A review: pricing and valuation of interest rate swaps
In this first session we review the methodology for pricing and valuation of generic and simple non-generic swaps, and examine the practical steps of constructing swap discount curves. Knowledge of the contractual structure and mechanics of interest rate swaps is assumed.
– Review of theoretical basis of swap pricing
– Fair value = cost of replication
– Modeling the deterministic discount curve
– Blending different market data sources:
– Cash rates, Swap rates and Bond yield data
– Interest rate futures data
– Adjusting for convexity bias in futures data
– Bootstrapping’ market data to generate a deterministic discount function
– Practical challenges in deriving benchmark curves in illiquid markets
– Interpolation methods – different methods; advantages and shortcomings
– Curve fitting and smoothing techniques
– Practical pricing and valuation applications:
– Mark to market - swap portfolio valuation
– Swap terminations and assignments - fee estimation
Recent developments in swap pricing
– Swap pricing incorporating funding risk
– Adjusting pricing to incorporate non-LIBOR funding
– LIBOR – OIS spread: funding risk premium
– Collateral agreements (CSAs)
– Impact of CSA on counterparty risk
– Adjusting discount curves for swap pricing:
– Non-CSA
– CSA curve
– ‘Cash out’ and ‘cash in’ curves
– CDS adjusted Non-CSA curves
– Incorporation of counterparty risk in pricing
– Computing DCA (Derivative Credit Adjustment) from CDS premia
WORKSHOP: Pricing and valuation of generic swaps
Non-generic swaps – structuring, pricing & applications
– Forward start swaps - structures and pricing
– Amortizing and Roller coaster swaps
– Deferred coupon, stepped coupon and zero coupon swaps
– Adapting the pricing framework to non-generic structures
– Pricing adjustments for funding and counterparty risk
Day 2
Asset swaps
– Structuring and pricing methodologies for asset swaps
– Par/par asset swap
– Yield/yield asset swap
– Market value accrued (MVA) asset swap
– Yield curve shift (YCS) – Z-spread analysis
– Pricing adjustments for funding and counterparty risk
– Advantages and shortcomings of different methodologies
– Using asset swaps in asset restructuring
– Using asset swap pricing in RV analysis
– Credit Default Swaps (CDS)
– Over of CDS contract mechanics, market conventions
– Pricing CDS
– Arbitrage based approach i.e. replication using asset swap
– Understanding the relationship between CDS premia and Asset swap spreads
– Determinants of the (Asset swap - CDS) basis
WORKSHOP: Identifying asset swap opportunities; Structuring and pricing and asset swaps
Overnight Index Swaps (OIS)
– Mechanics of overnight index swaps
– Calculating the overnight index rate – actual funding rates
– Conventions of different OIS markets (EONIA, SONIA etc.)
– Computing the compounded average overnight rate leg
– Constructing the OIS curve
– Pricing and valuation of OIS
– Convexity effects in pricing
Basis swaps
– Floating – floating index swaps
– Tenor basis swaps
– Alternative reference indices (CP, Prime, Fed Funds etc.)
