
rating embedded in it. This is done to utilize the dynamic leveraging of trades. CPDO offers high
yields with low credit risk.
Collateralized debt obligation (CDO)
It is a form of CD where banks collect all their loans and make a bundle that acts as debt instruments.
These instruments are backed by an asset or collateral security and then sold to the investors in small
parts after splitting them into tranches. They are only available for sale to institutional investors.
FOREIGN EXCHANGE RISK MANAGEMENT
Foreign exchange risk, also known as exchange rate risk, is the risk of financial impact due to
exchange rate fluctuations. In simpler terms, foreign exchange risk is the risk that a business’ financial
performance or financial position will be impacted by changes in the exchange rates
between currencies.
The risk occurs when a company engages in financial transactions or maintains financial statements in
a currency other than where it is headquartered. For example, a company based in Canada that does
business in China – i.e., receives financial transactions in Chinese yuan – reports its financial
statements in Canadian dollars, is exposed to foreign exchange risk.
The financial transactions, which are received in Chinese yuan, must be converted to Canadian dollars
to be reported on the company’s financial statements. Changes in the exchange rate between the
Chinese yuan (foreign currency) and Canadian dollar (domestic currency) would be the risk, hence the
term foreign exchange risk.
Foreign exchange risk can be caused by appreciation/depreciation of the base currency,
appreciation/depreciation of the foreign currency, or a combination of the two. It is a major risk to
consider for exporters/importers and businesses that trade in international markets.
Types of Foreign Exchange Risk
The three types of foreign exchange risk include:
1. Transaction risk
Transaction risk is the risk faced by a company when making financial transactions between
jurisdictions. The risk is the change in the exchange rate before transaction settlement. Essentially, the
time delay between transaction and settlement is the source of transaction risk. Transaction risk can be
mitigated using forward contracts and options.
For example, a Canadian company with operations in China is looking to transfer CNY600 in
earnings to its Canadian account. If the exchange rate at the time of the transaction was 1 CAD for 6
CNY, and the rate subsequently falls to 1 CAD for 7 CNY before settlement, an expected receipt of
CAD100 (CNY600/6) would instead of CAD86 (CNY600/7).
2. Economic risk
Economic risk, also known as forecast risk, is the risk that a company’s market value is impacted by
unavoidable exposure to exchange rate fluctuations. Such a type of risk is usually created by
macroeconomic conditions such as geopolitical instability and/or government regulations.
For example, a Canadian furniture company that sells locally will face economic risk from furniture
importers, especially if the Canadian currency unexpectedly strengthens.
3. Translation risk
Translation risk, also known as translation exposure, refers to the risk faced by a company
headquartered domestically but conducting business in a foreign jurisdiction, and of which the
company’s financial performance is denoted in its domestic currency. Translation risk is higher when
a company holds a greater portion of its assets, liabilities, or equities in a foreign currency.
For example, a parent company that reports in Canadian dollars but oversees a subsidiary based in
China faces translation risk, as the subsidiary’s financial performance – which is in Chinese yuan – is
translated into Canadian dollar for reporting purposes.
