BILL FRENCH CASE
Submitted By: Pratichi
Sharan Section B
Question 1: What are the assumptions implicit in Bill Frenchs
determination of his companys break-even point?
The following assumptions are implicit in Bill Frenchs determination:
He has assumed tha
The deals of currency swaps are structured by a bank which also routes
the payments from one party to another. Currency swaps involve exchange of
assets and liabilities. The structure of a currency swap agreement can be
understood with the help of the fol
face value. E.g. bid price of 6 % of Dec. 06 T-note is 100 and
4/32% of face value.
The US government has the option of calling the bonds away
from their owners before maturity and are called callable
T-bonds. E.g. 12% of Nov. 09-13 T bonds are first
Suppose an FRA in which a financial institution agrees to earn an
interest rate of Rk for the period of time between T1 and T2 on a principal
amount of L.
Let RF is the forward LIBOR interest rate for the period between T1
and T2. R is the actual LIBOR in
to floating swap, one party pays one floating rate and the other pays another
floating. Forward swaps include exchange of interest rate payments that do
not begin until a predetermined future date in time. In a swaption, the
features of swaps and options
If m = 3 or 9 months, then the CBOT estimates allowed interest
to be c/4 (half a semi-annual coupon). Under these assumptions,
the price of the bond if YTM is 3% will be:
C /2 + C /2(PVIFA3%,2 y+1 ) + 1(PVIF8%,2 y+1 ) C
(1 + 0.03)0.5
if m = 9.
In the recent past, there has been integration of financial markets
world-wide which have led to the emergence of some innovative financial
instruments. In a complex world of variety of financial transactions being
taken place every now a
1 + y/7
(1 + y)
Hence the modified duration is the relative price change with respect to
change in yield.
In the above Table 4.1 the price of the bond is 94.213 and duration is
2.653. The view expressed in semi-
Fabozzi et al., Foundations of Financial Markets and
Institutions, Pearson Education inc. Delhi, 2002.
Gupta, S.L., Financial Derivatives (Theory, Concepts and
Problems), Prentice Hall of India Ltd., New Delhi, 2005.
Hull, John C., Options, Futures and O
the hedge ratio, which denotes the number of futures contracts made by
comparing relative price sensitivities of futures and cash instruments. With
the help of duration period and regression method, this hedge ratio can be
calculated. Minimum hedge ratio
rs = a + brF.
where rs is historical changes in interest rate of the cash instrument
rF = Historical changes in the futures interest rates.
a, b = Regression coefficients
The hedger will be interested in seeking a relationship between yield
For infinitesimally change in yield curve ( y) the bonds price will be
changed as B shown by following equation.
= D y
Hence from relationship expressed by equation (4.6) it is clear that the
percentage change in bond price i
Theories determining term- structure: There are two types of risks
associated with interest bearing securities. Interest risk arises due to
changing nature of macro-economic variables such as inflation, money supply,
growth rates, government policy and ex
3.6.1 Monitoring of hedge
To monitor the hedge on a continuous basis the following information
should be looked for:
Cash/spot position: The hedger should have an idea of the current
position in cash/spot and the relevant changes in the same. The gains/lo
4.2.4 Zero rate
An n-year zero interest rate is the interest rate on an investment which
starts on todays date and last for n-years. In this time period no intermediate
payment is made. All the interest and principal payment is realized at the
end of n-ye
Hedging with T-bond futures
Fixed interest bearing securities have risks associated with the volatile
interest rate markets. Unfavourable interest rate change may lead to
potential capital loss to the investors. Interest rate futures have been devised
fixed and pay floating. These rates are quoted for the number of maturities
and number of different currencies. The following table 5.1 shown an
illustration of the quotes where payments are exchanged semi-annually.
TABLE 5.1: BID AND OFFER RATES IN A SWA
price sensitivity w.r.t. interest rate changes. In other words, a high duration
bonds price is more sensitive to interest rate changes than the low duration
bond. It is also defined as the weighted average as the maturities of the
bonds coupon and the pri
Self assessment questions
What do you understand by hedging? Explain the concept with
Discuss various concepts of hedging with suitable illustrations.
Hedging prevents the investor from future price fluctuations? Do
4.3.5 Euro Dollar Futures
Dollars deposited in foreign banks are known as Eurodollars. This
practice was started in Europe to gain higher yield available on other
instruments in US money market. The foreign banks offer attractive interest
on deposits beca
fixed rate at 68 basis points above (i.e. 5.95 + 0.68 = 6.63%) the Treasury
yield. Another example to understand the concept: Suppose a bank quotes a
US dollar floating to a fixed 6-years swap rate as:
Treasury + 30 bp/Treasury + 60 bp vs. six months LIBO
to initiate trading in long-term interest rate futures with the introduction of
T-bonds by CBOT in 1977. Other countries like Japan, France and UK have
long-term interest future market with almost similar pricing mechanism and
TABLE 4.2: CALCULATION OF FORWARD RATES
Zero rate for an n-year Forward
investment (% p.a.)
year (% p.a.)
Thus a 10% p.a. rate for one year means that in return for an
Rationale behind swapping
To avoid risk of fluctuation in forex, interest rates, stock indices
investors attitude etc. the swap market has merged now to explain that why
firms and people want to enter into swap agreement. The rationale can be
brokerage, fees, translation and management costs etc. For this purpose expost measure of effectiveness should be calculated with the help of deviation
or significant difference between the anticipated and ex-post hedged strategy.
Hedging is a
portfolio of Rs. 1,00000 is vulnerable contracts.
to increase in long-term interest rate.
reflecting 6% p.a. interest rate.
Long term interest rate rises to 71% Closes out by buying 4 futures bond
p.a. The value of b
interest rate bonds. The discount rate used reflect the riskiness of cash flows.
Generally the fixed rate interest cash flows have almost similar risk as the
floating rate flows. This is so because in case of one party making default, the
other will termi
What are currency swaps? Discuss various features and types of
currency swaps with suitable examples.
Explain various factors affecting the valuation of swaps. How
will you calculate the value of interest rate swap?
The valuation of currency swap