– Uses and applications in asset-liability management
– Theoretical framework for pricing basis swaps
– Rationalizing (tenor) basis swap margins
– Supply-demand drivers
– Counterparty risk of mis-matched payment cycles
– Liquidity/funding risk
– Incorporating actual funding rates into pricing
Pricing and valuation of cross currency swaps
– Generic and non-generic cross currency swaps
– Cross currency coupon swaps
– Basis point conversion factors
– Cross-currency basis swaps
– Theoretical framework for pricing CC basis swaps
– Rationalizing CC basis swap margins
– Supply-demand drivers
– Liquidity/funding risk
– Recognition of actual funding rates in pricing
– Skewness of FX forwards; impact on pricing
– Hedging cross currency basis swaps
– Accounting for cross currency basis swaps
– Building adjusted swap curves for valuation of cross currency swaps
WORKSHOP: Identifying arbitrage opportunities; structuring a new issue driven cross currency swap
Day 3
Interest rate options: caps and floors
– Generic interest rate caps and floors
– Conventional pricing methods: Black (1976) model
– Why do markets use this model? Advantages and disadvantages
– Calibration to a volatility surface
– Put-call parity relationships: Caps, Floors and Forward swaps
– Hybrid structures and combinations:
– Interest rate Collars / Participating swaps
– Collared swaps; embedded caps and floors
– More complex structures: Mid-curve caps; periodic caps; barriers
Interest rate options: swaptions
– European and Bermudan style swap options
– Pricing: Black vs. Term structure models
– Calibration of swaption volatility surfaces
– Compatibility and consistency with Cap pricing
– Option Embedded Swaps
– Extendible and cancellable swaps (European, Bermudan styles)
– Structured (callable, puttable) bonds; call monetization
– Balance guarantee swaps, index amortizing swaps (IAS)
Advanced interest rate modeling
– Stochastic term structure models
– Numerical methods
– Single-factor models (BDT, HW)
– Calibrating arbitrage-free bimonial, trinomial models
– Multi-factor models
– BGM (LIBOR) market model
– Model implementation by simulation
– Calibration to cap/swaption volatility surfaces
– Specifying the forward rate correlation matrix
WORKSHOP: Calibration of term structure pricing model; pricing and valuation of complex interest rate derivatives
Constant maturity swaps
– CMS structures; market conventions
– Pricing and valuation of CMS swaps
– Determination of convexity bias
– Risk management: managing Delta, Vega and Gamma risks
– Using swaptions for pricing and replication
Arrears swaps
– LIBOR-in-arrears swaps
– Arrears Coupon and Basis swaps
– Pricing and valuation of Arrears swaps
– Convexity bias in pricing arrears and other mis-match structures
– Estimation of convexity adjustment
Inflation swaps
– Index linked securities; structure and mechanics
– Rationale for investors and issuers
– Inflation derivatives
– Inflation swaps (fixed rate, basis swaps [CPI/HICP])
– Caps and floors
– Market development
– Inflation swaps: basic mechanics and structure
– Pricing and valuation of Inflation Swaps
– Constructing the forward inflation curve
– Pricing and valuation of inflation swaps
– Pricing inflation – LIBOR swaps
Differential (Quanto) swaps
– Structures and applications
– Pricing and valuation considerations
– Volatility and Correlation effects
– Dynamic risk management of quanto structures
Day 4
Swap portfolio risk management
– Interest rate risk measures: Delta (DV01), Gamma and Vega
– Linear risk analysis: Constructing a Delta vector risk report
– Yield curve risk analysis; parallel and non-parallel shifts
– Risk reporting: creating a replicating portfolio (futures, bond, swap) equivalents
– Hedging swap portfolios: Basis risks in portfolio hedging
– Non-linear instruments and risks: Gamma and Vega risks
– Constructing Vega and Gamma risk matrices
– Dynamic hedging of Vega and Gamma risks
– Value at Risk
– A VaR based approach to analyzing and managing swap portfolio risk
WORKSHOP: Hedging a swap transaction; Risk analysis of swap portfolio; Delta risk measurement and replicating portfolio construction.
Interest rate linked structured products
The objectives of this session are to, with the aid of example transaction term sheets, illustrate key product types, and to understand in greater detail how to break down such instruments into their component derivatives, and to price and value such instruments. The primary focus will be to focus upon the quantitative basis of pricing and valuation, and measurement of product market risk exposures, as well as the understanding the operational mechanics and implications of different product types, and investor motivations and risks.
– Structured notes; securities with embedded options and other derivatives
– Use and applications of embedded derivatives
– Rationale for issuers and investors
– Yield enhancement – creating new asset structures
– Range notes
– Guaranteed returns; principal protection
– Risks of structured debt instruments:
– Market risks
– Structured interest rate linked products:
– European / Bermudan callable bonds
– Range Accrual
– LIBOR
– CMS-linked
– Capped, floored FRNs
– Inverse FRNs
– TARN structured notes
CASE STUDY: Analyzing a reverse floater with embedded options
CASE STUDY: Pricing a cancellable swap; Bermudan step-up Callable bond
CASE STUDY: Pricing CMS – linked note.